How to hedge against DeFi risks?

The price fluctuations of cryptocurrencies have not extinguished people’s enthusiasm for DeFi. Although DeFi is a flower in the decentralized world, everything is risky, and DeFi is no exception.

So what should we do if we want to hedge the risks of DeFi?

The recent indicators show that options can be regarded as a hedging tool.

The following is to understand the overall market situation from the perspective of DeFi, and on this basis, the methods to solve its problems are proposed. The article is simple and easy to understand.

introduce

During the fall of the crypto market, DeFi users found themselves like crayfish in boiling water. With the sharp drop in the price of mortgage assets, the funds of DeF miners are on the verge of liquidation, and most of them don’t even realize this.

If there is a theoretical wave of selling, you and I may see a large-scale liquidation of DeFi assets. For new DeFi users, this will be the first important lesson about the risks associated with this asset class.

DeFi users

If the price of collateral assets falls, this will expose a large amount of capital to liquidation risks, creating conditions for price fluctuations in March 2020. For position holders-those who are not actively trading in the market-these conditions are not ideal. This creates a good opportunity for traders.

However, the reality is that most crypto traders are not ready to recognize this market trend. The unique feature of DeFi assets is that almost all transactions with them are conducted outside the exchange. There is no order book, and there is no ratio between longs and shorts. Tools for more accurate warning of market adjustments have just been developed. Although these developments are very new, the first traders to apply these methods and techniques will be able to reap the greatest benefits.

Let’s try to understand market conditions through a DeFi perspective, what this means for the price behavior of underlying crypto assets, and how traders can profit from the combination of these factors.

Ready

In the past 30 days, 474000 ETH and 9071 BTC have been transferred to DeFi. This can be seen more clearly in the DeFi Pulse diagram below.

The first chart shows that Ethereum locked by DeFi increased from 9.35 million to nearly 9.9 million.

How to hedge against DeFi risks?

The second chart shows the number of BTC locked in the DeFi contract. The trends are similar. In the last 30 days of the study, this number increased from 180,000 bitcoins to 192,000 bitcoins.

How to hedge against DeFi risks?

This is a significant increase in a short period of time. When it comes to DeFi, most of the assets are locked in smart contracts so that users can use them to borrow. This allows the borrower to generate a rate of return higher than the loan interest rate, or achieve the same rate of return through leveraged capital transactions.

Thanks to the collateral, this is possible. Therefore, as long as the value of the frozen funds exceeds the loan amount, everything is good. Normally, the initial cost of frozen collateral is 200% or more of the loan amount. In other words, the value of the mortgaged asset is twice the loan amount.

In other words, this is a measure of the risk that DeFi users take on their locked encrypted assets. Due to the value of frozen assets, for example, due to the value of frozen assets when the price of ETH falls, the mortgage rate of issued loans will also fall. This is where everything I mentioned above comes into play, and things start to change interestingly.

For clarity, let’s look at an example: if a user deposits 10 ETH at a price of 402 USD, he can obtain 2010 USD collateral with a collateral rate of 200%.

But when the price of ETH dropped from $402 to $300, the ratio of the value of the collateral to the loan amount was no longer 200%, but 149%. When this ratio drops to about 113% (collateral cost is about $2275), the 10 ETH contained in the DeFi contract can be liquidated.

According to this mathematical calculation, this happens when the price drops to $227. This means that, roughly speaking, if the price of ETH reaches $227, the above 2.5 million ETH will be traded on the market. The main content here is to understand how the described mechanism works.

(Knocking on the blackboard) It is important to remember:

For example, last September, the price of gold fell from $490 to $310 in just a few days. The liquidation will not start at $227. At this level, we will see the main part of the funds locked in the DeFi contract. In fact, assets locked in 200% of collateral near the peak of $490 were not affected by the fall in September. The price of ETH is about $280.

However, we have seen the beginning of this liquidation wave.

Look at the few pages of clearing records from September 5th, when the price reached the lowest point of last year.

So this is just a glimpse of what might happen when prices fall. At a price level below $280, traders should expect that with the liquidation of DeFi contracts on the open market, the market will be forced to sell in an avalanche style.

Although it is not necessary to precisely lock most of the tokens in the MakerDAO smart contract, in most cases, most of these tokens are locked there. For example, YETH is one of Year.finance’s most popular repositories. It is one of the 10 largest pools on MakerDAO. The key to this situation is that most users are not aware of this risk.

This is why forced selling is a real risk and sets the stage for radical price fluctuations.

How to hedge against DeFi risks?

what can we do about it?

The pattern of the encryption circle is changing. New DeFi products enter the market every day, attracting a wave of former coin holders. In essence, these products create a market where users no longer just use spot leverage, but use their own assets.

This means that the market itself is undergoing a transformation, and more crypto assets are being leveraged. You may or may not know that the higher the leverage, the greater the volatility.

We can compare her to the engine of a car. With the increase in power and other improvements, it will be able to get the car from point A to point B faster, but at the same time, higher speed means higher risk. At high speeds, even small bumps on the road or wet asphalt can cause fatal accidents. The same is true in the market: if market instruments generate more profit for every dollar of ETH or BTC price changes, the risk of serious accidents will increase.

A one-day price drop is no longer just a bad day, it can mean almost complete capital loss. This is why it is important to remember safety measures.

So, in this constantly changing situation, how can traders predict and stay ahead? Or how to improve the safety of funds while improving profitability through DeFi?

Expand your toolbox

The indicators that most traders are accustomed to will no longer be as reliable as before. The transaction volume on the DeFi platform is increasing day by day. Liquidation levels, leveraged positions, profits and losses are no longer limited to the largest centralized exchanges.

This also means that the inflow and outflow of cryptocurrencies from exchanges no longer provides an overall picture of the buying or selling pressure of asset prices. Therefore, traders need to use tools to handle the trading volume of decentralized exchanges, the profitability of various assets, the clearing rate of DeFi smart contracts, and even the state of the network memory pool. The latter factor is unique because it is not An increase in the number of confirmed transactions or network congestion may lead to greater price fluctuations.

Use derivatives

The increase in volatility brings new opportunities. This is the dream of every trader. When prices fluctuate more frequently and violently, more opportunities for profit-taking will be created. On the other hand, an increase in price volatility means an increase in the possibility of losing a position, even if it is a correct entry. This is a very unpleasant experience.

This is why many traders start to use options. They allow traders to take advantage of this volatility by ensuring that they are not eliminated due to reasonable open positions. This is a simple way to increase the chances of successful trading.

However, options are not only useful for traders. Crypto investors exploring the possibilities of DeFi should also consider using options to hedge risks.

For example, if a new project promises a rate of return of more than 200% on ETH, users can “ensure” their capital from loss by purchasing put options. This will enable him to compensate for losses that may occur during the liquidation of the collateral. Of course, this may reduce profitability by a few percentage points, but it allows DeFi miners to explore riskier projects and allocate more funds to DeFi without sacrificing security.

example:

If a DeFi user believes that he may lose 13% of his capital when placing 100 ETH and 200% collateral at a price of $402, he can purchase an appropriate number of put options. If the price of ETH moves to a clearing level of around $300, he will get a profit of at least $102 for every contract bought at $402. In this way, he can buy approximately 0.33 ETH for each option.

Due to the (implied) low volatility, the value of the near-value put option after two months is approximately 0.1 ETH. This means that each bearish contract makes a profit of 0.23 ETH.

The user has the risk of losing 13 ETH in 100 ETH capital and can hedge this loss. If he buys ETH put contracts at a premium of 0.1 ETH per contract, and the price drops from $402 to $302, then his put contracts are worth 0.23 ETH each. For a contract worth 5 ETH, this is equivalent to 50 contracts, or a potential profit of 11.5 ETH, which almost covers the loss of clearing DeFi collateral.

This small scenario illustrates the importance of risk management in DeFi and provides an example of how to hedge DeFi risks.

The importance of this cannot be overstated. Options can be a good hedge against the risks of DeFi mining.

 

Posted by:CoinYuppie,Reprinted with attribution to:https://coinyuppie.com/how-to-hedge-against-defi-risks/
Coinyuppie is an open information publishing platform, all information provided is not related to the views and positions of coinyuppie, and does not constitute any investment and financial advice. Users are expected to carefully screen and prevent risks.

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