Cryptocurrencies, and Bitcoin in particular, are becoming increasingly popular. As they get more widely accepted, the interest of investors grows as well. Bitcoin adoption by institutions is on the rise and investment banks have begun to offer Bitcoin investment products due to the demand of their clients.
There are a lot of positives linked to cryptocurrencies as they are not heavily correlated with traditional markets. This can turn them into good additions to portfolios. This will spread out the overall risk. Having that said, cryptocurrencies can still remain volatile assets with all the additional risks. This does not have to be a negative factor when only a separate/smaller portion of a portfolio is allocated to this segment, but portfolios that are heavily concentrated on simply opening long positions in cryptocurrencies can possibly get hit hard during corrections and bear markets. The Bitcoin Volatility Index shows the volatility of Bitcoin since October of 2020.
During times that Bitcoin becomes volatile, altcoins usually tend to move in an even more extreme fashion.
Because of the high volatility in the cryptocurrency market some might choose to allocate their capital to different strategies in order to diversify their risk profile. One way to do so is by looking towards staking and the DeFi industry which is offering investors a wide range of solutions that allow them to generate yields on their investments.
When generating a yield on cryptocurrencies such as Ethereum by utilizing a lending protocol like Aave or Compound, investors can maintain a long position while increasing their position size over time, somewhat cushioning any potential drawdown of the underlying asset. But this is a slow process and the fiat value of the portfolio still can fluctuate widely.
When utilizing a lending protocol to earn a yield on stablecoins there is no additional market risk involved, only the return on the stablecoin. This can then be used as a buffer to buy additional cryptocurrencies on significant dips should they occur.
Although a very attractive tool to increase returns, the use of DeFi solutions has its risks. There have been many instances where these projects became the victims of exploits that sometimes result in losses worth tens of millions of dollars. Rek.news is a website dedicated to these events. Their leaderboard shows some of the most costly exploits and hacks. Insurance can be purchased for many DeFi solutions, but the premium that is paid lowers the yield as well.
Another solution would be to use recently announced permissioned offerings that leverage DeFi such as Coinbase, Aave, and Compound that offer institutional investors a stable yield. Compound and Coinbase have announced this to be 4% on stablecoins. Although this is significantly higher than banks offer on their savings account currently, it is still a relatively low yield that will not make too much of a difference on an investment portfolio in crypto.
Arbitrage strategies are focused on capitalizing on inefficiencies in the market such as different prices for the same asset across different exchanges. This is just one example. As long as there are inefficiencies, there are arbitrage possibilities. Algorithms are designed to do this automatically. Because of the nature of this strategy, the returns are delta neutral, meaning that the direction of the market is uncorrelated with the returns of the strategy.
It also offers a way to potentially earn significantly more fiat over time which can then be used in bear markets to accumulate more cryptocurrencies for the investment portfolio.
Despite the delta neutral nature, algorithmic trading has its risks as well such as network connectivity errors, system failure, a technical glitch and bugs in the program.
So while cryptocurrency investments can generate massive returns, they also bring a lot of risk to portfolios due to the significant volatility. The DeFi industry offers certain diversification options in terms of additional (stable) yields. However, these also bring other risks and often generate low yields or are cumbersome to use. Arbitrage strategies through the use of algorithms can bring an additional delta neutral money stream to the portfolio with its own set of risks.
By combining different investment strategies such as going long on cryptocurrencies, utilizing DeFi to generate a yield, and using arbitrage to capitalize on inefficiencies, a portfolio can become a lot more balanced in this volatile market. The additional yields on the delta neutral strategies could then be used to increase the long positions during bear markets.