This report is targeted towards those new to Risk Management. BitOoda strives to not only help clients with execution, but advise on prudent approaches to identifying and mitigating risk.
We will structure the discussion in the following sections:
I. Defining market risk
II. Pros and Cons of engaging in a risk management program citing common pitfalls
III. Market risk management framework
I. Definition of market risk
- “Market risk encompasses the risk of financial loss resulting from movements in market prices” (per US Federal reserve https://www.federalreserve.gov/supervisionreg/topics/market_risk_mgmt.htm).
We broadly think of Market Risk as a variability of an entity’s cash flows due to market events.
For most crypto market participants, the main Market risk is the price movement of the cryptocurrency. However, other risks, such as electricity price for producers, FX fluctuations for payment processors, interest rate, etc., may be significant depending on one’s particular business.
Before engaging in a risk management program, a firm should consider:
· It’s ability to identify and correctly quantify the exposure (magnitude) of market risk
· The availability of counterparties willing to provide risk management at acceptable prices (plenty of enterprises de facto self-insure due to lack of available hedging vehicles or prohibitive pricing)
· Is risk mitigation part of the firm strategy? Knowing your risk and being comfortable with it, while considered speculative from a trader’s perspective, is not necessarily imprudent. Not knowing your risk is.
II. Pros and Cons of Engaging in Risk Management
Effective risk management reduces variability of cash flows; it does not necessarily improve cash flows. As a matter of fact, most of risk management products come at a cost in the form of transaction fees and directly in the form of the cost of some of the derivative products (like financial options costs). Essentially, one ends up paying somebody else to manage one’s risk. So why do then firms engage in risk management?
Pros of engaging in a Risk Management program:
1) Operational focus — Example: a world-class low-cost miner may want to mitigate the risk of a crypto asset price to prevent running it’s mining below break-even costs, avoiding management distraction due to market fluctuations, insuring survival versus less prudent competitors in a bear market scenario, and adding certainty around capex planning.
2) Asset/liability matching — Reducing variability in revenues and/or costs can allow for easier long-term planning, and reduce bankruptcy risk.
3) Capital efficiency — Predictable cash flows allow for easier capex planning. Firms can increase their borrowing levels to increase their return on equity. Owners can take advantage of the debt tax shield in jurisdictions where interest payments are tax deductible without exposing themselves to the risk of insolvency.
Cons of engaging in a Risk Management program:
1) Inability to quantify market risk exposure — If risk is incorrectly identified then a hedge will not reduce volatility of cash flows but rather swap one kind of risk of another, leading to unexpected surprises. Solution — We would advise to search for either in house or external (BitOoda) expertise in risk assessment before engaging in a hedging program.
2) Hedging not cost effective — If transaction costs are very high and/or the market is not developed enough to provide desired level of risk protection at an acceptable price it may be reasonable to manage risk in house. Options such as reducing leverage, executing only partial hedges, seeking operational flexibility or excellence all contribute to higher probability of a firm’s survival and success. Solution — Use of experienced brokers, such as BitOoda, who can negotiate within the market and execute derivatives strategies to get best pricing.
3) Unacceptable Credit risk — Swapping Market risk for Credit risk is a common pitfall. A hedger has to make sure the counterparty will honor the hedging contract in an adverse event. If no well capitalized exchanges or counterparties are available hedging becomes ineffective. Example: many banks purchased credit default swaps from AIG in the run up to 2008 subprime housing crisis. Needless to say, the protection they purchased became useless since AIG did not have the capital to back up the claims.
4) Unfavorable margining terms — Derivatives contracts usually require margining. When prices move unfavorably against one of the parties in a transaction, it has to post cash or other assets according to a predetermined schedule to mitigate credit risk to the other side. A hedger has to make sure this margining does not result in a liquidity crisis where the operations are excellent (hence the hedge is losing money) but there is no immediate cash available to post margin. A classic textbook example of this is Metallgesellschaft debacle (https://financetrain.com/risk-management-case-study-metallgesellschaft-ag-mgrm/). Solution — transacting a derivatives contract, BitOoda recommends counterparties should enter into an ISDA contract with a CSA (Credit Support Annex). This CSA would set the margining terms of the trade i.e. posting cash, coin, mining equipment, etc. as collateral.
Finally, you must ask yourself, is risk exposure a desired strategy? If owners and/or management WANT market risk as a core strategy in current market conditions, then they would not hedge their risk. Example: an investor may seek ownership in a miner as a leveraged bet on a crypto asset price recovery. If the miner hedges its exposure fully, the investor will be disappointed in the lack of appreciation in his holding during a recovery. One has to realize that such desire not to hedge may be temporary. It is essentially a market view. If prices recover well beyond mining cost and opposite view and a desire for an aggressive hedge may develop.
III. Market risk management framework
We advise hedgers to adopt a disciplined formalized approach to risk management.