VARiM(Forward-looking risk management)

The importance of risk management cannot be overemphasized as the Crypto Market is a market with very large volatility and frequent creation and disposal of traded assets. If the protocol allows for leverage, intelligent risk management methods are needed to maintain the stability of the pool. In an environment where daily fluctuations exceed 30%, such as cryptocurrencies, and operates 24 hours a day, 365 days a year, a risk management method that is too complex, difficult to understand, or takes a long time to calculate is not appropriate. The above-mentioned conditions are essential because any type of risk management method must be finally executed on the block chain in the end.

Existing Risk Management : Notional Limit

Many DEFI Protocols use notional limits as a risk management method. Notional Limit is a method to set a specific value and execute risk management when an event larger or smaller than the set value occurs. For example, if the value of the collateral becomes less than the set value of 1.1, it is a method of liquidation. This method is simple, intuitive, and has features of not complicated calculations.

However, Notional Limit has two major problems. 1) Asset comparison is impossible and 2) it is a backward-looking measure.

No Asset Comparison

Notional limit is used by setting a threshold value for all assets or individual assets. Since this method simply judges whether or not a set threshold value exceeds a set range, it is difficult to compare and determine which asset volatility is increasing and which asset volatility is decreasing by comparing the risk of each asset class. For example, as of today, when there are three assets: BTC, ETH, and ADA, it is difficult to compare and find out which asset's volatility is increasing. So, since the volatility of each asset in the pool cannot be compared, it is impossible to know which assets in the pool should be reduced and which should be increased. Notional Limit simply compares with the threshold value, so it only informs whether the event has occurred or not, but does not provide any other information related to volatility.

Backward-Looking

It can be said that the critical problem of Notional Limit is that it has a Backward-Looking characteristic. Risk Management is executed simply by comparing the Threshold Value, and all these actions are known only after the corresponding event has occurred. Notional limiting is not a method of continuously tracking market volatility to determine whether volatility is increasing or decreasing and then executing risk management according to volatility, but only after an actual event occurs.

The Backward-Looking characteristic of Notional Limit has two potential problems: 1) Slippage and 2) Market Crash.

Slippage in Liquidation

When an event that exceeds the threshold value occurs, it is a time when market volatility is maximized, so there is a high probability that you will not be able to sell your collateral at the desired price when you try to sell your collateral to protect the fund and minimize losses. Moreover, since the crypto market is highly volatile and not yet stabilized, the larger the size of the asset to be sold, the greater the volatility of the price. So, in order to minimize the loss, the more you try to sell at any price, the more slippage increases. An increase in slippage inevitably creates a loss for the fund, so there is a possibility of incurring a considerable loss.

Market Crash

Many DEFI Protocols use Notional Limit as a risk management method, but the thresholds they set do not show much difference. Although they set threshold values ​​differentially according to the type of collateral, most use similar values. If market volatility is at its peak, many DEFI Protocols currently operating on the blockchain will execute large-scale liquidations at approximately the same time to minimize fund losses. So, if a large number of sell orders are placed in the market at once, this will result in accelerating market volatility. In other words, the big market trend will be concentrated in one direction: selling. Since this flow is automatically executed by the program, it will be executed regardless of the market situation, even if the price drop is large. The 2008 financial crisis, which was the decisive moment for the birth of Bitcoin, occurred for this reason, and the same problem has the potential to occur in DEFI. If a similar situation occurs, the damage could be even greater than the 2008 financial crisis. This is because the market is not mature enough and there is no mechanism to control the above situation.

Advanced Risk Management : VARiM

VARiM (Volatility Adaptive Risk Management) is a technology to solve the problem of notional limit and safely operate funds according to market volatility. VARiM collects market data, measures volatility, and predicts market volatility by creating a model that can explain it.

VARiM aims to measure market volatility and manage it in a forward-looking manner.

Advantage

VARiM has the following three advantages.

Intuitive

VARiM suggests how much loss a fund can have with a certain degree of probability. For example, if you have 100 BTC, it tells you that there is a 5% chance of losing $10,000 at this point. Since the two numbers presented by VARiM are intuitive, even people without financial knowledge can easily understand them, and since the magnitude of the value represents the volatility of the market, it is possible to know whether the volatility is large or not. It is possible to understand market volatility without needing to refer to separate data to understand the figures shown by VARiM.

Asset Comparison

The value of VARiM can be calculated for each asset class. For example, if you have three assets, BTC, ETH, and ADA, you can calculate the risk of each of these assets. BTC-$10,000 , ETH - $5,000 , ADA - $4,000 You can quantify in this format, so you can compare the risk of each asset. So, it is possible to know whether the loss probability of BTC is greater or the loss probability of ETH is greater. If the relative loss potential between assets can be compared, liquidity between assets can be adjusted. For example, if the risk of BTC is increasing, VARiM can reduce the risk by reducing lending to secure BTC liquidity and withdrawing existing loans.

Forward-Looking

The biggest advantage of VARiM is Forward-Looking. Since VARiM models the volatility of the market, it is possible to measure the risk at the present time using the generated model and also measure the volatility after n-days. For example, the loss possible after 10 days of BTC is $15,000, and the probability is 5%.

Forward-looking characteristics can raise risk management to the next level. Because the existing Notional Limit is backward-looking, risk management is carried out after market volatility is maximized. However, VARiM predicts future volatility and adjusts the liquidity of the fund in advance if the risk of loss increases due to continued increase in volatility. do. By doing so, VARiM preemptively conducts risk management and prepares for losses in advance. Therefore, VARiM can provide a higher level of risk management.

The forward-looking nature of VARiM is effective in reducing DeFI Market Crash when rapid market volatility occurs.