Adapting traditional risk parity into defi

Risk Parity Protocol | The Lite Paper V1.0

Practically speaking, there are three key components to adopting a risk parity approach to portfolio management within crypto: diversification, classification / calibration, and management. First, it must be actually possible to diversify across non-correlated assets. This may seem trivial, but until recently this was impossible in crypto. Bitcoin held such a dominant position that all other crypto assets were strongly or weakly correlated with it. Where Bitcoin went, every other asset followed. But the rise of Ethereum and DeFi in particular has seen crypto asset prices decouple from Bitcoin for the first time, at the same time as crypto as a whole has decoupled from the stock market. The conditions are finally right for the Risk Parity approach to be feasible within crypto, allowing an all-crypto risk-balanced portfolio which can weather any environmental conditions. Second, there needs to be a reliable way to classify and quantify assets. Investment isn’t an exact science, but it’s impossible to adopt a risk parity approach without a reliable way to classify and track crypto assets and identify negatively correlated pairs. Fortunately, DeFi is a goldmine of data and token analytics, with smart contracts publicly viewable and transactions transparent and trackable on-chain. Figure 3 below is an adaptation of Figure 1, replacing stocks and bonds with our own indices that share the same characteristics.

Figure 3: Positively and negatively correlated indexes within the Formation Fi ecosystem.

Having identified and calibrated negatively correlated asset classes within DeFi we now construct a risk-adjusted portfolio using the indexes we created. Figure 4 below illustrates how we might slot our indexes into the risk management framework developed by All Weather to build a portfolio which can withstand all major macroeconomic changes.

Figure 4: An example of a risk-balanced portfolio using the Formation Fi index approach

But simply building such a portfolio is not enough. The final step is managing it over time. Unfortunately, The reality of DeFi makes managing such a portfolio extremely complex and unintuitive. DeFi platforms are difficult and expensive to use, with no standardization and limited automation. This is where Formation Fi’s Risk Parity Protocol comes in.