HOW TO MANAGE COUNTERPARTY RISK WHEN TRADING BITCOIN

In light of the recent Bitfinex hack I thought it would be appropriate to write another article about reducing counterparty risk. Active traders need to use exchanges with liquidity in order to make a living. Even those who aren’t traders still tend use exchanges from time to time. 

Anyone who’s an active crypto trader should factor in counterparty risk as a part of their risk management strategy. Keeping your coins on an exchange can be even more dangerous than taking a bad trade. Here is a strategy that can reduce your risk exposure. 

RULE #1: NEVER TRADE WITH 100% OF YOUR PORTFOLIO

Personally, I only trade with 20% of my entire crypto portfolio. If some unfortunate event were to cause me to lose that 20% then I would still be in the game. This 20% was derived from a portion of my trading profits, which means I’d still be in the positive. 

Those who keep 100% of their crypto capital on an exchange have a higher risk of getting wiped out. If you need the capital to trade size for bigger gains then understand that your gains can be erased in an instant. Patience and persistence is the way to survive in this digital jungle. 

RULE #2: HEDGE THROUGH DIVERSIFICATION

I consider that 20% as my high risk trading capital but still want to make every effort in preserving and growing it. For traders, taking an occasional hit and losing money is the cost of doing business but losses should be minimized. 

To protect my trading capital I diversify that 20% amongst at least 5 different exchanges. This means that if one exchange gets hacked then I only stand to lose 4% of my portfolio. Taking a 36% haircut on the Bitfinex hack meant that I only lost 1.44% of my entire crypto portfolio. 

RULE #3: REMOVE YOUR COINS WHEN NOT ACTIVELY TRADING

Removing your coins when not actively trading can greatly reduce the probabilities of being adversely affected by a hack. I had executed an arbitrage trade on Cryptsy a couple of weeks before they withheld people’s money but because I immediately withdrew my coins I was unaffected. 

Sometimes traders need to keep capital that’s quickly accessible in order to catch opportunities. If you take the approach of gradually scaling into a full sized position then you’ll still have time to add more to your trade at a later point. 

RULE #4: PAY ATTENTION TO WARNING SIGNALS 

Most exchanges will start giving off warning signs months before they even get hacked. Usually if people have issues with an exchange they’ll report it to others on social media. The more people who make these public claims the higher the warning signals might be. 

Bitfinex had a series of problems prior to the hack including: their trading engine glitching out, issues with the SEC and another hack that happened last year. Other exchanges like Cryptsy and Mt.Gox also showed signs of weakness months before they went down. 

RULE #5: TRADE QUALITY OVER QUANTITY 

Successful trading is often counterintuitive, sometimes to turn a profit you need to do the opposite of the market. Also, trading less often tends to bring in more profit. People make the common mistake of over trading the markets, which can greatly diminish your returns. 

Being patient and waiting for quality trades can not only increase your performance, it also reduces the amount of time you need to keep coins on an exchange. 

RULE #6: MAKE INCREMENTAL TRANSACTIONS

Sometimes regular users who aren’t actually traders lose money on exchanges as well. There are some unlucky users who lost money as a result of trying to make a single purchase or sale. 

In the event that you need to make a large purchase or sale, it’s safer to break that up into multiple smaller transaction. Alternatively, you could also diversify your purchases amongst several exchanges. 

RULE #7: START SUPPORTING DECENTRALIZED EXCHANGES

Bitcoin was created to eliminate third party risk and yet here we are sending our private keys to be managed by someone else. There are decentralized exchanges like Bitsquare that exist but they tend to lack liquidity.

Traders are in a catch 22, since most of the liquidity is on centralized exchanges we tend to use them as our main option. We need to start solving the problem of counterparty risk by using the decentralized alternatives. 

The transition doesn’t need to be all or nothing, it can be gradual. The best way to boost decentralized exchanges is to allocate a percentage of your trading portfolio to become a market maker on these platforms. 

Eventually once these platforms have enough market makers, then the liquidity will entice more traders to join. Decentralized exchanges will solve counterparty risk and reduce interference from outside entities. 

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