We construct liquidity-adjusted return and volatility using purposely designed liquidity metrics (liquidity jump and liquidity diffusion) that incorporate additional liquidity information. Based on these measures, we introduce a liquidity-adjusted ARMA-GARCH framework to address the limitations of traditional ARMA-GARCH models, which are not effectively in modeling illiquid assets with high liquidity variability, such as cryptocurrencies. We demonstrate that the liquidity-adjusted model improves model fit for cryptocurrencies, with greater volatility sensitivity to past shocks and reduced volatility persistence of erratic past volatility. Our model is validated by the empirical evidence that the liquidity-adjusted mean-variance (LAMV) portfolios outperform the traditional mean-variance (TMV) portfolios.
Tarun Chitra, Theo Diamandis, Nathan Sheng, Luke Sterle · 5 authors
Decentralized perpetuals protocols have collectively reached billions of dollars of daily trading volume, yet are still not serious competitors on the basis of trading volume with centralized venues such as Binance. One of the main reasons for this is the high cost of capital for market makers and sophisticated traders in decentralized settings. Recently, numerous decentralized finance protocols have been used to improve borrowing costs for perpetual futures traders. We formalize this class of mechanisms utilized by protocols such as Jupiter, Hyperliquid, and GMX, which we term~\emph{Perpetual Demand Lending Pools} (PDLPs). We then formalize a general target weight mechanism that generalizes what GMX and Jupiter are using in practice. We explicitly describe pool arbitrage and expected payoffs for arbitrageurs and liquidity providers within these mechanisms. Using this framework, we show that under general conditions, PDLPs are easy to delta hedge, partially explaining the proliferation of live hedged PDLP strategies. Our results suggest directions to improve capital efficiency in PDLPs via dynamic parametrization.
Decentralized finance (DeFi) lacks centralized oversight, often resulting in heightened volatility. In contrast, centralized finance (CeFi) offers a more stable environment with institutional safeguards. Institutional backing can play a stabilizing role in a hybrid structure (HyFi), enhancing transparency, governance, and market discipline. This study investigates whether HyFi-like cryptocurrencies, those backed by institutions, exhibit lower price risk than fully decentralized counterparts. Using daily data for 18 major cryptocurrencies from January 2020 to November 2024, we estimate panel EGLS models with fixed, random, and dynamic specifications. Results show that HyFi-like assets consistently experience lower price risk, with this effect intensifying during periods of elevated market volatility. The negative interaction between HyFi status and market-wide volatility confirms their stabilizing role. Conversely, greater decentralization is strongly associated with increased volatility, particularly during periods of market stress. Robustness checks using quantile regressions and pre-/post-Terra Luna subsamples reinforce these findings, with stronger effects observed in high-volatility quantiles and post-crisis conditions. These results highlight the importance of institutional architecture in enhancing the resilience of digital asset markets.
Dion Bongaerts, Thomas Lambert, Daniel Liebau, Peter Roosenboom
We investigate the drivers of vote delegation in Decentralized Autonomous Organizations (DAOs), using the Uniswap governance DAO as a laboratory. We show that parties with fewer self-owned votes and those affiliated with the controlling venture capital firm, Andreesen Horowitz (a16z), receive more vote delegations. These patterns suggest that while the Uniswap ecosystem values decentralization, a16z may engage in window-dressing around it. Moreover, we find that an active and successful track record in submitting improvement proposals, especially in the final stage, leads to more vote delegations, indicating that delegation in DAOs is at least partly reputation- or merit-based. Combined, our findings provide new insights into how governance and decentralization operate in DeFi.
This paper distinguishes between risk resonance and risk diversification relationships in the cryptocurrency market based on the newly developed asymmetric breakpoint approach, and analyzes the risk propagation mechanism among cryptocurrencies under extreme events. In addition, through the lens of node association and network structure, this paper explores the dynamic evolutionary relationship of cryptocurrency risk association before and after the epidemic. In addition, the driving mechanism of the cryptocurrency risk movement is analyzed in a depth with the epidemic indicators. The findings show that the effect of propagation of risk among cryptocurrencies becomes more significant under the influence of the new crown outbreak. At the same time, the increase in the number of confirmed cases exacerbated the risk spillover effect among cryptocurrencies, while the risk resonance effect that exists between the crude oil market and the cryptocurrency market amplified the extent of the outbreak's impact on cryptocurrencies. However, other financial markets are relatively independent of the cryptocurrency market. This study proposes a strategy to deal with the spread of cryptocurrency risks from the perspective of a public health crisis, providing a useful reference basis for improving the regulatory mechanism of cryptocurrencies.
A simple model-free and distribution-free statistic, the functional relationship between the number of "effective" degrees of freedom and portfolio size, or N*(N), is used to discriminate between two alternative models for the correlation of daily cryptocurrency returns within a retail universe of defined by the list of tradable assets available to account holders at the Robinhood brokerage. The average pairwise correlation between daily cryptocurrency returns is found to be high (of order 60%) and the data collected supports description of the cross-section of returns by a simple isotropic correlation model distinct from a decomposition into a linear factor model with additive noise with high confidence. This description appears to be relatively stable through time.
Decentralized Finance (DeFi), a financial ecosystem without centralized controlling organization, has introduced a new paradigm for lending and borrowing. However, its capital efficiency remains constrained by the inability to effectively assess the risk associated with each user/wallet. This paper introduces the 'On-Chain Credit Risk Score (OCCR Score) in DeFi', a probabilistic measure designed to quantify the credit risk associated with a wallet. By analyzing historical real-time on-chain activity as well as predictive scenarios, the OCCR Score may enable DeFi lending protocols to dynamically adjust Loan-to-Value (LTV) ratios and Liquidation Thresholds (LT) based on the risk profile of a wallet. Unlike existing wallet risk scoring models, which rely on heuristic-based evaluations, the OCCR Score offers a more objective and probabilistic approach, aligning closer to traditional credit risk assessment methodologies. This framework can further enhance DeFi's capital efficiency by incentivizing responsible borrowing behavior and optimizing risk-adjusted returns for lenders.
Abstract Conditional risk measures and their associated risk contribution measures are commonly employed in finance and actuarial science for evaluating systemic risk and quantifying the effects of risk interactions. This paper introduces various types of contribution ratio measures based on the multivariate conditional value-at-risk (MCoVaR), multivariate conditional expected shortfall (MCoES), and multivariate marginal mean excess (MMME) studied in [34] (Ortega-Jiménez, P., Sordo, M., & Suárez-Llorens, A. (2021). Stochastic orders and multivariate measures of risk contagion. Insurance: Mathematics and Economics , vol. 96, 199–207) and [11] (Das, B., & Fasen-Hartmann, V. (2018). Risk contagion under regular variation and asymptotic tail independence. Journal of Multivariate Analysis 165 (1), 194–215) to assess the relative effects of a single risk when other risks in a group are in distress. The properties of these contribution risk measures are examined, and sufficient conditions for comparing these measures between two sets of random vectors are established using univariate and multivariate stochastic orders and statistically dependent notions. Numerical examples are presented to validate these conditions. Finally, a real dataset from the cryptocurrency market is used to analyze the spillover effects through our proposed contribution measures.
We introduce a novel class of systemic risk measures, the Vulnerability Conditional risk measures, which try to capture the "tail risk" of a risky position in scenarios where one or more market participants is experiencing financial distress. Various theoretical properties of Vulnerability Conditional risk measures, along with a series of related contribution measures, have been considered in this paper. We further introduce the backtesting procedures of VCoES and MCoES. Through numerical examples, we validate our theoretical insights and further apply our newly proposed risk measures to the empirical analysis of cryptocurrencies, demonstrating their practical relevance and utility in capturing systemic risk.
Rik Ghosh, Samrat Gupta, Arka Datta, Abhimanyu Nag · 5 authors
Compound Finance is a decentralized lending protocol that enables the secure and efficient borrowing and lending of cryptocurrencies, utilizing smart contracts and dynamic interest rates based on supply and demand to facilitate transactions. The protocol enables users to supply different crypto assets and accrue interest, while borrowers can avail themselves of loans secured by collateralized assets. Our collaboration with Compound Finance focuses on harnessing the power of the Chainrisk simulation engine to optimize risk parameters of the Compound V3 (Comet) protocol. This report delineates a comprehensive methodology aimed at calculating key risk metrics of the protocol. This optimization framework is pivotal for mitigating systemic risks and enhancing the overall stability of the protocol. By leveraging Chainrisk's Cloud Platform, we conduct millions of simulations to evaluate the protocol's Value at Risk (VaR) and Liquidations at Risk (LaR), ultimately providing recommendations for parameter adjustments.
In decentralized finance, any individual can pool their assets into an automated market maker (AMM) -- herein we focus on the constant product market maker (CPMM) -- in exchange for a claim on a fraction of future pool assets and fees earned from the market making operations. This position is represented by a liquidity token, whose prevailing on-chain price is effectively the initial deposited assets. Though this price is well-defined, we treat the liquidity token as a derivative position in the prices of the underlying assets for the CPMM in order to deduce risk-neutral pricing and hedging formulas, not dissimilar to the Black-Scholes result. Adopting this perspective, in a frictionless environment, hedging the CPMM liquidity token under fair valuation should produce a riskless process, which therefore grows at the risk-free rate, something that is not seen in empirical case studies under the prevailing price. With our novel pricing formula, we construct a method to calibrate a volatility to data which provides an updated (non-market) valuation which is consistent with the (near-continuous) replication strategy out-of-sample. We conclude with a discussion of novel AMM design considerations motivated by this derivative-pricing perspective.
Reducing financial risk is of paramount importance to investors, financial institutions, and corporations. Since the pioneering contribution of Johnson (1960), the optimal hedge ratio based on futures is regularly utilized. The current paper suggests an explicit and efficient method for testing the null hypothesis of a symmetric optimal hedge ratio against an asymmetric alternative one within a multivariate setting. If the null is rejected, the position dependent optimal hedge ratios can be estimated via the suggested model. This approach is expected to enhance the accuracy of the implemented hedging strategies compared to the standard methods since it accounts for the fact that the source of risk depends on whether the investor is a buyer or a seller of the risky asset. An application is provided using spot and futures prices of Bitcoin. The results strongly support the view that the optimal hedge ratio for this cryptocurrency is position dependent. The investor that is long in Bitcoin has a much higher conditional optimal hedge ratio compared to the one that is short in the asset. The difference between the two conditional optimal hedge ratios is statistically significant, which has important repercussions for implementing risk management strategies.
Shafique Ur Rehman, Touqeer Ahmad, Wu Dash Desheng, Amirhossein Karamoozian
This study examines the interdependence between cryptocurrencies and international financial indices, such as MSCI World and MSCI Emerging Markets. We compute the value at risk, expected shortfall (ES), and range value at risk (RVaR) and investigate the dynamics of risk spillover. We employ a hybrid approach to derive these risk measures that integrate GARCH models, extreme value models, and copula functions. This framework uses a bivariate portfolio approach involving cryptocurrency data and traditional financial indices. To estimate the above risks of these portfolio structures, we employ symmetric and asymmetric GARCH and both tail flexible EVT models as marginal to model the marginal distribution of each return series and apply different copula functions to connect the pairs of marginal distributions into a multivariate distribution. The empirical findings indicate that the eGARCH EVT-based copula model adeptly captures intricate dependencies, surpassing conventional methodologies like Historical simulations and t-distributed parametric in VaR estimation. At the same time, the HS method proves superior for ES, and the t-distributed parametric method outperforms RVaR. Eventually, the Diebold-Yilmaz approach will be applied to compute risk spillovers between four sets of asset sequences. This phenomenon implies that cryptocurrencies reveal substantial spillover effects among themselves but minimal impact on other assets. From this, it can be concluded that cryptocurrencies propose diversification benefits and do not provide hedging advantages within an investor's portfolio. Our results underline RVaR superiority over ES regarding regulatory arbitrage and model misspecification. The conclusions of this study will benefit investors and financial market professionals who aspire to comprehend digital currencies as a novel asset class and attain perspicuity in regulatory arbitrage.
Every publicly traded company in the US is required to file an annual 10-K financial report, which contains a wealth of information about the company. In this paper, we propose an explainable deep-learning model, called FinBERT-XRC, that takes a 10-K report as input, and automatically assesses the post-event return volatility risk of its associated company. In contrast to previous systems, our proposed model simultaneously offers explanations of its classification decision at three different levels: the word, sentence, and corpus levels. By doing so, our model provides a comprehensive interpretation of its prediction to end users. This is particularly important in financial domains, where the transparency and accountability of algorithmic predictions play a vital role in their application to decision-making processes. Aside from its novel interpretability, our model surpasses the state of the art in predictive accuracy in experiments on a large real-world dataset of 10-K reports spanning six years.
Xintong Wu, Wanling Deng, Yutong Quan, Lin William Cong · 5 authors
Trust mechanisms diverge between centralized and decentralized exchanges, representing distinct sociotechnical governance paradigms. However, quantifying trust dynamics and their redistribution between these architectures remains empirically challenging, limiting understanding of how institutional shocks affect market behavior. The FTX collapse offers a natural experiment to bridge this gap. Through an interdisciplinary approach combining causal inference and computational text analysis, we find significant price declines and capital reallocation from centralized to decentralized exchanges following the event. While sentiment metrics showed no sharp discontinuities, topic modeling and network analysis of Discord communities reveal that seasonal holiday discourse obscured underlying trust concerns in centralized exchange forums. These findings underscore the fragility of institutional trust architectures and demonstrate how mixed methods can illuminate behavioral patterns during systemic crises, offering insights for exchange risk management and regulatory assessment.
We develop several innovations to bring the best practices of traditional investment funds to the blockchain landscape. Specifically, we illustrate how: 1) fund prices can be updated regularly like mutual funds; 2) performance fees can be charged like hedge funds; 3) mutually hedged blockchain investment funds can operate with investor protection schemes, such as high water marks; and 4) measures to offset trading related slippage costs when redemptions happen. Using our concepts - and blockchain technology - traditional funds can calculate performance fees in a simplified manner and alleviate several operational issues. Blockchain can solve many problems for traditional finance, while tried and tested wealth management techniques can benefit decentralization, speeding its adoption. We provide detailed steps - including mathematical formulations and instructive pointers - to implement these ideas and discuss how our designs overcome several blockchain bottlenecks, making smart contracts smarter. We provide numerical illustrations of several scenarios related to our mechanisms.
In decentralized finance (DeFi), stablecoins like DAI are designed to offer a stable value amidst the fluctuating nature of cryptocurrencies. We examine the class of crypto-backed stable derivatives, focusing on mechanisms for price stabilization and exemplified by the well-known stablecoin DAI from MakerDAO. For simplicity, we consider a single-collateral setting. We introduce a belief parameter to the simulation model of DAI in a previous work (DAISIM), reflecting market sentiments about the value and stability of DAI, and show that it better matches the expected behavior when this parameter is set within a particular range of values. Our methods include comparing simulated data with real-world data, focusing on monthly correlations between ETH and DAI prices and scatter plots illustrating the relationship of their price trends over time. We also propose a simple mathematical model of DAI price to explain its stability and dependency on ETH price. Finally, we analyze possible risk factors associated with these stable derivatives to provide valuable insights for stakeholders in the DeFi ecosystem.
Marcel Bluhm, Adrian Cachinero Vasiljević, Sébastien Derivaux, Søren Terp Hørlück Jessen
Stablecoins have turned out to be the "killer" use case of the growing digital asset space. However, risk management frameworks, including regulatory ones, have been largely absent. In this paper, we address the critical question of measuring and managing risk in stablecoin protocols, which operate on public blockchain infrastructure. The on-chain environment makes it possible to monitor risk and automate its management via transparent smart-contracts in real-time. We propose two risk metrics covering capitalization and liquidity of stablecoin protocols. We then explore in a case-study type analysis how our risk management framework can be applied to DAI, the biggest decentralized stablecoin by market capitalisation to-date, governed by MakerDAO. Based on our findings, we recommend that the protocol explores implementing automatic capital buffer adjustments and dynamic maturity gap matching. Our analysis demonstrates the practical benefits for scalable (prudential) risk management stemming from real-time availability of high-quality, granular, tamper-resistant on-chain data in the digital asset space. We name this approach Crypto Asset-Liability Management (CALM).
Dennis Koch, Vahidin Jeleskovic, Zahid Irshad Younas
This paper introduces a unique and valuable research design aimed at analyzing Bitcoin price volatility. To achieve this, a range of models from the Markov Switching-GARCH and Stochastic Autoregressive Volatility (SARV) model classes are considered and their out-of-sample forecasting performance is thoroughly examined. The paper provides insights into the rationale behind the recommendation for a two-stage estimation approach, emphasizing the separate estimation of coefficients in the mean and variance equations. The results presented in this paper indicate that Stochastic Volatility models, particularly SARV models, outperform MS-GARCH models in forecasting Bitcoin price volatility. Moreover, the study suggests that in certain situations, persistent simple GARCH models may even outperform Markov-Switching GARCH models in predicting the variance of Bitcoin log returns. These findings offer valuable guidance for risk management experts, highlighting the potential advantages of SARV models in managing and forecasting Bitcoin price volatility.
Decentralized Finance (DeFi) has reshaped the possibilities of reserve banking in the form of the Collateralized Debt Position (CDP). Key to the safety of CDPs is the money supply architecture that enables issued debt to maintain its value. In traditional markets, and with respect to the United States Dollar system, interest rates are set by the Federal Reserve in an attempt to influence the effects of excessive inflation. DeFi enables a more transparent approach that typically relies on interest rates or other debt recovery mechanisms being directly informed by asset price. This research investigates contemporary DeFi money supply and debt management strategies and their limitations. Furthermore, this paper introduces a time-weighted approach to interest rate management that implements a Proportional-Integral-Derivative control system to constantly adapt to market activities and protect the value of issued currency, while addressing observed limitations.
Decentralized Finance (DeFi) money markets have seen explosive growth in recent years, with billions of dollars borrowed in various cryptocurrency assets. Key to the safety of money markets is the implementation of interest rates that determine the cost of borrowing, and govern counterparty exposure and return. In traditional markets, interest rates are set by risk managers, portfolio managers, the Federal Reserve, and a myriad of other sources depending on the market function. DeFi enables an algorithmic approach that typically relies on interest rates being directly dependent on market utilization. The benefit of algorithmic interest rate management is the system's continual response to market behaviors in real time, and thus an inherent ability to mitigate risks on behalf of protocols and users. These interest rate strategies target an optimal utilization based on the protocol's risk threshold, but historically lack the ability to compensate for excessive or diminished utilization over time. This research investigates contemporary DeFi interest rate management strategies and their limitations. Furthermore, this paper introduces a time-weighted approach to interest rate management that implements a Proportional-Integral-Derivative (PID) control system to constantly adapt to market utilization patterns, addressing observed limitations.
This study aims to examine the intricate dynamics between BRICS traditional stock assets and the evolving landscape of cryptocurrencies. Using a time-varying parameter vector autoregression model (TVP-VAR), we have analyzed data from the BRICS stock market index, cryptocurrencies, and indicators from January 6, 2015, to June 29, 2023. The results show that three out of the five BRICS stock markets serve as primary sources of shocks that subsequently affect the financial network. The transcontinental (TCI) value derived from the dynamic conditional connectedness using the TVP-VAR model demonstrates a higher explanatory power than the static connectedness observed using the standard VAR model. The discoveries from this study offer valuable insights for corporations, investors, and regulators concerning systematic risk and investment strategies.
The issue related to the quantification of the tail risk of cryptocurrencies is considered in this paper. The statistical methods used in the study are those concerning recent developments in Extreme Value Theory (EVT) for weakly dependent data. This research proposes an expectile-based approach for assessing the tail risk of dependent data. Expectile is a summary statistic that generalizes the concept of mean, as the quantile generalizes the concept of the median. We present the empirical findings for a dataset of cryptocurrencies. We propose a method for dynamically evaluating the level of the expectiles by estimating the level of the expectiles of the residuals of a heteroscedastic regression, such as a GARCH model. Finally, we introduce the Marginal Expected Shortfall (MES) as a tool for measuring the marginal impact of single assets on systemic shortfalls. In our case of interest, we are focused on the impact of a single cryptocurrency on the systemic risk of the whole cryptocurrency market. In particular, we present an expectile-based MES for dependent data.
Jakub Michańków, Łukasz Kwiatkowski, Janusz Morajda
In this paper, we develop a hybrid approach to forecasting the volatility and risk of financial instruments by combining common econometric GARCH time series models with deep learning neural networks. For the latter, we employ Gated Recurrent Unit (GRU) networks, whereas four different specifications are used as the GARCH component: standard GARCH, EGARCH, GJR-GARCH and APARCH. Models are tested using daily logarithmic returns on the S&P 500 index as well as gold price Bitcoin prices, with the three assets representing quite distinct volatility dynamics. As the main volatility estimator, also underlying the target function of our hybrid models, we use the price-range-based Garman-Klass estimator, modified to incorporate the opening and closing prices. Volatility forecasts resulting from the hybrid models are employed to evaluate the assets' risk using the Value-at-Risk (VaR) and Expected Shortfall (ES) at two different tolerance levels of 5% and 1%. Gains from combining the GARCH and GRU approaches are discussed in the contexts of both the volatility and risk forecasts. In general, it can be concluded that the hybrid solutions produce more accurate point volatility forecasts, although it does not necessarily translate into superior VaR and ES forecasts.