This post is the first in a tetralogy series which will address the management of crypto default risks. The series is targeted at any crypto industry participants, ranging anywhere on the spectrum from individuals holding digital assets (or “crypto assets”) with centralized exchanges (CEXs) to institutionals deploying capital to crypto custody solutions, and users of decentralized finance (DeFi) protocols.
When referring to the committee of banking supervisory authorities — the Basel Committee on Banking Supervision (BCBS) — traditional financial risks can be typically categorized across 3 types of risks:
- Credit risks, including counterparty risks: most simply defined as the potential that a borrower or counterparty will fail to meet its obligations in accordance with agreed terms;
- Market risks: defined as the risk of losses arising from movements in market prices;
- Operational risks: defined as the risk of direct or indirect loss resulting from inadequate or failed internal processes, people and systems or from external events.
Translated in the crypto space, much has been written already to present the risks incurred by an activity dealing with crypto assets such as cryptocurrencies. This is particularly the case for crypto market risks — with key attributes: asset volatility, correlation risks, liquidity risks — and operational risks — with key attributes: technical failure, bugs, private key management. However, credit risks — and default risks more generally — for crypto exposures have been relatively less covered by research papers or by projects.
In that context, let’s start with this first question: why does the crypto industry need risk management solutions for crypto default exposures?
Lessons from the 2022 default events
2022 has been marked by more widespread financial distress than the previous years. A combination of risk management failure by crypto blue ship players, contagion effects within the crypto industry (a.k.a. “Widow” trade) and a fast-changing macroeconomic environment have highlighted crypto default risks as one major challenge plaguing trust in the crypto industry itself and putting a strain on large institutional adoption. The reverberating echo of the FTX collapse still holds a long journey for self-introspection and new business models.
The main lessons and features from these default events can be summarized as follows:
- Lack of good Corporate governance within crypto institutions, which translated into the absence of supervision, flawed transaction recording process, and pervasive conflicts of interests;
- Failed third-party auditing and inadequate financial controls (internal and external controls), which led to produce unreliable financial data and default risk profile;
- Failure in due diligence and bad risk management by investors and trading counterparties, which translated into risk concentration to centralized entities and lack of disclosure requirements;
- Contagion risks turning into systemic risks, which highlighted inter-company financial crossovers and the Global Systemically Important Banks (GSIB) concept applied to crypto.
“Never in my career have I seen such a complete failure of corporate controls and such a complete absence of trustworthy financial information as occurred here,” John J. Ray III, the new court-appointed CEO for FTX in bankruptcy.
Crypto default events looking forward
Looking forward, the lackluster macro-environment is expected to continue to put pressure on crypto capital inflows and crypto project valuations. These market conditions can lead to financial stress, all the more as when coupled with operational risks run by exchanges where hacks and customer deposit losses have been a pervasive component of the crypto industry for a decade.
Enhanced competition and 2022 default events had their tolls on CEX transaction revenues, which led to net result losses. Although CEXs have tried to diversify their revenue mix to compensate for lower transaction revenues, CEXs have yet to demonstrate stabilized net incomes.
Contagion risks are also a source of potential insolvency, particularly with the fate of the Digital Currency Group (DCG), one of the systematically important companies in the crypto ecosystem. Its lending arm, Genesis Capital, which was a large counterparty to 3AC and FTX, filed for bankruptcy in January 2023. A restructuring process has been on-going, with the debt owned by DCG to Genesis Holdco under restructuration and some potential lawsuits against DCG directly.
But heightened regulatory risks are currently the primary drivers of default risks. The US Securities and Exchange Commission (SEC) has taken aim at a broad swath of the cryptocurrency market, launching a pair of lawsuits against exchanges that together account for half of global trading in digital assets. On 6June, the financial regulator sued Coinbase, alleging it violated US securities law by failing to register as a broker, national securities exchange or clearing agency. The enforcement action came a day after the SEC filed a complaint against Binance and its chief executive Changpeng Zhao, alleging an array of civil charges including improperly mixing customer funds with those of a trading firm owned by Zhao.
Coinbase and Binance join a list of crypto companies against which the SEC has taken action, including Kraken, Genesis and Gemini. Other regional CEX — whether they are European (Bitstamp, Kraken) or Asian (OKX, Huobi, KuCoin, Upbit) — are not immunized against new regulations.
The need for risk management solutions for crypto counterparty default risks?
Institutional demand for crypto assets is conditional to getting risk management practices and solutions in place tailored to crypto exposures. This is the case for the vast majority of traditional funds who don’t accept any exposures to CEXs.
“ The collapse of FTX is likely to increase investor and regulatory pressure on crypto entities to disclose more information about their balance sheets, to safeguard client assets, to limit asset concentration and will induce more diligent risk management including management of counterparty risk among crypto market participants,”
Nikolaos Panigirtzoglo, JPMorgan Strategist.
CEXs have their own benefits particularly for individuals: liquidity, access to friendly User Interface (UI), outsourced private key management. This comes as the expense of counterparty risks and potential censorship. The balance between liquidity and counterparty risks is a salient consideration for institutional players, including even other CEXs. Indeed, CEXs are used to deploying capital across other CEXs as a way of provisioning liquidity for their own daily client activities (using them as hot wallets).
Capital inflows from traditional finance into DeFi are largely dependent on solutions that would facilitate under-collateralization for capital efficiency reasons. The future is certainly “credit on-chain”, in other terms “accepted credit risks” running on chain. For such accepted credit risks, institutionals can apply similar risk management and assessment techniques to the ones used in traditional finance — starting with “hybrid” techniques (using both TradFi and DeFi techniques) before eventually relying on fully decentralized techniques.
Capital inflows from traditional finance into crypto, particularly into DeFi, are largely dependent on solutions that would facilitate under-collateralization for capital efficiency reasons. This is not the standard for the moment as crypto loans to give one example are mostly over-collateralized — and the trend since the default 2022 events has played against under-collateralized lending protocols. But the future is certainly credit on-chain, in other terms “accepted credit risks running on chain”. For such accepted credit risks, institutionals can apply similar risk management and assessment techniques to the ones used in traditional finance — starting with “hybrid” techniques (using both TradFi and DeFi techniques) before eventually relying on fully decentralized techniques.
In traditional finance, regulated entities have the obligation to categorize and disclose their risks. This requirement is on its way for crypto assets. In December 2022, the BCBS finalized with its standard on the prudential treatment of cryptoasset exposures. The standard outlines minimum regulatory, supervisory review and disclosure requirements of banks’ cryptoasset exposures under Pillars 1,2 and 3 of the Basel framework. Looking at the history of financial regulations, next steps are for consultation on credit counterparty risk, then on calculation of risks and use of credit hedge as an economic and regulatory offset.
Conclusions
- The 2022 crypto default events have illustrated poor risk management from CEXs and poor due diligence from investors and trading counterparties, above all highlighting the structural market gap for hedges against crypto default events;
- Contagion risks, current macro-environment and regulators’ negative stance against crypto activities are weighting on default risk profiles of blue ship players, raising systemic risks;
- This has supported the institutional demand for more data disclosure and risk management best practices, but more importantly the demand for specific risk management solutions that financially compensates against default losses by leveraging the promises of the blockchain technology.
- The long-term game: crypto market future developments depend on the emergence of default protections to support credit on-chain and improve capital efficiency of the overall crypto industry in the context of upcoming prudential regulations on credit risks.
What’s Next?
Part#2: The landscape of risk management solutions for crypto counterparty default exposures .
