For the next instalment of our series on crypto default risk management, we wanted to lay out the landscape of current solutions directly or indirectly playing a role in that space. For an introduction on why the crypto market needs risk management solutions for counterparty default exposures, please check our first article on the topic.
Recall the goal of the tetralogy: uncover what type of solution the crypto industry needs to mitigate crypto default risks. In other terms, how can retail or institutional users hedge their cryptocurrency holdings or their positive transaction mark to market against the default of their asset custodians?
Risk management Vs. Risk assessment
The crypto industry has been struggling to find the path forward to address counterparty exposures. Most product development and company governance have been focusing on risk assessment, which is a subset of risk management. Risk management encompasses the entire process of:
- Identifying, categorizing risk factors and estimating risks (“risk assessment”);
- Reducing risk factors (“risk mitigation”)
In the FTX aftermath, risk assessment solutions have surged, particularly facilitated by zero-knowledge proof and quantitative technologies for on-chain/off-chain data analytics. However, risk mitigation techniques are still in their infancy. Due to market structural gaps, some emerging risk management solutions have failed to deliver liquid, wide universe risk coverage, although the promises of blockchain, and DeFi more specifically, are considered as potential future proof infrastructures for counterparty default risk hedging.
Default risk assessment solutions
Default risk assessment solutions are critical insofar as they constitute the foundation of a sound risk management process. Regulators and supervisors have called the finance industry to adapt risk frameworks for crypto assets, starting with risk assessment that supports safety, stability and soundness.
“Firms will likely need to adapt existing risk management strategies and risk management systems to suit the different risk profile of many crypto activities,”
PRA letter to banks and investment firms CEO, March 2022.
Proof of Reserves
Proof of Reserves (PoR) is an auditing technique used to provide transparency and evidence that a custodian holds the digital assets it claims to own on behalf of its clients. The solution has been reinvigorated and a Wall of Fame (Proof of Reserves — Nic Carter) can now display a larger number of users.
A PoR audit is a strong show of faith to the public. It ensures companies commit to gaining trust through self-regulation. PoR audits also guarantee that a centralized service will not move your funds into the custody of a counterparty. It also empowers users to verify their own balances (thanks to merkle-tree techniques).
But PoR is not perfectly trustless in its current implementation and faces many challenges when dealing with liabilities to establish Proof of Solvency. Indeed, while the proof of assets on chain is normally trivial, the liabilities are the hard part. Emerging solutions, such as the Summa protocol, address proof of solvency by leveraging zero-knowledge proof technology and incentives mechanism for user verification.
Credit oracles
Credit Oracles, Credora and Cred Protocol, such as provide credit valuation and real-time risk monitoring based on on-chain and off-chain information. Some of the solutions use zero-knowledge proof technology to ensure privacy of private data used in risk modelling and often use proprietary SPAN-type of methodologies. They are mainly used to facilitate lending activity, either applied as counterparty credit ratings or capital allocation engine.
Crypto rating and scoring
Traditional rating agencies have developed their services to cover crypto counterparty risks by publishing ratings based on traditional credit rating methodologies, which then include some additional idiosyncratic crypto risk factors. Noticeably, in May 2022, S&P issued the first rating for a crypto company with a B- long-term rating for Compound Prime. These rating agencies also publish research papers which address risks inherent to crypto and DeFi, thereby contributing to general awareness and due diligence in the industry.
Crypto native solutions also provide solvency ratings, mainly based on on-chain data. They aggregate different indicators ranging from security to asset-liabilities balances. They cover centralised exchange risks (CER), or lending activities (Spectral), or are used for more generic-use risk scoring, including AML/CFT (Blockmate analytics). Some new solutions are under development to create standardized risk scoring index for DeFi risks, such as Index Coop.
Counterparty whitelisting
Whitelisting provides a permissioned trading environment which can only be accessed by verified counterparties meeting some standards. These standards primarily relate to KYC and AML/CFT, but can also take into consideration the reputation (a measurement of integrity and “good behaviour”) or activity tiers (institutional Vs retail, institutional size). This approach has been in use by a few lending DeFi protocols. For example, Aave ARC offers its own, separate, permissioned liquidity pools which can only be accessed by verified counterparties. Interestingly, another initiative is the project Guardian led by the Monetary Authority of Singapore (MAS). This project, which is closely monitored by traditional institutions, integrates TradFi and DeFi by creating a “permissioned liquidity pool” through a common trust layer of independent “trust anchors”.
Third-party auditing
Third-party auditing of on-chain and off-chain assets ensures that a custodian such as a centralized crypto exchange actually has ownership of the assets it claims to have. Third-party auditing is very valuable to cover complex set-ups and assess potential credit seniority claims on deposits, especially when exchanges don’t segregate assets on the platform. However, the FTX collapse illustrated the challenges of third-party auditing and reputation risks associated with it. This led former popular PoR audit firms Mazars Group and Armanino to stop providing this type of services to their crypto clients.
Specialized credit reporting services
These services are used for risk management and capital efficiency, and typically include risk analysis and recommendations for risk parameter optimization. For example, Gauntlet is a DeFi risk management service provider and one of the major players in the Business-to-DAO space. It provides financial modelling platforms that simulate risk parameter optimization for some of the largest protocols in DeFi. Messari Diligence Report is another crypto intelligence platform that provides structured reports focused on core project details, legal and regulatory risks, economics and technology. Some lending DeFi protocols, such as Untangled Finance, act as loan arrangers and report default risk profiles on crypto loan portfolio and quantitative impact assessment on risk factor portfolios.
Default risk mitigation solutions
Compared to risk assessment solutions, default risk mitigation solutions directly provide financial compensation should a crypto default event occur, or transfer counterparty risk to another entity which is deemed safer from a financial and governance perspective. Some mitigations are proven techniques in traditional finance but some others are emerging with the use of a decentralized infrastructure.
“The question is whether we have the right building blocks (credit scores, insurance, and yes, credit default swaps) that make this sector of DeFi viable in the short term. Can we use smart contracts, on chain data, soulbound NFTs, and DeSoc identities to replace loan officers?
I hope so, but it feels like it may simply be too early,”
Messari 2023 crypto thesis report.
Collateralization
Collateralization is a mechanism widely used by CEXs, DEXs and crypto over the counter (OTC) dealers. The term “collateral” is mainly referred to in the context of crypto lending activities but is also interchangeably used for margin trading as the amount of assets kept in a margin account to cover potential losses traders may have when trading on leverage.
CEXs use collateralization in conjunction with other mechanisms such as liquidation, platform insurance funds and auto-deleveraging. This is a one-way collateral mechanism where only traders of the platform have to post collateral. As a consequence, collateralization only contributes towards building more entangled assets exposure to centralized platforms.
Crypto OTC counterparties tend to mirror collateralization best practices in traditional finance by adapting legal framework such as ISDA Schedule and Credit Support Annex (CSA).
DEXs mainly use over-collateralization and (auto-)liquidation to cope with counterparty risks. Some lending DEXs used to require lower collateralization by resorting to whitelisting, although the market standard has recently come back to the main case of overcollateralization. Some derivatives DEXs such as dYdX are using similar margin accounts and liquidation mechanism to CEXs.
Third-party custody
Following the 2022 default events, a growing number of banks and institutions have seen potential benefits of third-party custody solutions. Attractiveness of such solutions comes from their core attributes: an operational framework for private key management overlaid with a compliance & regulatory-proofed framework, let alone a trusted reputation of the custody service provider (a core principle in TradFi).
Liquidity access is an important consideration: access can be slow with third-party custody solutions compared to deploying capital on CEXs. There are solutions addressing this issue such as Copper Clearloop or Fireblocks, which allow for near-instantaneous transfers to exchanges and hence circumvent a continuous exposure towards an exchange. However, such solutions are based on the premise of scalability achieved across all major exchanges, which is still under development. Furthermore, these solutions are designed for large-scale, institutional operations and not for retail end users.
DeFi insurance
As access to traditional insurance products for crypto risks is costly and limited to large institutions, DeFi insurance solutions, such as Nexus Mutual, Sherlock, Unslashed and InsureAce, have emerged over the last years. Particularly, Nexus Mutual is a discretionary mutual protocol that leverages a liquid pool model. In that approach, cover pricing directly depends on the cover ratio, defined as the amount of liquidity (“collateral amount”) Vs. the amount of insurance required (“cover amount”).
Out of the already very small list of decentralized insurance protocols, very few cover custody risks. Nexus Mutual was used to propose custody covers but decided to deprecate this type of cover in June 2023. Noticeably, the main arguments behind this decision included i) the lack of transparency and high correlation between custodians and ii) high risks Vs. low rewards.
Under-collateralized crypto loan protection
Some DeFi protocols, such as Carapace, specifically address counterparty risks on under-collateralized lending protocols such as Goldfinch, Maple Finance, TrueFi. This type of protocols offers protection against the default risk of a specific underlying lending pool, by paying some premium to a pool contract and get the right to claim a payout if the lending pool default. The pool contracts aggregate lending pools across those different lending protocols for diversification and liquidity. Risk premium for the protection is generally calculated based on leverage (i.e. how much protection is covered by collateral and interests from premium), APY from the lending pools and other parameters. Access to protection is generally constrained to lenders only, with compensation of loss up to the incurred loss on the defaulted loan.
Claim put options
A claim put option is an OTC which gives right to the option buyer to exercise the put option in case of a bankruptcy. Platforms such as Claims Put Market offer a marketplace for this type of products.
Upon exercise, the buyer (the vendor) assigns a bankruptcy claim to the seller (the investor) against a predefined purchase rate (in %) applied to a claim amount. The procedure for the exercise requires the vendor to provide specific information about the claim so that it establishes the claim is a valid, liquidated and non-contingent unsecured claim or administrative priority claim against the Reference Entity specified in the contract. The potential payout from the investor is generally not collateralized. If the buyer’s requested put option terms are accepted by an investor, the buyer is provided with the investor’s financial statements and needs to formulate their own risk due diligence on the creditworthiness of the investor before agreeing to the claim put option.
Crypto default protection (“Crypto DS”)
This is where Hexaven comes in. Hexaven is a decentralized hub which provides protection contracts against crypto default risks. The platform uniquely leverages the full promises of DeFi to achieve default remoteness, but also transposes key principles of traditional finance (KYC, trust and reputation) into a decentralised default management mechanism. In short, it brings what credit default swaps (CDS) are for traditional finance but in crypto: a synthetic solution to hedge against or invest into crypto credit . This is “Crypto DS”. More about Hexaven at a later stage.
Comparison of default risk mitigation solutions
All the abovementioned default risk mitigation techniques do not share the same level of maturity and present different benefits and drawbacks for hedgers and investors. The table below gives a comparison across default risk mitigations for different dimensions, with an indication for “completeness” (or benefits):
- Capital efficiency: driven by the amount of collateral needed from investor (and potentially from buyer as well);
- Type of underlying exposure: physical (the protection buyer is compensated only for their incurred losses) or synthetic (the protection buyer can hedge synthetic exposure for proxy hedging or based on a market view);
- Liquidity & scalability: conditions to gather liquidity and offer secondary trading for investors, capacity to cover different underlying risks (from CEX to DeFi);
- Operational efficiency: transparency and easiness for payment processing to protection buyer after default event;
- Default remoteness: immunization against any indirect/third-party counterparty exposures.
Taking DeFi insurance as an example.
Specifically for crypto default risks, the DeFi insurance model does not ensure deep liquidity for protection buyers/sellers as the pools are subject to some vesting period. Also, cover pricing does not fully follow the market supply and demand dynamics but is constrained to a parametric model approach that defines a minimum price and a maximum amount of cover subject to local and global capacity limitations. Additionally, these DeFi protocols require claimants to provide proof of losses for claim eligibility. In other terms, cover buyers are only financially compensated up to the amount of their incurred losses.
Apart from these operational constraints — collection of asset ownership information could be challenging when users are deprived of their access rights by the defaulted platform — this type of cover is not suitable for traders looking to sell protection as a speculative investment (with no actual claim attached) or for hedgers looking to proxy hedge a position of similar nature.
It is important to note that all these solutions contribute towards a greater maturity and stability of the crypto industry, and, consequently, a higher chance of institutional adoption. Although certain solutions do not achieve a satisfying level of completeness, the industry may still need a mix of solutions to cover all use cases.
What about the recent market trends?
Demands have certainly surged for separate custody services from exchanges but also for FX prime brokerage-style arrangements. These demands are more driven by the need for better management of credit relationships. Crypto prime brokers such as Hidden Road have become important market participants by providing market access but more importantly credit to trade crypto OTC.
Another trend has been to flex collateral requirements from CEX to trade on their platforms, either reducing minimum deposit amounts for unilateral posting or locating deposits required by CEX in external accounts associated with lower risk credit counterparties (e.g. central Bank style accounts).
These recent trends have been quite supportive of the crypto institutional adoption. However they don’t preclude the use of all abovementioned mitigating techniques. Financial intermediaries can hedge counterparty risks inherited from their client activities, or residual risks, or even tail risks (e.g. hedging against large custodian partnership).
Conclusions
- While the crypto industry can already benefit from risk assessment solutions, few risk mitigation solutions have emerged for counterparty default risks;
- Risk mitigations range from proven techniques in traditional finance to crypto-specific, decentralized solutions;
- A practical framework to compare solutions available can look at different dimensions: capital efficiency, type of exposures (synthetic or physical), liquidity & scalability, operational and default remoteness;
- Most of the solutions do not provide the necessary liquidity and scalability;
- Despite recent trends which alleviate trading exposures towards CEXs, risk mitigations are still needed, particularly for financial intermediaries which bear counterparty risks on behalf of their clients;
- Crypto DS offers a protection in synthetic format which ensures frictionless event default management, liquidity and scalability.
What’s next?
Part#3: Structural gaps of the crypto industry for counterparty default hedging
