Default Risk and How It Relates to the Cryptocurrency World

Published in

CryptoDigest

11 min readNov 12, 2018

Default risk is something that is prevalent all around us. By definition it is the chance that someone fails to pay you back on their debt obligation. Yet how many of us actually assess and try to quantify this risk? For instance do you think how likely your friend will pay you back when you lend them money, if so how do you measure it and assess?

Hence in this article I share my thoughts on this and also how it relates to/impacts the cryptocurrency world.

Default Risk

Default risk is the “the chance that companies or individuals will be unable to make the required payments on their debt obligations” — from Investopedia. In layman term it is the probability that someone or something fails to pay you back.

As mentioned, default risk is all around us and we actually take it on all the time. It is not only limited to the finance world and making investments. For example:

If you pay for a group meal, there is a chance that your friends might not pay you back. This is default risk.
If you paid for a hotel accommodation next year, there is a chance that the hotel might shut down before you stay there. This is also default risk (even though its not directly about money).

Hence it is important to be aware of these risks even though honestly you normally shouldn’t really worry too much about them on a day to day basis.

Assessing Default Risk

When you are making investment decisions default risk is very important as you need to figure out how likely they will pay you back. However this isn’t an easy task. Just imagine lending your friend a large amount of money, what do you assess them on?

You would probably ask yourself:

How much money they earn/have?
How likely they will pay you back even if they had the money?
Are there any other factors that will prevent them from paying you back i.e. are they expecting a baby soon.

So the business/finance world does the same and they review:

Their ability to repay the debt
Their willingness to repay the debt
Other factors in the future that can impact their ability to repay

As this is such a difficult task that the finance world has a dedicated industry for it: credit rating agencies whose job is to assess company or individuals credit rating/score. They do this by reviewing their current financial situation (via bank statements, financial records etc.) and provide a qualitative rating/recommendation.

For example Standard & Poor is a credit rating agency that will provide a credit rating that ranges from AAA to D on a company’s debt. This is suppose to help investors make informed investment decisions.

Below are some figures of credit default risk on different companies based upon their credit score and typical yield:

This is by no means a foolproof method (as seen in financial crisis) and there are areas of issues with it but that is for another article in itself. Though in summary default risk is a qualitative assessment based on quantitative metrics.

How Does All This Relate to Cryptocurrency World?

So investing in the cryptocurrency world also means you will be subject to default risk. It can happen in a variety of ways but the one I wish to discuss in more detail is…

Exchange Default Risk

Exchange default risk is definitely one of the largest risks when investing/trading cryptocurrencies. It is in essence the risk that if you put money/crypto with the exchange and if the exchange goes bankrupt you don’t get it back.

And remember putting money in an exchange is different to a bank (or even a regulated exchange) because:

To illustrate this point we have…

The Infamous MT. Gox Case

MT. Gox was the largest bitcoin exchange in the world at the time and from Wikipedia: “In February 2014, Mt. Gox suspended trading, closed its website and exchange service, and filed for bankruptcy protection from creditors. In April 2014, the company began liquidation proceedings.” (For more details you can refer to the wikipedia link here).

This incident opened up many concerns some of which were:

How vulnerable were crypto exchanges?
What is the likelihood of this happening again?
What happens if an exchange defaults?
Do the crypto deposit count as the exchanges assets or does it get recognized as a deposit just like in a bank situation?
If it is a deposit, does its order of seniority come ahead of bond holders?
What would be the process for depositor in getting their funds back? Would it be in USD or BTC or…?

This set a precedent on the market and as the situation continues to develop (it is still ongoing) it will be remain a cautionary tail of what could happen in the case of a default.

Oh My Gosh, Can We Avoid It?

Yes, and many people do. What you have to do is avoid using centralized exchanges (which is generally what the popular exchanges are) and instead:

Utilize a cold wallet to store assets so it doesn’t have to stay in the exchanges
Transact using decentralized exchange (DEX) to avoid having to pass over your assets to the centralized exchanges at any point.

However there are clear drawbacks to these method.

Cold Wallet:

If you lose your secret key (or it gets stolen) your fund is lost forever. (It happens more often than you think!)
Getting your funds from your cold wallet to DEX takes times.

Using DEX:

Currently still fairly low liquidity
Some DEX require confirmation on the blockchain which isn’t as quick as using a centralized exchange.
No way of turning your money into Fiat.

In addition there are some positives to using centralized exchanges:

Customer service to assist
Some mechanism in place to prevent fat finger orders

Personally I still use centralized crypto exchanges due to it convenience/advantages and would recommend it to most. However you do need to make sure to do some sort of exchange default risk assessment which I share my methods below.

How Should We Assess Crypto Exchange Default Risk?

As someone that actively trades in crypto market, exchange default risk is something that I try to assess constantly since it is definitely one of the largest source of risk in my arbitrage strategies. The difficulty is how do we assess this?

Below is my current thinking when conducting this type of assessment (by no means is this a recommendation but just an insight into how I think about default risk):

#1 — Gather Quantitative Data

Normally for finance investments I would look at historical data. However given the fact that this industry is very new and undergoing significant development, past data is unlikely to be reliable and also difficult to come by. So at minimum I would gather:

How many symbol the exchange trades
What is the 24 hour trading volume
Where it ranks amongst the other exchanges

#2 — Qualitative assessments

Next I do a qualitative assessment of the exchange and try to score based upon different metrics. Some of the things I look for are:

Licensing — any regulatory body they report to
Country of domicile — which jurisdiction the exchange has to adhere
Country of operation — where the exchange actually runs
General sentiment by the community — e.g. are people having problems getting their withdrawals
Any recent positive/negative news — e.g. hacks
Investor/Support — Is it easy to reach support?
Profitability/Financial statement (if available)

This list is not exhaustive and there could be other factors that affect my scoring on a case by case basis such as bitfinex relationship with tether.

In addition I do use certain reports to assist and one of them that is publicly available is this exchange security report: https://icorating.com/report/exchange-security-report/

#3 — Market Trends and Developments

Besides exchange specific factors, there are also general market trends and development that could affect the assessment. For example:

Trading volume of overall crypto
Recent crypto price trends
Regulation
Any special incident/events — For example: many of the recent hacks have been compensated by the crypto exchanges in full. This seems to be a growing theme where credibility is more important than short term losses (and that many of these exchanges can raise money).

This is because some of these factors will impact the profitability of the actual exchanges themselves. As seen in the oil company’s, when oil prices rise the chance of them defaulting is lower and in the case of distressed prices then their changes of default also increases.

#4 — Putting it all together

In this final step you need to figure out whether you:

Have to use a centralized exchange (like me)
Don’t have to use a centralized exchange

Because if you are in camp 1 then what you need to do is compare the relative default risk between the exchanges. Hence you only need the information in step #1 and #2 to decide which exchanges you feel are the best ones and weigh it against the potential gains.

For example which of the exchanges below do you think is less risky and why? Highlight here to see my thoughts: Exchange B probably has a lower default risk because it is licensed and domiciled/operates in crypto friendly countries (Vietnam is not crypto friendly). It is also owned by a larger financial institution which is a positive. The only concern is its relatively lower volume and uncertain profitability but given that it only offers a fraction of the crypto for a reasonable volume it should not be too much concern.

Note: Above table is all hypothetical information

Whereas if you are of camp 2 (don’t have to use a centralized crypto exchange) your decision is to decide whether you feel the default risk is worth taking at all and you would probably be using mostly the information in steps 1–3 to evaluate whether the risk is worth it.

Example:

For example if I had an opportunity to invest in a crypto fund that could yield me 30% per year but in exchange I would need to take on exchange default risk, then my thinking would be:

Firstly what is the opportunity’s expected return:

Expected Return = Yield x Duration — Potential Loss x Default Risk x Duration

Plug in:

30% = Yield of fund
100% = Potential Loss( Assuming worst case scenario of complete loss due to default)
1 Year = Duration

We get: Expected Return = 30% — Default Risk

Next we need to figure out what is our expected default risk. To do this I would review the information I gathered from step 1–3 earlier.

So for this example let’s say I have the following hypothetical information about the fund’s exchange choices:

Uses only top 20 exchanges with $100M+ 24 hour trading volume
All exchanges are domiciled and operate in crypto friendly locations
Sentiment can vary on exchanges but generally neutral to positive
No recent negative news
Crypto exchanges have been getting a lot of venture capital investment and subject to acquisitions

At this point it is just a combination of gut check and analysis to review whether you are happy with the expected return based upon our earlier “Expected Return = 30% — Default Risk”

Extra: Sometimes I would also do what I call a “sanity check” on my default risk estimate. For example if I estimate my default risk is 2% then I would look at comparable metrics, such as the chart below. It currently shows high yield default rate is only 5% or so which would mean that my 2% estimate is probably too low and that I should revise higher.

Final Thoughts

Hopefully this article got you thinking about assessing default risk for your next crypto investment. The methods suggested here are not the only methods and may not be the best but have been what I have been working with so feel free to change it as you see fit and lets hope no one has to actually suffer a default.

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