Yogi Berra Understood Counterparty Credit Risk
“In theory, there is no difference between theory and practice. In practice, there is.” YB
In theory, if you lend a buddy $100, they’re good for it. You might even say that the loan is collateralized because you have the “value” of the friendship.
Your friend is disincentivized to default, presuming you are friends and they’ve been laughing at your jokes because they’re funny, and not because they’ve been softening you up for the ask. In practice, you know how this often goes. Your friend says they need a few more days; then they stop returning calls, then you realize the friendship’s value was far less than initially thought.
If you lend $10K, it’s preferable if your friend leaves you with their car until they repay the loan. Far better from a risk management perspective. No comparison. If you’re going to lend someone your bitcoin, wouldn’t it be better to have their collateral in your possession? Concerning risk, there is no mistaking a transaction that is properly collateralized with one that isn’t. Full stop.
As with most things we turn to Shakespeare for the rubric, “Neither a borrower nor a lender be;/ For loan oft loses both itself and friend.” Hamlet Act:1 Scene:3
Obviously, he was referring to uncollateralized loans!
Making sausage, opacity = good. Lending crypto, opacity = not good
On a centralized platform, your counterparty is the platform itself. Most of the time it’s opaque. You have no visibility into their risk management, their loan book, and any information regarding whether their other customers (synthetically your counterparties) are being held to the same rules that you are.
There are no audited financials, no credit-rating agency, and no track records. Through a traditional capital market lens, it’s a room full of sub-junk credits. Non-starter. The platform is offering you yield in exchange for you placing your assets with them. How are they paying for it? With VC money? If so, how long until that music stops? Are they lending it to someone else at a higher rate? If so, what is that entity’s creditworthiness? Again, that party is, by extension, your counterparty. To be clear, there is NOTHING inherently wrong with them giving you interest. However, one would like to be able to see how it’s working, and with whom. Without such visibility, this is a faith-based transaction.
Hold on, what about DeFi?
On a decentralized platform, your counterparty, in many respects, is the smart contract to which you have given your crypto. If you didn’t look at the code, or you don’t understand how it works, then you have just entered into another faith-based credit arrangement. You entered into an agreement without reading the contract! And it’s not only the code; it’s also the workflow, too. If an asset rapidly declines in value, it is safe to say that there will be an increase in demand placed on the network that supports that asset. If this congested network is how you need to send a time-sensitive payment to address your shortfall … then, well, you do the math. Worse yet, pricing and auction mechanisms failed, and millions of dollars worth of crypto were sold at, wait for it…., ZERO. March 12th was bad, but it can get a lot worse. A lot.
Many DeFi entities appear to be repeat offenders. It seems they often know there are problems but go straight to production anyway. Maybe they feel it’s a land grab and so there isn’t time for appropriate testing. Dunno.
This is all a big experiment. Everyone is participating in beta. Know that. Own that.
Digital Gamma’s Tri-Party Repo (TPR)
It is based on models from traditional finance that have been adapted for crypto. It solves for counterparty credit risk by replacing it with a risk that can assess, which you can manage — market risk. Some of the key features:
- Loans are collateralized: you can take your counterparty’s collateral external and do whatever you need/want to; yes, that means it is in your possession;
- Two-sided escrow: both parties have skin in the game;
- Borrow & Finance: this is a complete solution; created leveraged long crypto, borrow crypto for shorting or trading, lend crypto or cash for interest, borrow money for bills or business;
- No Liquidations: Don’t wake up and find half you coin gone because some risk manager sold it overnight; with TPR there are no liquidations short of full default;
- Standardized Legal Framework: based on the Global Master Repo Agreement; if you are a capital-markets professional, this protocol should be familiar;
- Transparent Rules-Based Process: No surprises, defined and agreed upon risk management and default procedures;
- We are P2P, but not reliant on smart contracts that can be hijacked by external parties;
It’s customizable and flexible. Come to the venue to see the rate. Do not execute off-market. Benefit from transparent price discovery before showing your hand. Find counterparties. Collateralized loans. Understandable and robust risk management. A protocol where both parties can tick the necessary boxes. Safer. Better.
Please let me know if you agree, disagree, or are interested in learning more.
Next Week: Moe Berg Understood Embedded Negative Convexity?
