Sikka Addresses Centralization Counterparty Risk
In the DeFi ecosystem, it’s imperative that we all do our own research. Furthermore, supposedly stable assets don’t come without their risks. So let’s take a look at counterparty risk today. Investopedia defines counterparty risk as “the risk that the other party in an agreement will default, or fail to live up to its contractual obligation.” Another way of saying this is, if you invest your money with an exchange or cryptocurrency, the risk would be that they aren’t able to return the money you invested and it gets lost forever. It’s nothing new in the financial world, but since crypto has seen increasing adoption, it’s come front and center once again, permeating the global financial ecosystem.
Historical Example of Colossal Counterparty Default
The epitome of counterparty risk on a colossal scale is what happened with the 2008 financial crisis when the Lehman Brothers defaulted on customer loans. In this case, Mortgage-backed securities tied to American real estate collapsed in value, resulting from a high default rate. As a result, the Lehman Brothers Bank went bankrupt, involving more than $600B in assets. On a smaller scale, this is the risk associated with many cryptocurrencies.
Analyzing Risk of Various Types of Stable Assets
As we saw with Luna/UST, when a coin isn’t backed by a sufficient reserve, it can lead to mass panic and the company defaulting on its contractual obligation (or, more aptly, its value proposition of maintaining a peg to the USD.) In the case of UST, the coin wasn’t backed by adequate assets, and thus when there was panic in the market, the price of UST plummeted to nearly 0, with investors losing everything. It was a tragic circumstance, but not something we can’t learn from. The primary lesson is that algorithmic stable assets have exorbitant counterparty risk.
Additionally, counterparty risk is especially pertinent as it relates to stable assets because they aim to keep their peg by holding a reserve larger than the total value of the coinin market circulation. As a result, if the total value of the reserve ever falls below the circulation supply, then the risk of default becomes paramount.
Less Centralization, Less Counterparty Risk
This risk can be alleviated by ensuring that the value is larger than the stable asset supply in circulation. But on top of that, if you’re buying the stable assets from a centralized exchange (CEX), then they hold your private keys, and you don’t have irrevocable access to your assets. If the exchange, like Kraken, were to default on their assets, then you would be stuck holding the bag once again.
A good heuristic to follow is that counterparty risk increases the more concealed and centralized the financial institution is. With this in mind, the safest option is to hold the stable asset on your private non-custodial wallet. Extracting your assets from a centralized exchange like this gives you unchallengeable rights to your crypto. And by further doing your own research and avoiding algorithmic stable asset, you’re set to go.
Over-Collateralized Crypto = Smallest Counterparty Risk
As we’ve talked about in previous articles, some stable assets are backed by centralized fiat reserves, others by decentralized crypto reserves, and others not by any reserve at all. You may have come to the conclusion that stable assets backed by reserves are the safest bet. And you’d be right. But I’d like to get even more granular here.
Fiat-backed stable assets have slightly more counterparty risk because not only does the company that minted the coins externalize risk, but the bank that the reserves are held in also holds risk. All things considered, algorithmic stable assets hold the most risk, but crypto over-collateralized stable assets are less risky than fiat-backed stable assets because the counterparty risk is limited only to the minters.
Sikka Ensures Maximum Transparency & Lowest Risk
Sikka’s collateral, unlike centralized-backed stable assets, lives completely on the blockchain. Its stability is unmediated by any central convergence, and its solvency doesn’t rely on trust counterparties. All Sikka is backed by MATIC collateral and is publicly viewable on smart contracts built on the Polygon blockchain network. Meaning that anyone can audit it at any time and see if the total reserve of MATIC is larger than the total amount of SIKKA in circulation.
With Sikka’s over-collateralized stable assets, you hold the coins in your private wallet, so there’s no need to trust an exchange, broker, or custodian. You maintain full control and safety of your funds because they’re held in your non-custodial wallet, like Metamask. You can think of this as a private safe or vault that is digital. Only you know the private key to access the funds and thus have complete ownership over the funds, unlike storing money in a bank account.
This decreases counterparty risk because the only party that could default is the creator of the stable asset, and since the blockchain is completely transparent, you can tell exactly how much they have in reserve and ensure that you’re money is backed up and safe.
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Disclaimer: Although we reference “stablecoins,” we don’t claim that these assets will always hold their peg. We call SIKKA a stable asset, reflecting that it’s over-collateralization price stability has a few days lag time.
