Risk I: The Game of Stablecoin Domination
Lesson 11: How Counterparty Risk Applies to Stablecoins
This is part one of a two-part article where we will explore two types of risk with respect to stablecoins — namely, risk related to persons (Part I) and risk related to design (Part II).
If you need a primer or refersher on the general concept of stablecoins, you can go here.
In this first part, we’ll focus on the idea of counterparty risk, or the risk presented by other people and institutions when making a deal, trade, or loan.
What Is Counterparty Risk?
The easiest way to understand counterparty risk is in terms of default (or default risk) and credit (or credit risk).
A counterparty is someone or some group of people involved in a transaction. They are considered “counter” because they are opposite you in a transaction; and furthermore, they can oppose you by presenting an adversarial threat if they do not uphold their end of the deal or fail to act honestly. Typically, in counterparty situations there is usually some monetary responsibility the counterparty must meet, the failure of which means the transaction falls through. The likelihood of failure, or the amount of counterparty risk, is the likelihood of the counterparty defaulting. This likelihood can be gauged:
- by the counterparty’s credit score, or history of making loan and bill payments on time; or
- by other factors, like their financial context in relation to adverse conditions or ongoing commitments.
The most common type of counterparty risk is one in which the counterparty owes money. If the party cannot pay the amount owed by the required date, or can only pay a portion of the outstanding amount, they have defaulted.
Imagine you have some spare money:
Two of your friends, Bob and Sarah, are in need of money. You can only lend to one of them. Sarah has been employed for several years, and Bob has not been employed for a few years (a factor lowering his credit score). You decide that because Sarah is employed, Sarah is more likely to pay back the money. You have basically decided Bob is a default risk, and therefore a counterparty risk. If you lend to Bob, you may never get your money back!
The Office of the Controller of the Currency thus defines counterparty risk:
the probability that the other party in an investment, credit, or trading transaction may not fulfill its part of the deal and may default on the contractual obligations.
When it comes to cryptocurrency trading, counterparty risk can emerge in straight-up lending situations (peer-to-peer), but more often counterparty risk is complicated since cryptocurrency markets are not regulated. In this sense, counterparty risk can also include deception and bad faith.
Counterparty Risk & Cryptocurrencies
Let’s look at three examples of counterparty risk related to cryptocurrencies.
Collateralization
Offering your coins to a lending pool to provide liquidity to borrowers can involve a form of counterparty risk in the strict sense that a borrower may not be able to pay back the loan amount. Luckily, DeFi systems employ various requirements and methods to mitigate this risk. Collateralized debt positions are used to ensure that adequate collateral backs a loan/pool. Other mechanisms include smart contracts to adjust or close positions according to market conditions. In fact, most DeFi exchanges require over-collateralization up to 150% to ensure any run within a pool will not cause it to collapse. (But this is not guaranteed! A liquidity pool is only as good as its smart contracts. Just read about the ICHI Fuse Pool #136 debacle.)
Adverse Selection
Adverse selection occurs when the person in a lending or selling position knows more about the product being offered than the buyer or loanee. It’s essentially a situation where the buyer/loanee does not have enough information to make an informed decision.
In a regulated space, there would be rules and sanctions preventing this. For example, with CeFI, insider trading can receive a penalty of up to $1M or three times the profit or loss avoided (whichever is more). Frontrunning, or trading before a block of trades in the same asset occurs in order to get a better price, is also penalized. With DeFi the constraints on adverse selection occur by virtue of the blockchain’s transparency and the use of over-collateralization. Though interestingly, preventing frontrunning has proved difficult due to MEV bots.
Conflict of Interest
Because DeFi is decentralized by definition, it cannot utilize a central authority to incentivize good behavior and disincentivize bad behavior. So, such (dis)incentives have to be built into the transaction structure. Financial (dis)incentives are most common, as for example, with proof systems requiring an enormous amount of capital to be burned if one wants to gain majority control in a 51% attack.
As well, the DAO structure of platforms involves a democratic governance process, though it is possible for a crypto whale or institution with large crypto holdings to gain and exercise control. Just read about the role of Arca in controlling Sushi Swap.
What Are the Typical Counterparty Risks for Asset-backed Stablecoins?
As with any currency, there can be a problem when the value of the currency is not actually backed or represented by something that has value. Most currencies are representative of value; not value itself. (Ok, this is admittedly a topic in its own right.)
But for our purposes, we need only refer to a common practice: a currency can be backed by gold. Another way of thinking about currency backing is in terms of it being backed by the production of goods (i.e. commodity-backed currency). In this latter case, currency represents the value of goods and services in a nation; and it thus facilitates the exchange of goods and services. Instead of trading one shoe for garderning services (i.e. barter), currency allows for a much quicker and more efficient method for satisfying needs without having to have a “coincidence of wants” between the people exchanging.
If a currency is not adequately backed, then a counterparty risk emerges. Whoever is in charge of ensuring that the currency is backed adequately is not acting diligently or honestly. This risk becomes more apparent when some event arises where holders recognize there is a need to exchange the currency in question. Rumors, a quick devaluation in the coin, or a collapse of a financial pool or institution can each result in people wanting to quickly exchange a currency for safer assets.
When a significant majority go to do this, it’s called a “bank run”. And, as you can guess, because the currency in question is not adequately backed, there isn’t sufficient collateral to meet the demand.
That situation equals a crash. (See the details on the crash of Anchor protocol.)
These same principles apply to stablecoins.
Stablecoins are supposed to be less volatile than other cryptocurrencies. Whether through some combination of being pegged to the US dollar or collateralized, they provide a store of value against the fluctuation of other blue chip and alt coins.
But this assumes that they are adequately backed or collateralized. Per above, a counterparty risk presents itself when a stablecoin lacks sufficient collateral. This concern is most often expressed in terms of whether a stablecoin can re-establish its peg to the US dollar. Generally, if it drops a few cents below $1, the stablecoin must quickly recover its value; otherwise, it can cause a collapse on those exchanges and for those projects heavily reliant on it.
Why should we worry about counterparty risk with respect to stablecoins?
For at least two reasons:
- They are widely used. Due to their stability, they act as a store of value within the crypto markets. USDT historically remains one of the most heavily traded currencies. USDC is no slouch either. Stablecoins therefore provide one of the main avenues for trading. Imagine if traders discovered USDT to be inadequately backed? All of that volume would go towards cashing out.
- They are the backbone of DeFi. Stablecoins provide some security when yield farming due to their stability. For that reason, stablecoin yield sites are very popular — just look at Curve. A failure of a stablecoin would cause enormous problems for lending pools that would reverberate across the entire crypto market. Case in point — UST’s collapse.
How This Can Be Applied
Try to think of how many stablecoins could reasonable be in existence in the cryptocurrency space. You’ll find that many protocols and platforms try to launch their own stablecoin in order to keep value locked into their respective ecosystem. As of June 2022, BitPlay reports approximately 200 stablecoins were in existence. (A quick search on CoinMarketCap at the time of writing shows 134.)
The truth is that not all of these stablecoins will survive because a stablecoin can really only maintain its stability (value) when its trading activity can ensure adequate collateral backing — or what comes down to the work of arbitrage traders helping to make the stablecoin market more efficient. In short, for arbitrage to work, there has to be incentive to want to trade the stablecoins in question. Only those that remain widely used will last in the long-run.
When considering whether to use a stablecoin, along with questions of counterparty risk, ask yourself how well placed a stablecoin is in the wider scheme of trading. An analogy to TradFi might perhaps put this question into perspective: How many world reserve currencies can there be?
There’s only one. I am not saying there can be only one stablecoin, but it has to be a lot less than 100, and probably no more than 5. But that’s just an educated guess.
For Part II of this article, please go here.
This article is a part of the Crypto Industry Essentials educational program presented by The Art of the Bubble.
Though this article is credited to me, it contains some written material by Sebastian Purcell, PhD from his The Art of the Bubble education series on cryptocurrencies.
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