Blockchain Confidential - 1 July 2022

Fear and Loathing in Crypto Vegas

Cloudwall’s mission is to build an institutional-grade platform for digital asset risk management, and the last two months have been an extended lesson in why it matters, and what can happen if you do not effectively understand and control risks in a big, complex digital asset portfolio. On Tuesday night this week we brought together panelists from around the industry for a level-setting of the risk landscape, and I wanted to reboot Blockchain Confidential in this new format with some broader reflections on where we find ourselves today.

Shiny new technology sometimes obscures our view of what is truly novel, and this is particularly true in the hype-addled world of digital assets. The reality is that financial crises tend to rhyme, whatever the asset class or trading venue; Kindleberger’s Manias, Panics and Crashes covers the history and patterns well if you want a longer read. And there are three elements that come up time and again:

• Leverage

• Mis-matches

• Contagion

When I heard about the Lido Finance team pushing back on institutional investors engaging in what they called folded leverage with stETH — essentially amping up leverage by multiple passes through DeFi protocols — it showed that this perilous element is no different even with new technologies. There is a good reason the standard for hedge funds is 5X leverage: with a 20% draw-down at 5X, you are out. Famously in The Big Short, the fund very nearly touched that level; if they had liquidated, being right on mortgage backed securities market would not have mattered. Leverage can come about through lending protocols or embedded in derivatives, but it comes up time and again as a crisis accelerant.

Mis-matches make for another bucket of trouble. The most common is a maturity mis-match, where funding and obligation terms do not line up, but I would add to this liquidity mis-matches too, something we may yet see if Tether keeps playing cute with easy-to-redeem stablecoins backed by higher-yielding, less-liquid commercial paper. When an obligation is due tomorrow but you are not paid until next month, or if you have to satisfy a demand now but getting liquid will take you five days, it’s cashflow that matters, not what you think of as your net exposure. Being eventually right is not good enough, except to tell yourself, as you sit in the wreckage, that you had it correct at least in theory.

Finally there is contagion, which we have been seeing play out most recently with the big DeFi yield protocols and the digital asset broker/dealers, especially their OTC desks facing big prop traders, hedge funds, market makers, treasuries, miners and the centralized exchanges, especially for derivatives. Here the main risk in frame is counterparty credit risk, and often the second and third order effects come out of the first two factors: deleveraging causes liquidity to dry up; you see freezes on withdrawals and other “stabilization” mechanisms that just serve to further paralyze things; and more than anything else there is a climate of fear and uncertainty. There were echoes of Archegos Capital Management as well as the Great Financial Crisis: it still is not entirely clear who is solvent, at risk, or what is the net exposure. This is where you see the multi-tab spreadsheets come out in a panic as everyone tries to figure out their exposures; if the company’s risk systems don’t aggregate by counterparty or if the full set of positions is not available in one place or if collateral systems are separate from risk systems, good luck with that.

Given my long-term view and hope is to see much of institutional asset management migrate on-chain, I have been thinking a lot about what all this means for DeFi. I suspect there will be a lot of stronger centralized players positioning themselves as reliable counter parties, but balance sheets are never infinite as Luna Foundation Guard found out, so does that mean in time they also require backstops from lenders of last resort, just yet another set of names designated as systematically important financial institutions? Part of the reason we started Cloudwall was from a view that clarity and insight about the market and the risks embedded in portfolios and the broader ecosystem would build confidence in this new model, and perhaps get us to a place where institutions can trade peer-to-peer, price risk appropriately, and make sound decisions. Leverage will always be dangerous and maturity mis-matches are hard to solve without protecting the parties that offer maturity transformation in the economy, but if we can stem contagion by letting everyone know where the risks are lurking, it becomes an informed choice to walk in the shadows.