In our latest "Defi Risk report - May 2023 outlook" we introduce you to some key ideas in risk management from the world of traditional finance such as factor models.

In this post we provide you with some basis on what this is. Read on.

RiskFi’s RFX index that we introduce in the May 2023 report.

Introduction

As digital currencies like Bitcoin become more popular, it's crucial for investors to understand and manage the risks involved. One helpful tool for this is the Factor Model, which is commonly used in traditional finance. In this article, we'll explain how the Factor Model can make cryptocurrency investing safer and more manageable.

RiskFi’s five-factor style model that we introduce in the May 2023 report.

Diversification

A key strategy in managing risks is spreading your investments across a bunch of different assets. This way, if one investment takes a hit, it won't hurt your entire portfolio too much. The Factor Model helps you create a well-rounded cryptocurrency portfolio by picking assets with different characteristics, like size, volatility, and how easy they are to trade (liquidity).

Factor-Based Risk Assessment

The Factor Model helps you understand the risks of each of the five factors: Size, Volatility, Momentum, Liquidity, and Market Return. By knowing how each factor affects a cryptocurrency's performance, you can make smarter decisions about your investments. For example, if you're not a risk-taker, you might steer clear of cryptocurrencies with high volatility.

Dynamic Risk Management

The Factor Model also helps you keep an eye on how your investments are doing over time. As the market changes, the characteristics of cryptocurrencies might change too. By regularly checking your investments, you can adjust your portfolio to keep the level of risk you're comfortable with. For instance, if your portfolio becomes too focused on high-volatility assets, you might decide to invest more in lower-volatility cryptocurrencies.

Factor Hedging

Sometimes, investors might want to protect themselves from specific risks, especially if they think a certain factor might hurt their portfolio soon. The Factor Model can help you find assets with low or negative exposure to the factor you're worried about, so you can create a protective strategy. For example, if you think smaller cryptocurrencies might not do well soon, you could reduce your exposure to the Size factor by investing in larger cryptocurrencies or other assets that don't move in the same direction.

Risk management is super important when investing in the unpredictable world of cryptocurrencies. By adapting the Five-Factor Model to the unique features of digital assets, investors can get valuable insights into the risks involved and make smarter decisions about managing those risks. By thinking about factor exposures, diversification, dynamic risk management, and factor hedging, investors can better navigate the complex and ever-changing cryptocurrency market.

New report with four new alt coins

In our latest "Defi Risk report - April 2023 outlook" we bring risk intelligence covering four alt coins - Ethereum, Solana, Matic, and MakerDAO, in addition to Bitcoin.

March bank runs

In March 2023, the US economy witnessed a tumultuous time. It began with the Federal Reserve raising the interest rate by 25 basis points to contain the high inflation. However, the consistent hikes resulted in unintended bank runs at Silicon Valley Bank, Silvergate Bank, and First Republic Bank. 

Stablecoin tumbles

Stablecoins are susceptible to financial system disruptions, they are directly impacted by bank runs. In particular, Circle's USDC lost its market capitalization as it held reserves in SVB. Additionally, Binance facing a lawsuit from US regulators for alleged willful evasion, further worsened the situation for its investors as it lost market capitalization.

Bitcoin rises

The Bank runs followed by the Stablecoins loss in market capitalization, catapulted the Bitcoins rise. Bitcoin rose from a market cap of $248 billion at the beginning of March to $438 billion by the end of march. Figure below shows the trend.

Macro drivers

The Federal Reserve is taking steps to combat inflation, including keeping the money supply low, which could impact bond and equity markets, as well as Bitcoin. Equity markets have experienced a decline, likely due to investors shifting from equities to bonds as they focus on potential inflation. The stablecoin USDT, which is widely used in the cryptocurrency market, is facing potential issues that could impact the entire cryptocurrency industry, including Bitcoin. Bitcoin has a higher level of systematic risk than the overall market. 

Stress testing and simulations

The report also discusses different scenarios that may impact the value of Bitcoin.

The "Current Macro" scenario shows that the equity effect has a strong influence on Bitcoin's volatility, with a recommended stressed monthly loss of 18% on Bitcoin-based portfolios.

The "Historic Scenario" analysis helps investors understand potential risks associated with investing in Bitcoin during periods of macroeconomic stress by simulating past events.

Hypothetical scenarios

The report also highlights forward-looking risk scenarios, including the collapse of Tether, increasing US inflation, decreasing US house prices, a deep recession in 2023, excessive Bitcoin leverage, and the collapse of Binance and crypto contagion.

These scenarios are categorized based on their severity level, with extreme stresses potentially having the most significant impact on Bitcoin.

FTX, the second largest Crypto Exchange, filed for Bankruptcy last week. Their irresponsible actions (and fraud) have yet again tarnished the crypto industry. While we wait for official confirmation, $1 billion worth of consumer wealth evaporated. Additionally, there is $8 Billion dollar balance sheet gap!

The collapse of FTX is the latest in a series of events and bankruptcies this year. Celsius, Terra Luna, Voyager, 3AC, Alameda Research (subsidiary of FTX) to name a few, all went bankrupt.

In our educated opinion there are two primary reasons for this:

1. The larger macro-economic conditions

2. Lack of discipline to manage risk

In this post we will break down and synthesize the key mistakes these crypto companies made. We are using publicly available information and our knowledge of traditional finance.

Note: This is not financial advice. Do your own due diligence. 

#1 Ring fence the “Retail” and “Wholesale” business activities

Retail activities include custody of retail accounts, deposits, loans to retail customers. Wholesale activities include sales and trading on equities, derivatives, futures, corporate lending and borrowing, issuance of equities and debt etc.  

Wholesale activities carry an enormous amount of risk. 

In TradFi, financial institutions have a clear segregation between retail and wholesale activities/businesses. Using retail funds into wholesale investment banking activity is a violation and calls for stringent legal actions.

In Celsius’s case, retail depositors were lured with greater than 12% APYs’ and were lent to 3AC, a hedge fund in return for a higher market return. 3AC indulged in high-risk derivatives trading. When 3AC collapsed due to economic contraction (Luna / Terra crash), it defaulted on Celsius’s payments. As a result, millions of consumers' deposits vaporized. 

This is a violation.

#2 Diversification of assets and liabilities

Loans lent or borrowed must be diversified to avoid concentration risk. Today no diversification practice exists in lending and borrowing with crypto currencies. The below FSOC diagram shows the lending and borrowing that happened between crypto participants when Three Arrows Capital (3AC) defaulted. As 3AC collapsed defaulted on loans, Voyager went under and so did Celsius.

Concentration of risks is a recipe for contagion.

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#3 Conflict of Interest 

FTX is an exchange - a marketplace for trading digital assets. FTX also functioned like a bank, where they issued (printed) their own FTT tokens. FTX marketed FTT to consumers and traders as a utility token to avail benefits on their platform. This included discounts on trading fees, leverage trading, rewards, and settlements. FTX used FTT tokens as collateral to borrow loans via Alameda research.

These tokens inherently have no value but were priced on FTX’s exchange due to trading activity. The reason there was any value attached to FTT was due to backing from FTX and branded by SBF. This is a flawed valuation. When the news got out about FTXs’ liquidity issues, these tokens went under.

An exchange indulging in banking activities is a conflict of interest.

#4 Proprietary trading from clients' capital is a violation

Financial institutions can perform proprietary trading activities with their own capital. They cannot do this using consumer funds. Utilizing capital of consumers, retail or corporate, is prohibited. TradeFi has strict regulations towards carrying out such activities.

FTX, the exchange was hand in glove with Alameda research. Alameda research was indulging in proprietary trading activities and are now under SEC investigation.

Consumer depositor funds cannot be used for risky trading activities.

Conclusion

The issues of the Crypto industry are no different to TradFi. Lehman's collapse in the US, Bernie Madoff’s Ponzi scheme, JP Morgans’ London Whale, SocGen’s Rogue Trader,LTGM etc, are examples of TradFi's bank runs and ponzi schemes.

What this also means is that Risk management and governance have evolved over years. Risk management gets calibrated every time there is disaster. The 2007/8 crash set us up for harmonization of risk governance and oversight on financial institutions.

There isn't a perfect risk mitigation technique to avoid a catastrophic collapse. But not having a perfect solution is not an excuse for organizations that deal with financial data. There is enough literature and history from TradFi that are applicable immediately. Crypto companies must take a rational and balanced approach in identifying and mitigating organization-wide risk metrics.

Crypto companies, unlike TradFi, have no Uncle Sam (governments) or central bankers to save them. While this is a main draw to the world of DeFi, the implications of not managing risks leave the retail user holding the bag. These companies need to start gauging and quantifying the financial risks. TradFi has come a long way in establishing a resilient risk management framework. A mindless rebellion against an established financial framework is irresponsible and arrogant. Instead, crypto companies should work with existing policy frameworks until The Network state comes true.

It's about time that the entire Crypto industry wakes from its adolescence and grows towards a responsible ecosystem driving efficient financial innovation.

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The catastrophic collapse of Crypto companies since the beginning of 2022 exposed many issues in the Crypto industry. Lack of disciplined Risk management practices, financial frauds, increased cyber attacks, money laundering, and pump-and-dump schemes remained rampant among many crypto participants. There is a dire need for regulations and oversight for stabilizing the tumultuous crypto industry.

For crypto experts this is unjust, and it opposes the ethos of Distributed ledger technology, i.e non-intervention of financial intermediaries. They further argue Traditional finance (TradFi) had monstrous financial frauds which had colossal implications on the economy. Any stringent regulations will wreck the democratization of Crypto innovations. But, the crypto investors both institutional and retail have called for globally agreeable regulations to bring stability and order to the industry.

Taking a cue out of this chaos, the Financial Stability Board published two papers, the first paper presents regulation, supervision, and oversight for "Crypto companies" and the second paper is a Consultative paper focusing on regulation, oversight, and supervision on "Global Stablecoins". These regulations capture a wide range of issues, covering Financial Risks, Payment infrastructures, Cyber security, Anti-Money laundering guidelines, and Counterterrorism financing. FSB says it is working closely with other Regulatory bodies such as BIS, IOSCO, and FATF to publish further regulatory disclosures by Crypto Companies to bring stability and reduce spillover or contagion effects (if they may pose) to TradFi.

So, what does it mean for Crypto companies and how are they affected?

In RiskFi, we will bring some of the key insights on how Crypto companies must prepare to brace for the impacts and challenges of these Regulations. We will cover a wide range of topics, aiming to help the crypto companies sail through the stack pile of regulations covering a wide range of financial risks, the financial market infrastructure setups, and the global changes in the industry.