The evolution of crypto risk management

Author: Ana De Sousa, CEO, Agio Ratings

Despite the enormous challenges of 2022, a surge in the crypto market has renewed investor optimism and heightened interest in digital assets. In fact, only recently, the SEC approved new rule changes in support of EFTs, setting up the potential launch of eight exchange traded funds, bolstering overall sentiment. 

The problem is digital assets may never reach their full potential if market participants get trapped in boom-bust cycles precipitated by poor risk management. Such conditions inhibit credit growth, which is necessary for any financial market to thrive. 

That’s why there’s a pressing need for specialized risk management tools and methodologies, like Agio Ratings. This article explores the risk controls that crypto asset managers need to support a successful and sustainable performance record.

The renewed focus on counterparty risk

The rapid growth in crypto and the fallout from the collapse of FTX have brought renewed attention to the risks associated with counterparty transactions. In fact, in a 2023 study, 50% of participants were concerned with counterparty risk, compared to 31% for operational risk, 13% for liquidity risk, and only 6% for market risk.

According to the study; “Following the collapse of FTX, crypto derivatives exchanges published proof-of-reserves to help reassure investors of their client fund management processes. However, 64% of surveyed participants said they remained concerned with the quality of proof-of-reserves from most exchanges.” 

Interestingly, no respondents were fully satisfied by most exchanges’ submissions, with only 14% happy with a small number of exchanges.

So if proof of reserves isn’t enough evidence, what’s the solution? We think it comes down to a better understanding of counterparty default risk.

Understanding crypto exchange default risk

One of the most significant challenges in the crypto ecosystem is the risk of default among exchanges. Investors and traders entrust their cryptocurrencies and funds to these exchanges, relying on them to maintain secure infrastructure and robust internal controls. 

Some firms will attempt to mitigate crypto risk through various strategies, such as:

• Custodial services: Engaging with third-party custodians to hold and safeguard their digital assets, aiming to reduce the risks associated with self-custody. 
• Diversification: Spreading their holdings across multiple exchanges and custodians to minimize the impact of a single point of failure. 
• Insurance: Purchasing insurance policies to protect against losses arising from hacks, thefts, or other security breaches. 

While these strategies provide some level of risk mitigation, they potentially fall significantly short in the event of counterparty default. Custodial arrangements, for instance, don’t necessarily protect against the risk of an exchange’s insolvency or operational failures. 

Diversification can help spread the risk, but it doesn’t eliminate it entirely, and finding comparable liquidity across multiple venues can be challenging. Insurance policies, too, often have strict limitations and exclusions, leaving risks unaddressed. 

The absence of comprehensive risk assessment and disclosure requirements has allowed some exchanges to operate with opaque practices, potentially masking underlying vulnerabilities or high-risk activities. This lack of transparency and accountability has contributed to the susceptibility of centralized exchanges to counterparty default risk, jeopardizing the assets and funds of their clients.

The collapse of FTX in November 2022 serves as a strong reminder of the potential consequences of inadequate risk management in this space. 

As an interesting side note, FTX was flagged by Agio Ratings as one of the riskiest exchanges as early as July 2022, highlighting the need for reliable and specialized risk analysis tools.

Building on traditional risk models

The need for robust counterparty credit analysis has been a hard-lesson learned multiple times across multiple asset classes in TradFi.  The market realized the importance of robust risk analysis after numerous incidents where investors lost significant sums due to counterparty defaults and failures. 

The crypto industry has experienced a similar evolution but at an accelerated pace. Agio Ratings has identified over 25 significant exchange defaults in the last three years. Crypto has essentially repeated the history of TradFi, but in a much shorter time frame. 

This rapid succession of defaults highlights the pressing need for firms to develop a comprehensive understanding of the risks they face. Staying alive and thriving in this dynamic market means building on lessons learned in TradFi, while accounting for the unique complexities of the crypto ecosystem. 

One of the earliest and most well-known models is the Z-Score, developed by New York University finance professor Edward Altman. This model used a combination of financial ratios to predict the likelihood of a company going bankrupt.  The Altman approach then gave rise to the type of discriminant analysis which underpins many of the quantitative rating tools used by traditional lenders today.

However, the Z-Score was developed specifically for traditional companies and industries. By introducing on-chain data to the analysis of default risk factors, Agio Ratings has been able to adapt these battle-tested methodologies to the problem of assessing exchange risk. 

The innovative aspect of Agio Ratings' solution lies in its ability to generate a highly accurate probability of default. By incorporating data from on-chain behavior, web traffic, and other sources with daily cadence, Agio Ratings' models can react to real-time changes and provide up-to-date risk assessments. This enables risk managers to make informed decisions and mitigate risks effectively.

How to mitigate crypto risk: Agio Ratings’ approach

Unlike traditional finance data that’s hidden in black boxes, in crypto, raw transaction data is visible to everyone due to the public nature of blockchains. But in practice, it only becomes usable once processed, aggregated and analyzed by platforms like Agio Ratings.

To address the unique challenges posed by the crypto space, Agio Ratings has developed a comprehensive 6-step approach to crypto risk management. This methodology is designed to provide a robust and tailored approach for assessing and mitigating risks in the digital asset ecosystem.

Compete effectively while protecting yourself from digital asset risk

As the crypto industry continues to evolve and mature, effective risk management will be crucial for serious market participants looking to navigate the inherent volatility and uncertainties of this space. The good news is that a next-generation ratings agency like Agio Ratings can now offer the industry a reliable map of exchange risk. 

Agio Ratings’ innovative approach, combining specialized risk models with a deep understanding of the digital asset ecosystem, provides a robust framework for assessing and mitigating crypto risks. 

Our primary rating products; Statistical Rating and Fundamental Rating aim to measure the 12-month probability of default for crypto firms and market participants.

This allows you to:

• Protect capital: Set risk-adjusted hurdle rates, enforce trading limits and policies, and monitor exposure at default and losses given default. 
• Underwrite credit: Accurately price margin, revolving, and term loans and properly account for credit risk during settlement periods.
• Ensure long-term success: Win more business, earn necessary regulatory approvals, and raise capital for long-term growth.

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To learn more about Agio Ratings solutions and how they can benefit your organization, book a demo and talk to one of our experts.

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