Risk Simulator: Managing Counterparty Risk in Crypto like a TradFi Quant
Spread your eggs across different baskets as much as you want, but if all the baskets tumble at once, like they did for FTX in 2022, you will end up just as scrambled. A collapse in one trading venue can set off a domino effect across the portfolio. The implication is that rating individual counterparties without holding a wider view of how their credit worthiness interacts can only get you so far.
At the time of writing, Agio Ratings provides Probabilities of Default (PDs) over a 12-month horizon for 45 Centralized Exchanges. These PDs are calculated for each day and the resulting time series make up our Statistical Ratings product. Ratings allow risk managers to re-evaluate individual default risk at regular intervals and to accordingly adjust their exposures. For instance, if the PD of one of their counterparties were to deteriorate suddenly, they might choose to reduce their exposures of that counterparty.
Moving towards the continuous assessment of credit risk is a big leap forward for crypto however two questions remain:
- What is the contagion risk in the digital asset sector?
- How does it affect the overall counterparty risk?
This is where the Risk Simulator comes in: Agio Ratings’ new tool to quantify overall credit risk effectively. It leverages the signal provided by the Statistical Ratings and combines it with a proprietary model of contagion risk in the crypto sector.
This post first touches on how quantitative risk measures are necessary to effectively manage counterparty exposure and how mis-quantifying counterparty exposures can lead (and in fact have led) to disastrous outcomes. It then describes how the Risk Simulator enables this quantification of credit risk. Finally, we describe the use cases and how teams can get the most value from the Risk Simulator.
Why is the quantification of credit risk necessary in crypto?
As the crypto industry evolves and integrates more deeply with traditional finance(TradFi) and institutional investors, the need to quantify credit risk becomes crucial. Unlike TradFi, where credit risk assessment frameworks are long-established, the crypto sector still lacks standardized risk management practices. This gap has contributed to notable failures, such as the high-profile insolvencies of crypto lenders in 2022. Accurate measurement and management of counterparty risk are essential for protecting investors, maintaining platform stability, and building trust.
Effective credit risk quantification helps lenders and borrowers assess potential losses and determine the likelihood of a financial failure. In TradFi, this process involves evaluating how much capital institutions must set aside as a buffer against potential losses, commonly referred to as regulatory capital. This capital, often held in forms like cash reserves or highly liquid assets, acts as a safeguard, ensuring the institution remains solvent even in adverse scenarios. For example, under the Basel III framework, banks must maintain a minimum capital adequacy ratio, which includes both Tier 1 (core) and Tier 2 (supplementary) capital, to cover credit, market, and operational risks.
Furthermore, risk quantification allows market participants to adjust exposures, diversify portfolios. It also helps to prevent over-concentration in risky counterparties, thereby avoiding catastrophic losses due to having "all your money in one place". By accurately assessing risk, firms can also ensure they are not overpaying for loans and are managing their risk profiles efficiently. Additionally, rigorous risk assessment and transparent reporting standards are vital for onboarding TradFi lenders, who will expect the same level of diligence and data-driven insights as in traditional markets and which we have hinted at above. These standards also serve as a critical commercial lever, enabling firms to optimize their capital structures and lending terms.
Ultimately, quantifying credit risk is about more than just compliance; it is about safeguarding the business, ensuring fair borrowing costs, and creating a resilient ecosystem that can attract and retain institutional capital as the crypto landscape matures.
What does the Risk Simulator do?
Agio Ratings’ Risk Simulator allows you to convert the individual Probabilities of Default (PD) for a portfolio of counterparties into a loss distribution.
While the future is uncertain, the Risk Simulator, as its name suggests, numerically simulates hypothetical credit events in the next year using the individual PDs of each counterparty as well as a measure of contagion risk in the digital asset sector. With over 1,000,000 simulations of default and non-default events, the model calculates the credit losses associated with each simulation and then compiles them into a comprehensive risk report that can then be used to assess exposure or onboard new counterparties.
1. Amplifies the impact of the Statistical Ratings into any risk methodology: The 1-Year Probabilities of Default are direct inputs into the Risk Simulator. By default, the platform uses Agio Ratings' Statistical Ratings, but users can override this setting and adjust the PDs as they wish. Users can add any counterparty, including those that are not covered in the Statistical Ratings.
2. Outputs credit risk measures reports: The customary credit risk measures used in TradFi are compiled for each portfolio: expected loss, unexpected loss as well as credit value-at-risk for three commonly used confidence levels (95%, 99% and 99.9%).
3. Increasing or reducing the current exposure to a counterparty: Users can vary the exposure of a single counterparty and monitor the sensitivity in the credit risk measures to decide whether to unlock new capital for a venue or, on the contrary, to reduce it if the risk breaches limits.
4. Augments the due diligence process of onboard new counterparties: Similarly, adding new counterparties to the model is simple and can be used to easily estimate the added (or the reduced) credit risk taken on with this new exposure.
Who is the Risk Simulator for?
We have tailored the outputs of the Risk Simulator to those responsible for making strategic decisions, protecting company assets, and ensuring their organization's financial resilience. That includes:
- Credit Risk Analysts: Specifically tasked with assessing the creditworthiness of counterparties, they would evaluate the likelihood of an exchange defaulting and the potential impact on their organization.
- Chief Risk Officers: Focused on managing overall risk limits and aligning the organization's risk appetite, they would use the tool to assess the risks associated with engaging with centralized exchanges and ensure exposures are within acceptable bounds.
- Chief Financial Officers: Responsible for managing capital and evaluating financial resilience, they would use the Risk Simulator to make informed decisions on how much capital is needed, how to optimize borrowing costs, and ensure that the company’s financial position supports its strategic objectives.
- Treasury Managers: To ensure that funds held on centralized exchanges are secure and to make informed decisions about where to store and transact digital assets.
- Portfolio Managers: Institutional investors and asset managers would use the tool to manage the risk in their portfolios by assessing the creditworthiness of exchanges where their assets might be held or traded.
We encourage you to explore this new product and share your feedback with us.
