The Bigger the Better: Default Risk Drivers
When we created Agio 18 months ago, our first controversial act was to label FTX nine times riskier than Coinbase. All the beta-testers rejected our thesis to varying degrees. They rhapsodised about the platform. It had market depth, keener prices, and great customer service. But in our view that had nothing to do with default risk. In July 2022, we were channeling established patterns from TradFi. Default risk is about business size, maturity, and ownership structure. Tread carefully around any small, young business owned by a mercurial founder -- not a particularly contentious opinion. That’s why we doubled down, and some of the doubters folded.A year later, and we have enough defaults to undertake something more precise. The graphic shows an example. The vertical axis is daily web traffic, a measure of size. The red line is the average traffic of 25 defaulted CEXs running up to the day they halted withdrawls. The green line tracks the other performing exchanges over the same 25 time intervals.
The most obvious feature of this graphic is that the failed firms are half the size of the performing exchanges. A discriminant analysis reveals that doubling a firm’s size reduces its default risk by x0.9. This is consistent with TradFi findings (e.g. S&P recently published a report1 estimating this odds ratio at x0.8). Likewise shrinking makes you riskier. The graphic shows how performing firms have generally experienced falling volumes over these periods. By contrast, the defaulting firms were initially growing. Even in a falling market, using investor capital, they could buy business. But then at 180 days they run out of money. Digital marketing spend gets cut. Traffic falls. Finally, there’s a sudden spike as depositors rush to withdraw funds. So x0.9 may not seem like a lot, but an equivalent analysis across many other data sources and metrics has identified at least another 13 predictive variables. When you put those all together you can with even greater confidence say which firms are safest and which are x9 riskier.
1. Lui, A. (2021, 20th November). Does Size Matter? S&P Global. https://www.spglobal.com/marketintelligence/en/news-insights/blog/does-size-matter-incorporating-company-size-in-credit-risk-assessment
