The Risk That Tripartite Agreements Can’t Mitigate

In the wake of 2022’s crypto defaults, many asset managers have turned to tripartite agreements to manage exchange risk. Very few have considered the potentially catastrophic risk that such agreements can’t mitigate: Position Replication Risk (PRR).

PRR occurs when an investor has an expectation of how a position will perform – either as part of a hedged position or as a portfolio allocation decision – but loses that position when their counterparty defaults. To be flat in a hedged construct, or to replicate the position they had on previously, they now must go into the market and replicate the position previously had.

Importantly, replication risk cannot be solved with tripartite agreements and the use of custodians, because no custodian will step into a risk-taking position if a counterparty has failed.

Custodians can help traders manage the variation margin in the position, but this tends to be a small part of the risk of default. In situations where firms are trading anything other than physical instruments, they will have to replicate a position either to get back to a hedged position (if you were hedged, you are naked now!) or to allocate assets to get to a desired investment position, because the position they had disappeared with the default.

The problem is the cost of replicating the position in a volatile market can be significant. And few things send market volatility soaring like the news of a significant counterparty default.

How big can a loss from PRR be? Modeling it requires some basic assumptions. In the example below, we model a position with a notional value of USD $50 million with the following assumptions:

1.    It takes the asset manager a whole day to cover their risk

2.    Their market impact is proportionate to the size of their position

3.    The default event causes a “market shock” to the underlying asset, creating a daily move 1.5x greater than was expected

With these assumptions we calculate a potential loss of more than 6% of the position:

An asset manager who settles margin through a custodian mitigates a small portion (22%) of the risk when a counterparty defaults. The more significant loss comes from replicating the position in a volatile market.  

From the perspective of evaluating PRR, there are instances where a counterparty default can be convenient. For example, an investor may be long BTC perps to hedge a short spot position. If the counterparty defaults, the investor now must replace a long in a falling market.  While you can get lucky, generally, there is chaos, stress, and disappointment when an investor is actively trying to replicate a position that evaporated with a counterparty default.Unfortunately, luck isn’t a strategy.

So what can investors do to better manage PRR? The first step is to pay attention to the credit agreement in the source contract when dealing with tripartite agreements and custodians , which creates a further layer of operational and legal risk.  The second is to know the default risk of their most significant counterparties, and to monitor potential losses associated with replicating a position in the event of default.

This is where Agio Ratings can help. We model default probabilities for 30+ exchanges daily. Our approach analyzes over 1,000 variables assembled from on-chain and off-chain data sources, and we have tracked default risk since July 2022. Notably, our model flagged FTX as one of the riskiest crypto exchanges several months before its bankruptcy.

For more information, book a demo with us or reach out to contact@agioratings.io.