The past couple months have been a rough ride for crypto investors. Valuations have come down across the board, and volatility has increased substantially. While these market conditions have made it difficult for investors, the same conditions are testing the risk management framework of the exchanges, brokers, and issuers of digital assets. In the absence of comprehensive regulation for digital assets, exchanges, issuers, and other service providers are left to develop risk management controls on their own.
To illustrate these points, we have highlighted some recent news related to digital asset issuers and lenders.
LUNA & UST
On May 9th, a large algorithmic stablecoin (UST) lost its peg to USD and dropped to a low of 26 cents. The root cause of the lost peg was a handful of large wallets withdrawing UST cross-chain to take advantage of arbitrage opportunities. LUNA subsequently dropped over 90% as faith in UST was lost.
After suffering a $650 million loan default from a large hedge fund client, Voyager filed for bankruptcy protection on July 6th. At the time of the statement Voyager claims to have assets of $110 million of liquid assets, and 1.6 billion in customer fiat and digital assets. The bad loan was over 5 times the size of Voyager’s assets and almost 40% of all client assets at the time of the bankruptcy petition.
After cutting staff and citing a “negative impact on growth” Blockfi has taken on more debt and agreed to be acquired for up to $240 million, less than 5% of its valuation in 2021. As Blockfi is primarily a digital asset lending platform, it is also left on the hook when customers can’t make margin calls or default on loans.
The crypto lending firm paused withdrawals in early June due to “extreme market conditions”. Celsius has over 2 million users (about the population of Nebraska) and withdrawals are still currently halted on the platform. Celsius apparently has a $2 billion hole in its balance sheet.
Another crypto lender paused operations, including withdrawals, on July 4th and is exploring restructuring options due to “financial challenges”.
What do these 5 stories have in common? While it’s easy to say that the down market in digital assets is the culprit, that is not quite the whole story. And while we don’t have all the details or any specifics around root causes, what we do have is a high-level belief that each of these firms has been affected by excessive credit and / or liquidity risk, a concept that is highly monitored and tested in traditional finance.
None of the entities are regulated in the US to the same standards as those of a bank or other lending institution. While they likely have risk management in place, there are no standards or regulatory agencies double checking their risk exposures and controls to ensure each entity can weather tough markets.
In traditional finance, banks and broker dealers also have to deal with increases in bad debt and volatile client withdrawals. 2008 is a good example of bank and brokerage failures caused by the same market conditions. Had these firms been subject to bank capital requirements, or broker dealer customer reserve requirements, these scenarios may not have happened, and even if they did, customer safeguards such as FDIC and SIPC may have served as a backstop against client loss.
As it is now, these rules as written can’t apply. Regulators do not currently know how to handle digital asset firms in this context. And further, we don’t believe that digital asset providers should be subject to the same rules as traditional lenders and issuers. We do however, believe that Client assets should be protected, whether digital assets, fiat, or securities. We believe that there should be a focus on ensuring the concepts of customer asset protection that have been developed over many down markets are applied to all investors, including those that hold digital assets.
Aspect Advisors can assist with your risk management requirements, whether it is testing your current controls or recommending and implementing a comprehensive risk management and compliance program.
Please contact Jennifer Csaszar at [email protected] for more information.