Hedgeweek exclusive: Albourne Partners’ Travis Williamson (pictured) and Steven D’Mello explain why, following the collapse of FTX, counterparty due diligence has become more important for all active trading strategies.
- The FTX collapse has underlined the importance of counterparty due diligence
- Legal and regulatory considerations continue to inhibit the migration to DeFi platform
- 2022 served as a stress test for digital assets, which will inform future developments
By Travis Williamson and Steven D’Mello
Following the collapse of FTX, counterparty due diligence has become even more crucial for all active trading strategies. Managers have been trying to find suitable counterparties, while accessing enough liquidity to reasonably execute their strategy.
In the long run, we may see regulatory pressure that forces separation of execution, custody, and financing in digital asset markets to mitigate systemic counterparty risks.
However, an early interim solution that is emerging to help manage counterparty risk is the increasing usage of off-exchange settlement which permits trading without pre-funding transactions on exchange by using leverage provided by the custodian, with settlement occurring on a daily basis.
We also expect to see increased usage of OTC trading, with tri-party settlement adopted as a tool to minimize settlement risk. While DeFi exchanges and liquidity providers have been discussed as a potentially attractive alternative to CeFi, operational, legal and regulatory considerations have inhibited material migration to these platforms to date.
Until some of these considerations are resolved, usage of centralized counterparties will likely continue, and we expect to see fund managers continue to push for greater transparency from counterparties.
If we look back to November 2022, risk taking was just starting to pick up as the FTX drama ensued. There was a false sense that the repercussions of the recent Terra/Luna sell-off had already washed through the system. There has been some localized pain in uniquely impacted coins and tokens, but in crypto terms, the impact has been relatively muted compared to other events of this nature in the industry.
Nevertheless, the risk of contagion remains real, with Genesis and BlockFi being some of the names reportedly to have run into financial trouble. FTX was a major backer of the Solana blockchain ecosystem as well as a major user of the Tether stable coin. The possible contagion could lead to further losses from a counterparty risk management standpoint.
Mitigating risks going forward
- Avoiding usage of centralized counterparties through trading over the counter (OTC): While there is settlement risk, OTC is wallet to wallet with no ongoing counterparty risk. Triparty OTC is likely to be sought by certain managers to reduce settlement risk. DeFi is also peer-to-peer and wallet to wallet, but regulatory solutions are needed to enable institutions to confidently access it. Decentralized protocols are still subject to substantial security risks (i.e., hacks). Therefore, more maturation of the smart contract security process is required before we see institutions substantially use decentralized exchanges.
- Potentially, there could be a shift towards centralized exchanges that offer more transparency. Proof of reserves involve having the exchange identify its wallets to verify that the exchange has sufficient assets to meet its liabilities. However, proof of reserves may lack granularity on the liabilities side of the balance sheet. Therefore, currently, there is no better alternative than audited financial statements. A combination of proof of reserves and audited financial statements would provide more transparency into counterparty health than currently present.
- Increasing usage of off-exchange settlement, trading on a T+0 or T+1 basis helps mitigate some of the risk.
- Reducing counterparty risk by sweeping assets off exchange into segregated trust accounts and by diversifying exposure across multiple counterparties may also be prudent.
- The FTX event highlights the need for a globally coordinated regulatory framework that would increase transparency around reserves, ideally separating financing, custody and trading into separate platforms, although this could be less likely to be achieved amidst the fallout from FTX.
- While some would argue that a more certain and friendly US regulatory environment would lessen the occurrence of offshore registrations, it is common to see offshore structures, and managers seeking to access them in traditional finance, so this risk factor will likely not be completely eliminated.
- Regulatory developments around stablecoins (e.g., MiCa regime in Europe) could help bring more certainty around regulated stablecoins, which may help participants manage counterparty risk.
While the events of 2022 have undoubtedly shaken investor confidence, the digital asset investment landscape remains compelling due to the transformative potential of blockchain technology. The failures in digital assets that have dominated the headlines in recent months are the result of what appears to be fraud and embezzlement, and not a failure of blockchain technology. In fact, the robust functioning of blockchain technology through a period of severe stress is encouraging for proponents of digital assets.
Ultimately, 2022 served as a stress test for digital assets, which will greatly inform future investors and developers in the digital assets ecosystem. While most of the investors who wanted to reduce exposure to digital assets have likely sold their holdings, several unknowns loom in the narrative surrounding the industry, including the uncertain macroeconomic environment, the regulatory response to FTX and the potential for further counterparty failures. Investor sentiment towards the space will likely follow an improved outlook on these fronts.
Travis Williamson, Head of Hedge Fund Research, and Steven D’Mello, Operational Due Diligence, are with investment consultant Albourne Partners. Their insights will feature in Hedgeweek’s next research report, due later this month. To receive this report, and others in our monthly ‘Insights’ series, follow this link.