Higher Volatility, Higher Risk
“What goes up, must come down,” is the saying. “What goes up and never comes down,” is the riddle. As BTC and other digital asset valuations have climbed over the past few months, the capital cushions of market makers has risen, and their leverage has fallen. Yet this month, Agio’s aggregate industry default risk is essentially flat, if not gently rising. What gives? It’s all about the chances of going up and down.
So to examine this somewhat counterintuitive result, consider Bitso. Bitso is a LatAm-focused centralized exchange that has been around since 2014. As such, it’s a well seasoned counterparty. On the other hand, it is not heavily regulated and comparatively small. Given that context, Agio has it rated at a baseline default risk of 12% per year. More recently, its rating has been on the move, as the competing forces of scale and asset volatility interact.
The graphic above demonstrates this interaction. The green line plots its on-chain balances (in effect its proof of reserves as measured by publicly available on-chain data). The red line is the daily volatility of those balances. During H1 2023, its on-chain balance was relatively stable at $170m and moved up and down by around 1% per day. In September, however, its trading flows increased. The green line started to rise, as it made money, as well as becoming much choppier. Daily volatility rose to around 6%.
Accordingly, Agio’s default risk rating for Bitso deteriorated. Sure, it had more revenues and rising reserves, but its volatility also tripled. This was due to either Bitso holidng higher risk coins or, more likely, increased operational leverage. Its 1-year default probability rose above 20% before settling back and then rose again for similar reasons over the past month. BTC’s value has risen. Bitso’s on-chain balances have risen. However, BTC’s daily volatility has also risen, taking Bitso’s with it.
It is true that what goes up doesn’t necessarily come down. Somethings don’t -- the answer to the earlier riddle is “Age”. But until the volatility associated with this surge in valuations subsides, the probability of prices coming down and the severity of that movement remains higher. As such, it will take several weeks before the recent rise in asset values feeds through into lower risk ratings.
