The Dawn of the Default

January 11, 2023

There can be no doubt that this has been a pivotal year for digital assets. Valuations have dropped dramatically. Investors have lost money. But the ecosystem has survived relatively intact and outflows have started to reverse. However 2022 has also been a transitional year for another important reason.

Until recently, crypto-investor counterparty risk was exclusively restricted to Fraud or Hack events. The two largest examples were Mt Gox and Coincheck respectively, depending on how you want to classify them. Arguably Three Arrows Capital was also a Fraud event. Time will tell as those details become public.

But, over the past few years, asset markets have also started to witness Defaults, where counterparties are unable to repay their obligations due to trading or operating losses. In the graphic we’ve gone back and classified the 55 largest counterparty loss events since crypto-markets emerged over a decade ago. About 80% of these losses have been due to Frauds or Hacks. The other 20% are Defaults and they’ve all occured in the past few years.

For example, this year Celsius, Vauld and Voyager have all frozen activities and entered re-structuring processes because of problems with their commercial activities. Either they were exposed to Three Arrows Capital, UST or otherwise. But, importantly, they were taken down by a mixture of counterparty and market risks, rather than being hacked or defrauded.

Whilst the investors and account holders of these firms won’t take much comfort from this, it’s an important sign of DeFi’s growing maturity and interconnected institutionalisation that Defaults are now a thing. Defaults have long been a feature of TradFi markets. Household TradFi names like Washington Mutual, Bank of New England, and Continental Illinois all ran into trading difficulties with billions on their balance sheets.

So 2022 has been some kind of weird crypto coming of age. Of course, the corrollary of this is that crypto-markets now need to measure and manage their counterparty risks. In TradFi there’s a large and elaborate infrastructure, comprising rating agencies, CDS markets and their ilk, to service this requirement. The same tools are now needed for DeFi. Hitherto, rising valuations meant this wasn’t a priority. That all changed this year.

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