When the Great Financial Crisis hit in 2008, investors weren’t worried about market risk, they were worried about counterparty risk. No matter the price of assets, financial institutions would survive, but if a lender went under, that would destabilize the market.
Risk spreads out through the financial system at a rapid rate, creating the possibility of contagion if even one big financial institution becomes insolvent. This is where “too big to fail” comes from and is why when Lehman Brothers collapsed, an incident that marked the worst day in modern memory in the financial markets.
With the recent collapse of BlockFi, the contagion is still being assessed. It is therefore important to delve deep into what has happened and how to determine when a lender is truly “safe”.
What Went Wrong with BlockFi
On the morning of November 28th, 2022, BlockFi filed for Chapter 11 bankruptcy. Although the full details are unclear, it looks like BlockFi has $1-10 billion in liabilities but only $256M of cash. BlockFi previously had financial issues in Q2 2022, with FTX bailing them out with a $250MM loan in June. Now in the wake of FTX’s collapse, BlockFi has been forced into bankruptcy.
BlockFi promised artificially high rates of return on assets deposited with it. Below are the rates of interest BlockFi was offering depositors as of May 1, 2022.
There are only 2 ways this could have been done:
- Use the borrowed Bitcoin to gamble on other, more risky coins.
- Subsidize their rates with marketing dollars.
Neither of these methods are sustainable, which led critics to predict BlockFi’s demise, but it still remains a shock to the cryptocurrency community. It has also led to many investors reassessing the risk associated with their counterparties.
What is Counterparty Risk?
Market risk is the risk of losses in a position that may arise from adverse movements in market prices. Counterparty risk is the risk associated with the other party in a financial contract not being able to meet their obligations.
If a company borrows $650K against $1MM of Bitcoin, the lender gets to keep the collateral in the case of default, and is protected against losses. However, if the lender goes under and there are other claimants on that $1MM of Bitcoin, the borrower suffers a significant loss. That loss, and the potential contagion that may result, is what constitutes counterparty risk.
So when a company like BlockFi goes under, the losses to the system start to spiral, as there is no way of valuing the risk on your trading book because the counterparties no longer exist. This makes lenders more dangerous than borrowers because of their ability to hurt the financial system.
In assessing counterparty risk, borrowers should look for a very low level of leverage with their lender. Regulators have long required traditional lenders to meet requirements around leverage as a means of managing counterparty risk, which allows would-be borrowers to use regulations as a proxy for determining the risk of a lender.
Far-Reaching Implications of BlockFi’s Demise
Although too late now, analysts are wondering how long BlockFi was insolvent. It’s possible they were allowing people to withdraw purely to maintain consumer confidence while they tried to cover their liabilities.
The potential for contagion is starting to show with Silvergate Capital and Genesis Trading being exposed to recently bankrupt institutions. Genesis has exposure to FTX, with $175M of locked funds on the exchange. Additionally, they have experienced significant losses relating to 3AC, Babel, and FTX.
It won’t be long before regulations are put in place requiring centralized crypto companies to keep customer funds in segregated accounts in a bankruptcy-proof manner, prohibiting their use for the company’s own accounts are the global standard. It isn’t clear how this would apply to DeFi.
The term “DeFi”, or Decentralized Finance, has become convoluted by companies like FTX and BlockFi, which are not decentralized at all. They fall under “CeFi” or Centralised Finance and don’t have the same level of transparency and decentralization. If FTX was decentralized, it wouldn’t have been able to drain its accounts of customer funds.
How SDM Lending Avoids Counterparty Risk
SDM Lending strongly focuses on limiting counterparty risk. SDM Lending acts as one of a select group of introducers globally for large fully-regulated family offices. These counterparties are regulated by the SEC and have no leverage or external lines of credit. Additionally, our team brings decades of traditional lending experience to the cryptocurrency world, reducing risk for borrowers.
All of these factors amount to a superior lending platform compared to our competitors, as is shown by the fact that SDM Lending has had zero exposure to any of the companies that filed for bankruptcy in 2022.
As always, our lending team is here to walk you through the details and show you why SDM Lending is a top tier lender with none of the counterparty risk that has been so prevalent in the markets until now.
Schedule a complimentary, no-obligation call with us today to learn how to better protect your investments from counterparty risk.
Book a free consultation with us today.