Panic at the US Markets: I Write Risk And Tragedies
Counterparty risk and the role of crypto: Navigating market volatility and regulatory changes amid a revolution in financial systems.
Centralized Exchanges. Tokenization. Credit crunch. Banks. What do they all have in common?
Counterparty risk.
These past two days have been tumultuous, to say the least.
The US Securities and Exchange Commission has filed charges against the two largest crypto players in the world, Binance and Coinbase, alleging the sale of unregistered securities on their platforms.
Even though these actions are recent, centralized exchanges have been searching for new jurisdictions for quite some time now.
The markets have been signaling fear of systemic banking issues, with regional banks trading down significantly.
This exposes vulnerabilities in the financial system, presenting opportunities for technology to provide a solution that banks and non-bank financial institutions structurally cannot solve without cannibalizing their businesses.
Dance of Jurisdictions: Coinbase and the SEC
Coinbase began to outwardly explore other jurisdictions such as the Middle East or Europe in search of a new home as they find themselves in the same SEC crosshairs as Bittrex and Kraken. The industry’s public relations playbook aims to rally support of the crypto industry to pit ourselves against the regulators and threaten to leave the US in defense of keeping our industry alive.
The Value of Keeping Crypto in the US
But why is the industry threatening to leave the US? If it makes sense for the businesses, then they will leave in search of business continuity and profits without making a fuss.
Clearly, there is value in keeping exchanges in the US as they are the on-ramps to the crypto economy, not to mention the US hosts the most liquid markets in the world given the robust legal system supporting it. Americans want to keep crypto in the US as it’s seen that this technology can help the Dollar maintain supremacy over the next generation of digitally-native financial markets.
Unlocking Potential: Tokenizing Securities
With that goal in mind, how can we leverage the strength of the US financial and legal markets architecture for ensuring the US Dollar continues to denominate assets in the digital economy?
To understand this question, we can look no further than the wave forming in tokenizing securities to unlock new potential on-chain. This is the single hottest area for analog finance as trillions of these assets sit immobile collecting dust as collateral to hedge against the risk of central clearing parties, wasting opportunities to generate yield.
Unfolding Vulnerabilities: The Struggles of Banks
There are current systemic and structural reasons why these banks in their current form are struggling and exposing vulnerabilities in our current financial system. From this understanding, we can see where the opportunities exist and where the early innings of the future of finance begin.
Seeking Partnerships: Blackstone and Regional Banks
Recently, Blackstone began talks with regional banks to engage in lending partnerships. The banks would originate loans and channel them through the private equity companies to the insurance customers. Banks need this relationship with these non-bank financial institutions as they want to maintain the relationships with their clients but cannot take more risk on their balance sheets after deploying their risk capital during the low-interest rate environment.
The Punishment of Investors and Banks' Lack of Liquidity
These issues are not just impacting new credit origination, as global chief investment officer of State Street Global Advisors, Lori Heinel, writes in the Financial Times: ”JPMorgan found the number of primary dealers to facilitate trading has stalled and market depth in the US Treasuries declined almost 60 percent in 2022 to levels only seen in times of a crisis.” Investors are being punished as banks are caught offside and unable to provide liquidity in the primary market for Treasuries.
Profiting from Inefficiency: Citadel and Other Market Makers
All the while, market makers stand by to take advantage of this illiquid market’s volatility and profit from asset managers who must fulfill their fiduciary duty to their clients who are saving money for retirement. Posting a record-breaking performance of $16 billion in profit in 2022, market makers like Citadel stand to gain from inefficiencies in the market structure. The inefficiencies in market structure arose out of two pieces of regulations which changed the amount of risk banks can take and how trades are routed to market, the latter being a subject of a later post.
Facing the Same Old Lack of Confidence
The Dodd-Frank regulations passed in the aftermath of the GFC created limits to the amount of risk banks could undertake, which really enabled non-bank institutions to fill the void in banking services such as proprietary trading and market making. Despite the complex regulations, we find ourselves with the same lack of confidence in the banking system as we had back then.
Reviving Memories: Geithner's Stress Test
The memoirs of Treasury Secretary Timothy Geithner, Stress Test, go into great detail about his perspective of handling the GFC and creating stress tests of banks in order to see if the institutions can handle further shocks. One of the key immediate concerns revolved around not incurring haircuts on creditors’ assets. The financial system was already in a crisis with potentially even bigger ‘bombs’ dropping should AIG, Citi, and Bank of America suffer further losses. Any haircuts against senior creditors would cause cascading runs on the banks as investors fear the counterparty risks on their deposits with the banks.
The Digital Financial System: A Potential Solution
However, former governor of the Bank of England proposes that banks could preposition assets at the central bank in return for a line of credit. Contingent upon banks’ liquid assets covering any runnable liabilities, there is a haircut applied against these types of assets. Given that banks would know the amount of cash available to cover liabilities as the haircuts bake in the amount of losses they can incur.
What regulators are really yearning for here is a way to institute risk management solutions that have deterministic execution based on predefined parameters with automated compliance and streamlined settlement and clearing processes. A digital financial system holds the potential to address these challenges and reshape how risk is measured and distributed within the system.
Central Clearing Parties: The Root of Counterparty Risk
The core issue where counterparty risk arises is with the central clearing parties that are required in order to reduce settlement risk between two or more counterparties. As described before, in analog financial systems, transactions often involve multiple intermediaries, each introducing its own layer of counterparty risk. A universal ledger of record provides a single, authoritative source of transaction data. All parties involved in the settlement and clearing process can access and rely on this ledger for accurate and up-to-date information.
The Promise of Universal Ledgers and Real-time Risk Management
Since the time to settlement and clearing of these transactions happen instantaneously, the opportunity cost of capital and the counterparty risk premium on that capital significantly reduces, especially in periods of heightened volatility.
To implement atomic exchange and instantaneous settlement effectively, a universal ledger of record is required. This ledger acts as a single source of truth that records all transactions in a transparent and immutable manner. It provides a consistent and reliable view of the entire transaction history, enabling automated net settlement and clearing processes. With a universal ledger, participants can also automate the reconciliation of transactions, calculate net obligations, and settle transactions instantaneously based on predefined parameters and smart contract logic.
Democratizing Markets: The Future of Finance
Moreover, a universal ledger enables real-time risk management. By having access to a comprehensive and up-to-date view of transactions and positions, risk management systems can continuously monitor and assess the risk exposure of market participants. Real-time risk analytics can be applied to detect and mitigate potential risks as they emerge, allowing for prompt action and reducing systemic risks. Stress testing just got that much easier.
As we imagine the future of finance, we can envision a more resilient financial system. The centralized exchange models of the past no longer work and will need to be replaced by new settlement engines that power new or modernized exchanges.
Tokenization
The evolving narrative around tokenization emanates from this vision that these digital marketplaces can offer better market structure given the automated execution and compliance of digital assets and related smart contracts.
The vulnerabilities that we see in the market now are derived from the complex regulations that significantly increased the cost and technology required to be compliant. Stress testing becomes an API call by baking the compliance into the systems. Automated execution reduces the need for insurance in the system as risk management tools become empowered with real-time data to institute asset impairments in adverse market circumstances.
Since all trading is fully funded in a transparent financial system, exogenous shocks should not distort the market into volatility that ultimately lines the pockets of banks and market makers. Instead, these markets become democratized and give asset owners full power to be their own banks and deal in the markets themselves.
The Bottom Line
While we may be on the edge of significant financial transformation, current challenges remind us of the structural issues in our financial system that need careful resolution.
Digital assets are currently navigating their first major macroeconomic downturn. The anticipation among asset managers for the next wave of digital asset adoption, despite current regulatory hurdles, is certainly noticeable.
This potential shift could lead to a profound change in how we manage counterparty risks in the markets.