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Roula Khalaf, Editor of the FT, selects her favourite stories in this weekly newsletter.
The writer is founder and chief executive of Everett Capital Advisors and chair and co-founder of Agio Ratings
Digital assets are going mainstream, turbocharged by recent endorsements from the US administration. If properly implemented, a more developed digital asset ecosystem could bring substantive benefits.
Yet even optimistic advocates must acknowledge that digital asset markets currently fall short in how counterparty risk is assessed. This must be addressed if digital assets are going to scale in global financial systems and provide lasting benefits to consumers.
Buying and selling assets on a blockchain ledger are often thought to be riskless — there is no need to trust a counterparty as transactions are carried out instantly and transparently. But most people trade through an exchange, which usually acts as a custodian.
That involves taking on risk. Recently, we have had booms and busts in the crypto world, with dramatic bankruptcies like Three Arrows Capital and Celsius leaving creditors nursing substantial losses. Likewise exchanges and custodians face the risk that a trader might not be able to meet their commitments to pay — in effect, a credit risk.
The erratic cycle of crypto points to the market’s inability to price such eventualities well. The history of traditional finance offers a compelling precedent. In the late 19th century, financial markets were plagued with fraud, lack of data and minimal oversight — perhaps like the digital asset landscape today. Regulation is only part of the story of how things developed. Credit rating agencies, such as Moody’s and S&P Global Ratings, emerged to provide much needed risk assessments on bonds, helping finance evolve into a stable and accessible system.
Likewise retail lending was boosted by tools like Fico credit scores for individuals, enabling more accurate pricing of risk. This ultimately lowered borrowing costs for consumers. These credit tools were not and did not have to be perfect, but they provided a framework for understanding risks, which could then be priced by the market.
To achieve their potential, digital assets must follow in the footsteps of traditional finance. It is why I co-founded Agio Ratings, a credit rating platform for digital assets.
In digital asset markets, the leverage allowed in trades is usually set through agreed initial margin, or collateral, requirements, with recalculations enforced in near real-time. This model mirrors certain commodity futures markets. However, such a hedging framework is ill-suited for building long-term value.
Imagine, for instance, if homeowners were required to post additional collateral whenever house prices dipped. The punitive nature of such capital calls would discourage all but the wealthiest buyers, rendering property ownership inaccessible for almost everyone. In much the same way, digital assets’ approach to leverage undermines the potential for broad adoption.
Mechanisms to assess counterparty credit risk pricing would not only reduce the cost of capital, but also establish trust in an industry often associated with bad actors. For digital assets to mature, credible participants must crowd-out charlatans. As in traditional finance, robust evaluation of counterparty is a prerequisite to banks’ and insurers’ adoption.
In traditional finance, users have accepted high fees charged by credit card companies as the cost of scalability, security and reversibility. Banks have fought losing battles against these incumbents.
Blockchain technology may have a hard time disrupting credit cards but offers solutions to some of finance’s more stubborn inefficiencies, particularly in trading illiquid assets. However, those benefits will only be reaped if counterparties are trusted, which is intrinsically a credit question.
As the ecosystem expands, financial regulators also will need to understand the growing links between traditional finance and digital assets to properly exercise their macroprudential responsibilities. They will require robust monitoring capabilities and risk analysis tools to enable rational risk assessments.
Blockchains and their tokens offer the promise of substantial efficiency gains, traceability and reduced costs. The decentralised nature of digital assets conveys those rewards to consumers in any jurisdiction, offering a wide range of potentially transformational benefits.
For proponents of digital assets, this is a pivotal moment. By working on better credit risk analysis, the industry can reduce its cost of capital and compete with traditional finance. Without them, the promise of digital assets risks falling short.
