annus horribilis

“The whole world is simply nothing more than a flow chart for capital.”

— Paul Tudor Jones

In KYC/AML, the Ultimate Beneficial Owner (UBO) is one of the key concepts: it’s the person or legal entity who at the end of the day controls and benefits from a particular account, which in a world of multi-layered shell companies and multiple sanctions regimes can be incredibly important. I am starting to think that in risk we need a similar concept, the Ultimate Bag Holder (UBH). The UBH is where the final net risk exposure lands, whatever that risk may be. And just as in poker, if you look around the table and it is unclear to you who is the UBH, there is a very good chance it’s you. (If you are the only retail investor at the table, it is definitely you.)

The process of identifying not only the UBH, but all the bags this UBH may be holding, is pretty much everything in counterparty credit risk management. And it’s not easy. A trader may seem to be running a lot of directional risk in a particular account, but if you look at the book inclusive of all the hedge accounts, she may well be net flat. And even if she is not, some of that risk may be back-to-back with another trader at the same firm or even another market participant. You think your Goldman Sachs OTC Bitcoin option position is purely with GS? Think again: they are probably back-to-backing it with Galaxy Digital because the House of Squid cannot warehouse the crypto spot or vega risk for a host of regulatory and balance sheet reasons. That nice GS sales trader is, under the hood, a proxy for a person who got a tattoo to celebrate his exposure to the LUNA token. Never forget that.

All right then, let’s use a DeFi Option Vault instead, because, you know, Web3, decentralization, code is law, yadda yadda yadda. Well, first, you just made yourself a counterparty to that smart contract, and so you got direct smart contract risk for which you are the UBH unless Jump Crypto decides otherwise. But wait! There’s more! Most DOV protocols rely on third party market-makers like Wintermute to provide liquidity for their option structures, so really all you have done is get yourself some additional opaque counterparty risk with a side helping of operational risk. Did I mention that the folks over at Wintermute lost $160M over their use of what is for all intents and purposes a blockchain vanity license plate? Best not to ask.

In consideration of the risks at play, you may also want to consider any unintentional UBH seated at your table, most commonly the sell-side traders, but not always. These parties aim to collect fees and then pass risk on to others: to exchanges; in the inter-broker dealer (IBD) market; to another trader in the organization, e.g. an equity derivatives trader laying off his or her rho exposure via an internal interest rate swap with the rates desk, trading float for fixed-rate exposure. These people get paid for the most part to the degree they successfully pass the bag at a cost less than the spread they charge their clients. The problem is the means at their disposal are often imperfect. Finance is lousy with mis-match hazards:

• liquidity mismatch: you have the money, but it’s locked up for X days, or the trade can only be done with such massive slippage that you can say goodbye to that fee you collected, and the client wants to unwind today
• maturity mismatch: you gave the money to someone to build a toll bridge that will be providing a nice steady cash stream five years from now, but you have an interest payment due tomorrow
• correlation risk: you were right about Bitcoin and Solana separately, but you hedged a less liquid position (SOL) with an option on a more liquid name (BTC) and unfortunately BTC-SOL correlation shifted on you
• curve risk: you made the right directional bet, but you got the relationship between your exposures to different tenors wrong, and rates or supply/demand shifts at different points in the curve wrong-footed you
• etc.

This is hard, which is why, generally, you do not want as your crypto hedge fund CEO someone who was in high school during the Lehman unwind or first joined a trading desk just after the end of that crisis. Institutional memory matters.

A recognition of these issues informs both the tendency toward regulation of banks and trading desks as well as extensive and expensive internal controls, and also design choices in decentralized protocols. In short, there is a price to be paid for getting a good mix of risk, capital efficiency and returns, and because nobody likes to pay for it, you generally need to have a hammer to force them to do it, or you pay for it explicitly, as with an AMM in DeFi or an over-collateralized lending protocol. In DeFi you do what is to TradFi this absolutely mad thing, namely lock up most of your capital just to ensure it’s always immediately available or ready for automatic liquidation, but which actually makes a lot of sense in a world where people cannot be forced to do the right thing and you don’t know who you are dealing with.

Which brings us to FTX, and the events of last week, an instance where the lines in the flow chart of crypto capital ended up pointing to an empty bag.

We have spent the better part of the last year building a digital asset risk platform, Serenity, which focuses on market risk in its current implementation. But market risk, especially based on models trained with historical data, is not the whole picture. Often you need to understand not just the risks of what you are holding, but the risks of whether you can get access to what you are holding: is your balance at an exchange or a bank or in a DeFi protocol in some way encumbered such that you cannot get it back? You are going to hear a lot of FUD in the coming weeks in response to FTX commingling funds with Alameda Research and making its retail accounts likely worth pennies on the dollar:

• From the DeFi degens & Bitcoin maximalists: if only you had trusted code and self-custodied, you would have been fine; this ignores smart contract risk; operational risk from self-custody; indirect and obscured counterparty risk that could lead to contagion; and that whole capital inefficiency issue
• From TradFi: if only you had stayed in the safe, warm confines of our regulated environment where you have SIPC and trade surveillance and account segregation none of this would have happened; this ignores the cost of this protection, the fact that it keeps failing, and that it often requires a backstop at the government level which leaves the taxpayer as the UBH in the worst instances
• From the CeFi exchanges in crypto: don’t worry, we’ll do a Proof of Reserves attestation and everything will be fine, it’s just like having your own wallet, but better; this conflates Proof of Reserves with Proof of Solvency, and actually, with FTX, what you really wanted to know was that the union of SBF’s empire was solvent, not that FTX had balances in a set of audited wallets it chose to disclose
• From the CeFi lenders, prop traders and crypto broker/dealers: please don’t ask about our OTC positions, that could be awkward

In short, I don’t think this gets solved unless there is a broader reification of that flow chart of capital, likely on-chain and using some mix of differential privacy and Zero Knowledge Proofs to let people selectively disclose both their positions and the graph of their exposures to other parties in the ecosystem. This is not a technical problem: it’s possible today. It is one of incentives and cooperation: the mechanism needs to be designed in such a way that parties who inherently not only do not trust one another but are in the midst of red-in-tooth-and-claw competition are nevertheless willing to disclose the information required to ascertain that it is safe to do business with them.

Sam Bankman-Fried saw the contradictions in Web3’s incomplete state, and took advantage of it. If we don’t want another annus horribilis in crypto and if we do not want to just recreate TradFi’s issues in crypto, we need a better way.