Risk is in the Relationships

What do social engineering; financial contagion; margin lending; and OTC derivatives all have in common? The primary risks come about not just due to any attributes of the participating entities, but in how they relate to one another. Whether it is the carelessness, greed, vanity or other foibles that a hacker exploits to gain entry into a system that a particular individual has access to or an ISDA agreement, the channel through which the damage travels is in relationships. Even financial fraud often has this component: Bernie Madoff’s crimes were in part an abuse of personal trust in his wealthy social circles, as he preyed on their greed.

The particularly toxic brew of the FTX bankruptcy sprung from the many relationships in play, not all fully recognized at first:

• the legal entity relationship between FTX and Alameda Research
• the issuer relationship between FTX and FTT
• the VC relationship between Alameda Research and many projects, most especially in the Solana ecosystem
• the economic relationship between central bank rates and risk assets

The list goes on. Terra/LUNA, another omnishambles atop a clusterfuck, offered much the same incestuous doom loop, with everything from the Curve 3-pool, Galaxy Digital’s canoodling with Do Kwan and the ETH-stETH relationship playing starring roles at various points, to say nothing of the menage-a-quatre between DCG, Grayscale, Genesis and 3AC that subsequently did for both Gemini Earn and Alameda Research, precipitating the balance sheet hole that ultimately took down FTX and more recently the Genesis bankruptcy. The events of 2022 were borderline biblical: everyone was in bed with one another, including the whole FTX management team.

Apparently there is a God, and she really, really loves Michael Lewis.

While I would like to tell you this can get better, the particular nature of a networked, decentralized financial system means if anything the risks of contagion across related entities will become more significant over time. We built the Serenity risk platform in part because we believe that Web3 is inevitable; valuable; and incredibly dangerous if the legacy mechanisms of risk management are blindly applied to it. The relationships are getting more complex at the same time that automation via smart contracts and algorithmic execution increases velocity. You not only cannot comprehend the full spectrum of risks at a glance or even with traditional risk tools, you also cannot react quickly enough when it all goes terribly wrong. The butterfly’s wing will flap, and no one can tell where the hurricane makes landfall — at least not yet.

In 2022 we built a full armory of traditional risk tools for digital assets: stress testing, risk attribution, multiple risk models and a world-class, institutional-grade platform to host it all. However, we have to recognize that it was not enough: the most serious risks our clients are exposed to are not captured by conventional tools. So in 2023 we are on a mission to grow Serenity well beyond its beginnings, and to build tools and models that capture the unique risks in Web3. This will involve solving complex data, modeling and infrastructure problems, but I am confident our team is up to the challenge, and that the production system we are delivering this week is a good foundation. Startups are made for solving the hardest problems, and this is ours.