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Coinbase (NASDAQ: COIN) revealed:
In recent weeks, some companies have struggled to remain solvent due to insufficient risk control. Learn how Coinbase implements secure and comprehensive risk management practices that enable institutions to successfully navigate the cryptoeconomy.
By Brett Tejpaul, Head of Coinbase Institutional, Matt Boyd, Head of Prime Finance, and Caroline Tarnok, Head of Credit and Market Risk
The shocks to the crypto credit environment over the past few weeks are likely to be a major inflection point for the industry. Solvency issues surrounding entities such as Celsius, Three Arrows Capital (3AC), Voyager and other similar counterparties reflected insufficient risk controls, and reports of other troubled companies quickly turn into stories of bankruptcy, restructuring and failure. Notably, the issues here were predictable and in fact credit-specific, not crypto-specific. Many of these companies were over-leveraged with short-term liabilities incompatible with longer-duration illiquid assets.
We believe these market participants have been caught up in the frenzy of a crypto bull market and have forgotten the basics of risk management. Unhedged bets, huge investments in the Terra ecosystem, and massive leverage provided and deployed by 3AC meant the risk was too high and too concentrated. These events are unfortunately more frequent in the traditional financial markets than we would have liked. We often think of Long Term Capital Management in the 1990s, Lehman Brothers in the 2000s or Archegos Capital Management in 2021.
Coinbase had no financial exposure to the above groups.¹ We did not engage in these types of risky lending practices and instead focused on building our funding business cautiously and with a deliberate focus on the customer. Today more than ever, our major institutional clients are demanding quality counterpart funding.
Our goal is to be the safest, easiest and most reliable bridge to the cryptoeconomy. We offer the most secure, comprehensive, and scalable products and services, including financing, and our multifaceted risk management programs are designed to protect our customers, shareholders, and the broader cryptoeconomy.
Prudent risk management is essential to our long-term strategy.
At Coinbase, risk management is a primary principle in the design of our products. We hold client assets 1:1. All institutional lending activity at Coinbase is at the discretion of the client and backed by collateral, which serves as the first layer of protection against potential default contagion. Our standard practice is to require more than 100% collateral, and we always measure risk against a significantly higher stressed price move.
As a result, we have a record of:
- no loss of our financing portfolio,
- no exposure to customer or counterparty insolvencies,
- no blocking for customer loan reminders or withdrawals, and
- no change in access to credit for our business customers.
We use the following principles to understand and manage counterparty credit risk.
This time is no different. This environment is no different. That’s why we rely on our risk management team, made up of professionals with decades of experience managing finance business risk through a range of economic cycles. Specifically, our team:
Performs rigorous due diligence. Counterparties are complicated relationships. Financial, commercial and structural considerations form the basis of credit risk management. Beyond that, a company’s behavior and actions must ultimately align with its financials and stated business objectives. A leadership team must be experienced and competent and must critically implement checks and balances within the organization.
It’s important to look the team in the eye – figuratively, if not literally. A company is a group of people; don’t underestimate the importance of trust (but verify).
Base hits are more durable than home runs. Big wins are great, but in another market environment, could they have been big losses?
Stress tests our exposures. Exposures take various forms, so we assess them from various angles: size, duration, directionality, volatility, liquidity, concentration and correlation with the health of our counterparties. We perform Monte Carlo simulations with several standard deviations. Additionally, in a portfolio, assets and liabilities should be matched to mitigate liquidity risk and ensure there is no misalignment in the duration of our borrowings versus our lending. And all of this has to happen all the time because the environment can change. When this is the case, the risk has changed.
Understands how things go wrong. Every product, transaction and counterparty has at least one potential point of failure. Each. We work to find it, calculate how bad it can be, and target our mitigators to the point of failure.
Anticipates internal deficiencies. The information we have about the future is always imperfect. There are no perfect models, and there are no perfect decisions. Reports may be incomplete. People miss things or give the benefit of the doubt. Processes fail. We manage our “known unknowns” and keep a buffer for “unknown unknowns”.
Anticipate external surprises. A mitigation plan is essential. So does knowing what might bring you back to the negotiating table. Leave room for Murphy’s Law and limit the size of the risk as much as possible.
We believe that our prudent risk management is why institutional clients continue to diligently and actively explore our financing products, including during recent market stress.
A healthy and well-functioning financing market is essential to the growth and sustainability of any economy. We believe that well-designed risk management programs will help usher in new waves of capital and fuel the next expansion. A leading prime broker, whether in crypto or other asset classes, must understand and effectively manage counterparty and liquidity risk for the safety of its clients, shareholders and the market. We do.
Ultimately, it may still take time for the industry as a whole to learn the right lessons from the systemic shortcomings we have seen. If you would like to explore a counterparty you can trust or learn more about our financing products, contact [email protected]