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What Is Counterparty Risk & How To Mitigate It

By Shawn Dexter / February 17, 2019

There’s been a lot of buzz around the most recent events surrounding QuadrigaCX.  For those of you who aren’t aware – QuadiragCX is a Canadian Bitcoin Exchange that have recently lost access to their customers funds. The entire incident is all rather suspicious, but we will not be diving into that drama over here. You can simply google “Quadriga Scam” to find out more. In this post, however, I want to discuss the risks that people tend to ignore when dealing with exchanges like QuadrigaCX.

Specifically I want to talk about Counterparty Risk.

In usual Mango-style, we’re going to break this concept down piece by piece. To understand what is Counterparty Risk, we first need to discuss precisely what is “Counterparty".

What is a 'Counterparty' ?

A counterparty is the person or organisation on the other side of a financial transaction. If you make a financial deal with someone, then the person on the other side of the deal is the counterparty. Here are a few examples of counterparties:

  • If you loan money to a friend, then your friend is the counterparty  (Credit Risk)

  • If you put money in the bank, then the bank is the counterparty

  • If you deposit money into a broker (or exchange), then the broker is the counterparty

Whenever you engage in a financial transaction with a counterparty, you are exposing yourself to Counterparty Risk.

What is Counterparty Risk?

Alright, so what is Counterparty Risk?  Counterparty risk is the risk that you are bearing incase the person on the other side of the transaction cannot fulfill their end of the deal 

Put briefly:
Counterparty Risk is the risk that the counterparty defaults or goes bankrupt.

In the previous section we listed a few examples of counterparties. In each one of those cases, you were also bearing Counterparty Risk. Let’s use those same examples when pertaining to Counterparty RIsk:

  • You lend money to a friend and he cannot pay you back

  • You put money in a bank, and the bank goes insolvent (due to bank-run, financial collapse etc)

  • You deposit money into an exchange, and the exchange gets hacked or loses all your funds.

By now, you’re seeing that it’s all pretty straightforward. Whenever you engage in a transaction with another party (counterparty), you are bearing the risk that the other party may not be able to deliver when the time comes to fulfill their end of the transaction

Difference Between Counterparty Risk & Credit Risk

I’ve received this question a few times now: What is the difference between counterparty risk and credit risk?

Counterparty risk is actually a subset of Credit RIsk. 

So essentially – Counterparty risk is a form of Credit Risk. Credit Risks typically refers to the risk you assume when the counterparty cannot payback a loan (for example when you buy bonds). 

​​​​Real Examples of Counterparty Risk

So, now we understand what Counterparty Risk actually is. But let’s go over a few examples how bad Counterparty Risk can get. A lot of people have lost a lot of money because they didn’t take counterparty risk seriously enough. Here are a few recent examples of counterparty risks that took a bad turn:

  1. The Flash Crash of EUR/CHF:  Several brokers actually went broke overnight on this one. In 2011, the Swiss National Bank (SNB) put a price floor on the EUR/CHF pairing. Essentially, they pegged the EUR/CHF at atleast 1.2 in an effort to facilitate cheap exports.  This caused a lot of traders to take advantage of the price floor.

  2. However, after a series of events – the SNB suddenly removes the price peg and the exchange rate dropped by 20% within the first minute. This caused a massive flash-crash. Traders not only lost their entire balance, but their accounts actually went into the negative! They owed more than they actually had.

  1. The Mount Gox Hack: Mt. Gox was a major cryptocurrency exchange back in the day. In 2014, it suddenly suspended all trading without any clear explanation other than “maintenance”. Apparently, a security breach/hack caused the exchange to go insolvent. They soon announced bankruptcy and closed trading altogether. Traders who had their funds in there lost everything.

  2. Death Of QudrigaCx CEO: This is the most recent event/example of counterparty risk at its truest form. QuadrigaCX is a Canadian Cryptocurrency Exchange. A few weeks ago, the CEO of the exchange dies while on vacation in India (apparently!). It was then uncovered that he was the only one who could access all the customer funds in the exchange. Furthermore, his laptop could not be found after his death  – making it impossible to access the cryptocurrency which was stored in a secure cold wallet. Almost $150 million dollars of customer funds have been lost. Some people lost their entire life savings.

How To Mitigate Counterparty Risk

While Counterparty Risk can be a scary thought, there are several ways to mitigate counterparty risk.  Taking the appropriate steps to mitigate these steps will keep your finances in tact even if a Black Swan event takes place.

  1. Divide your funds among Banks that insure your money:  Most banks provide deposit insurance on a your money up to a certain amount. You can reduce your counterparty risk exposure by placing your money in several different banks. This will ensure the most coverage.

  1. Don’t send your entire trading account to an exchange: If you’re a trader, it may be in your best interest to trade with only a portion of your funds and leverage the rest. For example you can send 20% of your account to the exchange, and keep the 80% in your bank. With a 5x leverage, you can trade the same amount while still protecting yourself in case the exchange goes down. If you’re looking for an good cryptocurrency exchange that allows for leverage trading, we recommend Deribit

  1. Credit Checks & Deposit Requests: If you’re renting out your apartment, or loaning money – it’s best to do credit checks on the counterparty. If you’re a landlord you can ask for security deposits. Banks and credit card companies do a credit check on your financial history for this very reason – to reduce their counterparty risk. They will assess their counterparty risk when dealing with you as a counterparty, and accordingly offer you an interest rate. Landlords do the same and ask you for a security deposit. The interest rate and deposit rate will cover any losses that they may incur in case you don’t fulfill your end of the deal (i.e payback credit card, and not damage property)

Conclusion: What Is Counterparty Risk?

When we engage in any sort of trade/ transaction with a counterparty, it’s more often a means to an end. In the process of achieving that end we often forget to account for counterparty risk. 

The rules & regulations that govern many counterparties ( banks, exchanges, businesses) usually evoke the feeling of safety and reliability amongst many of us. And while the crash of banks, exchanges and business is improbable, it is still possible.

Given that our world is highly reliant on counterparties for the purpose of trades and transactions, we can’t eliminate counterparty risk entirely. However, we can mitigate counterparty risk by doing the following: (limited to the scope of examples in the post)

  1. For those who are “banked” – Do not put all of your eggs in one basket. Divide your funds among Banks that insure your money

  2. For those of you who trade – Crypto, Forex etc – Don’t send your entire trading account to an exchange. Change the narrative around margin trading and use it to mitigate counterparty risk.

  3. loaners/landlords – Do a Credit Check, or ask for a Deposit Request

In short, always think of a means to protect your wealth in the case of a black swan event. Black Swan events are notorious for taking you for everything you’ve got and more.

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Bitcoin ETF Explained Simply – What Does This Mean For Bitcoin

By Shawn Dexter / August 28, 2018

There has been a lot of talk about Bitcoin ETFs recently - So let’s explore the basics of what a Bitcoin ETF really is, and the implications of it. 

What Is An ETF?

Put as simply as possible, an ETF (Exchange Traded Fund) is traded on the stock market just like a stock, but instead of being a share in a public company such as Amazon, it tracks the price of an asset instead. 

There are many types of ETF's that track different things, but for simplicity lets use Gold as an example:

If you think gold is going to rise in price, you could go to a stock exchange and buy shares of a Gold ETF, which can be shares in a Trust which stockpiles physical gold. If gold goes up, the ETF shares will go up similarly. This way, you don’t have to go to a futures market or hold any gold yourself. 

What Is a Bitcoin ETF?

A bitcoin ETF would be similar to the above example: an easily tradable asset that ultimately tracks the Bitcoin price. Traders and investors could go Long (buying in anticipation of increasing price) or Short (selling in anticipation of decline).

Bitcoin ETF - ​​Why Does It Matter For Bitcoin?

It may not matter much at all. We got this far without an ETF after all. However the clearest benefit to a Bitcoin ETF is in opening the market to many more participants and significantly more capital. 

In much the same way as you don’t want barrels of crude oil in your living room, many individuals and institutions don’t fancy getting their hands dirty on the unregulated, uninsured, hackable, dodgy overseas crypto exchanges such as Bitfinex.

Wait, Wasn’t The Bitcoin ETF Recently Rejected?

Many ETFs have been proposed to the SEC (US Securities Exchange Commision). However, all but one of these were all recently denied by the SEC, killing most of the dreams and leaving one last man standing: The VanEck SolidX ETF.

This is the ETF you have probably heard most about, brought to the SEC by a partnership of Investment firm VanEck and financial services company SolidX. This proposal is also endorsed by the CBOE (Chicago Board Options Exchange), known for launching their Bitcoin futures in December), and if approved it would trade on the CBOE exchange.  

Buying this proposed ETF would basically represent shares in a Trust, and the Trust’s assets would be securely-stored Bitcoin (insured against loss or theft). Therefore as bitcoin rises in price, the assets of this Trust appreciate and make money.

Why So Many Bitcoin ETF's?

You can’t just simply start an ETF and get it traded on a stock exchange. 

Before launching in the USA, any potential ETF has to get special permission from the SEC. This is because original securities laws never allowed for ETFs, so each new ETF has to be specially exempted and allowed to trade by the regulators. 

Therefore, any party wanting to start an ETF must apply for their own individual exemptive order. The SEC deals with them on a case-by-case basis, rather than simply allowing or denying all Bitcoin ETFs.

Getting An ETF Approved - The Process

ETF Hopefuls file a “Proposed Rule Change” to the SEC. When received, the SEC posts a “Notice of Filing” and then has 45 days to approve or deny (or delay decision on) the proposed ETF. 

Here is the Notice of Filing for the most hyped up ETF of the year, the VanEck/SolidX ETF (mentioned above):

Notice of Filing of Proposed Rule Change to List and Trade Shares of SolidX Bitcoin Shares Issued by the VanEck SolidX Bitcoin Trust”

VanEck/SolidX ETF Approval - When Will We Know?

The SEC delayed the decision on the VanEck/SolidX ETF to September. They are able to delay further 2 more times, and very likely to do so. This gives the deadlines of:

  1. September 30

  2. December 29

  3. And finally, February 27 

Bitcoin ETF's & The SEC - What Does It All Mean?

The SEC is not friendly to these proposals, and their reasons are clear.

The Bitcoin market is unregulated, easy to manipulate, and not liquid enough (not enough trading volume occurs). The SEC are concerned that Bitcoin trading almost exclusively 

occurs on unregulated venues overseas that are relatively new and that generally appear to trade only digital assets.

Given these problems, the VanEck/SolidX ETF is also in trouble, as currently it does not appear to solve any of them. There is a low likelihood that it will be accepted, at least before the Crypto markets have matured a whole lot.

While an ETF would be great for adoption and more widespread trading of Bitcoin, it is certainly not a necessity, and many other projects are in the works, such as those listed in our article:

Bitcoin’s Arrival In The Institutional Market – What It Means In The Long Run
Ever since Bitcoin was created in 2009 by Satoshi Nakamoto, it has largely been pushed aside by the traditional financial[...]

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Bitcoin’s Arrival In The Institutional Market – What It Means In The Long Run

Ever since Bitcoin was created in 2009 by Satoshi Nakamoto, it has largely been pushed aside by the traditional financial services industry and the institutional space. A similar attitude has been displayed towards most cryptocurrencies and digital assets, based on fear and the fact that very little was known about these new “actors” in the industry. Now that they are gaining traction and have received the attention of millions of investors, lawmakers and governments are beginning to address the question of regulation for these virtual currencies.

This war between the institution and the new wave of digital assets has been going on for years. However, it seems like we are noticing a shift in mentality and approach from the institutional space towards bitcoin. More and more financial organizations are changing their opinion about the first-ever virtual peer-to-peer currency and have developed interest in these new forms of potentially lucrative investments for their loyal customers.

In this brief overview, we will see how the tide is turning for bitcoin and how it is becoming one of the most sought-after assets by large and reputable financial firms all across the globe. In turn, we will demonstrate how this could eventually lead to the crypto markets regaining their strengths and how we might be on the cusp of one of the largest bitcoin bull runs in history.

Bitcoin & Institutional Investors - The SEC, ETF's and More

Some recent events and news have been very positive for bitcoin and its slow but steady breakthrough within the institutional space. Institutional investors refer to large entities such as banks, hedge funds, insurance companies, investment groups and more. The first major news that has been affecting the space as of recently and that showcases bitcoin’s growing position within the institutional markets is the upcoming (and recently delayed) decision by the U.S. Securities and Exchange Commission (SEC) regarding the approval of a bitcoin exchange-traded fund (ETF).

An ETF is a fund that represents an asset’s value and that is traded directly on the stock market. They are considered passive investments.

In the recent weeks, the cryptocurrency community, as well as actors in the institutional space and even some members of the SEC, have been strongly advocating for the creation of a bitcoin ETF. This truly shows that there is a heavy desire from financial firms and large investors to join the cryptocurrency trend.

Another recent report by Forbes has stated that the Northern Trust, a financial services firm that has close to $10.7 trillion in assets under custody, has opened their doors to companies involved in the crypto space. In addition, the firm is supporting multiple blockchain-based projects. Moreover, Northern Trust’s President, Pete Cherecwich says he believes in a tokenized economy and future.

The Launch Of 'Bakkt' - A Global ecosystem for digital assets

The Intercontinental Exchange (ICE), parent company of the New York Stock Exchange, has announced that it will be launching a new company called Bakkt which aims “to create an open and regulated, global ecosystem for digital assets”. It will enable big organizations to purchase, sell, and safely store virtual currencies and other decentralized assets. With large companies such as Microsoft and BCG involved in the project, this shows how blockchain-based applications and crypto-assets are gaining in popularity and are making their way through various industries. The ICE also plans to initiate a one-day physical bitcoin futures contract when Bakkt launches.

NBER Analysis - Cryptocurrency Forecasts

Furthermore, the National Bureau of Economic Research (NBER) recently published a 70-page-long report on the “Risks and Returns of Cryptocurrency”, analyzing three major coins: bitcoin, ripple, and ethereum. The fact that this paper is being published already shows that cryptocurrencies are actively being discussed by institutional investors. The NBER explains a “strong time-series momentum effect and that proxies for investor attention strongly forecast cryptocurrency returns”. The report even goes as far as recommending investing in digital currencies with “1 or 4 or 6 percent in bitcoin”.

First Cryptocurrency Index Fund?

Lastly, popular cryptocurrency exchange Coinbase has recently announced the launch of the Coinbase Index Fund. It allows institutional investors, with a minimum investment of $250,000, to place money and bet on the performance of the Coinbase Index. The Coinbase Index is composed of all the coins listed on the American giant’s platform. We clearly see that the desire to invest in cryptocurrencies is not strictly one-sided, but that the crypto space is also eagerly waiting for these institutional investors.

Long Term Upward Trend

As many have said over the last months, institutional money is on its way and it could be extremely positive for bitcoin and its value. Although the markets have been experiencing bearish trends and severe downturns in the past months, bitcoin and other major cryptocurrencies such as ethereum, litecoin, or ripple still show a lot of potential for growth and progress. With all the new excitement and innovations in the crypto space, in addition to the institutional investors finally joining the movement, the market has a lot to look forward to. Banks, financial organizations, hedge funds, and large investors are now less hostile towards these new digital assets, which are nothing short of programmable money. Coins and tokens have become more attractive and offer incredible potential, and institutional investors are aware of it.

Bitcoin & The Institutional Market - Summing It Up

In conclusion, there has been a shift in the way digital currencies, especially bitcoin, are viewed in the institutional space. Previously considered scams, frauds, and even fake, they are now starting to be looked at as real financial assets with considerable potential and upside. In this article, we have seen that numerous events have cemented the belief that opinions are changing, and so has the place of bitcoin in larger investors’ hearts. As a result, we can probably assume that the crypto markets will be positively impacted by the increase of institutional investors in the near future. 

About the Author

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​Mati Greenspan

Market Analyst @eToro

Senior Market Analyst at eToro; a man very up-to-date with the goings on of the Crypto markets. Follow him on twitter and other mediums at the links below.

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