TOKEN ECONOMY: IDIOSYNCRATIC RISKS? NEVER HEARD OF THAT…

Economics Design

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An Article by Oleksandr Ulytskyi, Associate Consultant at Economics Design

Disclaimer: This is not financial advice

Links between crypto and mainstream markets are getting stronger

In early April 2022 total crypto market capitalization was $2.1 trillion and dropped to as much as $0.9 trillion as of date of writing. One would say that this is just another “crypto-winter” and things would start picking up in a couple of months. But the big difference between current drop and prior drops is that current is less isolated to crypto and is more connected with mainstream finance and less is just sentiment driven.

According to “The Economist'' holders of crypto have become more sophisticated and richer and institutions accounted for ~63% of trading, up from 10% in 2017. Use of crypto assets as alternative investment vehicles and collateral became more common for traditional finance players, for example MicroStrategy borrowed $205 million in a 3 year loan from crypto-focused bank Silvergate to buy more BTC, using its own BTC holdings to secure the loan. We see mounting links between the crypto-sphere and mainstream markets as more public companies bridging the space like NVDIA, Coinbase or PayPal.

While on one hand those connections between two worlds are indication of continued adoption, on the other hand the managers of the traditional financial institutions as well as VCs, funding crypto projects, are not able to measure and predict the risk exposure of their portfolio and the possible cascade effects that may severely hit the system.

Where things started to go wrong?

Putting aside dollar rainmaking by the Fed, most would recall UST-LUNA collapse, which under different estimates has led to over $40 billion of value being lost. As of now it is the largest loss in crypto that happened not due to the hack but as the result of poor economy design and we can call the first domino that kick started the chain.

To save the 1:1 $ peg Terra Treasury started selling BTC, putting price pressure on it and expanding exposure beyond Luna and UST holders but to mainstream BTC holders especially for lending protocols and institutions that had used BTC as collateral and triggered chain of margin calls.

The largest known victim is crypto hedge fund Three Arrow Capital (3AC), that has invested over $200 million in LUNA tokens and was additionally known as one of the largest holders of Grayscale Bitcoin Trust (GBTC), an institutional bitcoin product,  which have seen steep declines due to BTC pressure. Ultimately as we know the 3AC filed for bankruptcy failing to repay its $670million borrowing. List of affected lending protocols, crypto exchanges, brokerages  continues to pile up - Celsius, BlockFi, Genesis, Babel Finance, Bitmex, Vauld, CoinFLEX, 2gether, Maple Finance, Nexo, Finblox and others. We see funds withdrawal or transaction limitations across those.

3AC co-founder Kyle Davies has told to WSJ “The Terra-Luna situation caught us very much off guard”. This can be converted into - there has been low understanding of idiosyncratic risks within LUNA-UST economy design.

Protocols idiosyncratic risk, what is that?

Idiosyncratic risk is the one that is applicable to specific protocol design and can be predicted and mitigated.

Using token economy framework let’s look at typical protocol idiosyncratic risks through the lenses of Market Design, Mechanism design and Token design

How to understand the exposure?

A possible way of determining the risk exposure level and usually used in due diligence is to assess the likelihood of happening and the consequence of loss for each of the risk areas, as shown in the table below.

Source: Karp, H. (2019, December 2). Understanding risks in DEFI #2: Makerdao multi-collateral Dai. Medium. from https://medium.com/nexus-mutual/understanding-risks-in-defi-2-makerdao-multi-collateral-dai-dcce43156fea

Conclusions

In the aftermath of the current “crypto-winter”, there is a dire need for efficient and professional due diligence of risk for token economies. The sub-system crises in LUNA-UST economy made it clear that a shock originating from a single token economy or token product can rapidly extend to other token economies and mainstream financial markets, hence putting at risk of losing investments made.