Michael Bodley

Properly measuring counterparty risk in crypto has rarely been more crucial.&nbsp;



This is the clear message emanating from a panel at the iConnections Global Alts conference in Miami on Tuesday featuring executives from Anchorage Digital, Bitgo, Coinbase and One River Digital.



Participants tapped the intended topic, the “evolution” of crypto custody, as a springboard to dive into all things due diligence in a post-FTX digital assets landscape.



Especially with <a href="https://blockworks.co/news/stablecoin-regulation-congress-priority">heightened US regulatory scrutiny on the horizon</a>.



Sarah Schroeder, a One River portfolio manager, said that “ultimately, this is a counterparties question.” She drew a parallel to Wall Street’s practices for safeguarding customer assets, including cash and derivatives. It’s “very easy” for institutional investors to “call upon Goldman Sachs” and its peers for that crucial function, she said.



But how cryptoassets are custodied is another question entirely for newcomer traders and allocators — with passive and active approaches alike — to wrap their heads around. How? By whom? And why?



There is no shortage of mechanisms these days, some more complex than others, for keeping digital assets under lock and key. There are more solutions being added by the day — especially after the historic implosion of Sam Bankman-Fried’s <a href="https://blockworks.co/tag/ftx">FTX</a>, plus the subsequent shutdowns and deep rooted complications for a number of crypto’s erstwhile giants.&nbsp;



Some of those custodial offerings, according to Adam Sporn, BitGo’s head of prime brokerage, have been around since crypto’s last major cycle. Some are still very much a moving target.&nbsp;



Drawing particular institutional interest of late from the likes of venture capitalist and family offices, Sporn said, are cold storage solutions. Cold storage works by keeping the private keys that <a href="https://blockworks.co/news/what-are-seed-phrases">govern ownership of digital assets</a> offline, as opposed to a “hot wallet” that is connected to the internet and may be hosted by an exchange.



READ MORE: <a href="https://blockworks.co/news/hot-wallets-cold-wallets">Everything you need to know about hot vs. cold wallets</a>



<h2 class="wp-block-heading">Rush for exchange exits</h2>



Both retail and institutional investors alike yanked their crypto assets off of exchanges in the wake of the wave of service provider bankruptcies and <a href="https://blockworks.co/news/genesis-gemini-charged-with-securities-violations-by-sec">related freezes on customer withdrawals</a>.&nbsp;



It’s been a bit of a slog for outright custodians to regain trust in markets that were already deemed risky by much of the mainstream.



BitGo, according to Sporn, has picked up on a trend: Crypto-native funds “don’t care about the cold storage” and instead have been using hot wallets as much as ever. High-frequency digital asset hedge funds and proprietary trading entities typically have little use for storing their cryptocurrencies offline.&nbsp;



But other portfolio managers with less time-sensitive trading styles have been carving out a middle ground, Sporn said, keeping something like 2% of their book in hot wallets for ‘liquidity needs” and locking up the remainder elsewhere.&nbsp;



Neither trend is especially new when it comes to family offices and venture capitalists. But industry eyes and ears have been following the money — and, more precisely, how the money moves — since crypto markets collapsed in the fourth quarter of 2022.&nbsp;



<h2 class="wp-block-heading">What to do about custody?</h2>



In that (brutal) context, industry participants are now looking for options when it comes to the digital asset products at their disposal, according to Yuriy Anosov, Anchorage’s head of trading. The longtime custodian is working on setting up a settlement and exchange layer similar to setups that have been commonplace on Wall Street for a while, Anosov said.



Anchorage is now supporting a couple of hundred cryptoassets, according to Anosov — adding that it’s now “really important to see what the inter-party agreements are like.” Anosov was referring to relationships between a protocol, or a DAO, and its own counterparties.&nbsp;



The basic idea is that limited partners and general partners ought to do their homework on the service providers they choose to entrust with their capital. And, in turn, those service providers ought to carefully parse the internal governance of cryptocurrencies and Web3 initiatives they choose to bring onto their platforms.



Those dual layers of due diligence have become paramount, according to Lauren Abendschein, Coinbase’s head of institutional sales for the Americas.&nbsp;&nbsp;



“We saw this with FTX, not having properly experienced individuals, particularly in control functions — and a well-documented history across those control functions,” Abendschein said. “It applies to crypto very much, as it does every other industry.”&nbsp;



The SEC and the CFTC have taken note. Anosov said that he thinks “regulators are actually going to be speeding up their timeline in the case of actually [moving] regulations forward” in 2023.



There are a number of pending US legal and regulatory initiatives the panelists said they’re following. Among them: <a href="https://blockworks.co/news/these-5-crypto-friendly-us-states-show-initiative-on-tax-laws">digital asset taxation</a> and <a href="https://blockworks.co/news/stablecoin-regulation-congress-priority">stablecoin oversight</a>.



Jiri Krol, a top AIMA executive who moderated the iConnections conversation, said that “hopefully we get something done this year, but I’m not holding my breath.”



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Regulators May Be ‘Speeding Up Their Timeline’ on Cryptocurrencies

<div id="highlights-block_631f5dae6cd98" class="highlights">
 <ul>
 <li>Transparency that comes with public code review is useful, but the history of Defi exploits shows it doesn’t solve the problem</li>
 <li>A new payment structure will better align Gauntlet’s incentives to the DAOs they serve</li>
 </ul>
 
</div>



It’s truly exciting that changing one line of solidity code — the language of Ethereum smart contracts — can create an entirely new financial product.



But how can we understand whether these new instruments work as intended? The risks are poorly understood, and the scale of losses <a href="https://cms.blockworks.co/?s=exploit" target="_blank" rel="noreferrer noopener">is staggering</a> — the system is broken! We can improve, if not fix, this with better incentive alignment — putting our money where our mouth is.



Professional code audits and the transparency that comes with using only open source code are not enough — we’ve seen protocols that suffer losses even though they have undergone three audits!



DAOs have been formed around new protocols that allow them to incentivize and coordinate contribution. Protocol DAOs need to address the risks their products create — token holders are often left holding the bag when things go awry, and one solution we’re optimistic about is based on a simple guiding principle.



<h3 class="wp-block-heading">If you are wrong, you don’t get paid</h3>



If users get rugged by a protocol hack, auditors should too. If the market tanks and a protocol becomes insolvent, the risk manager shouldn&#8217;t get paid either.



In this spirit, we will move all Gauntlet engagements to a new payment structure where we are held accountable for the quality of this service.



How?



Service fees will be held in an escrow contract until it’s crystal clear that the work was successful.



A strong ecosystem of independent organizations contributing to protocol development and operation is essential to a successful decentralized protocol. Since the proliferation of DAOs in 2020 and 2021, we have seen a few core services emerge:



<ol><li>Protocol development (e.g. Comp Labs, BGD)</li><li>Risk Management (e.g. Gauntlet, BlockAnalitica)</li><li>Smart Contract Auditing</li></ol>



Add to that services such as tooling and analytics (e.g. Chaos, Flipside). While these service providers have taken the first step into the new decentralized economy by working with DAOs, the structure of these engagements has lacked innovation.



One exception here is Bored Ghost Development, which <a href="https://governance.aave.com/t/aave-bored-ghosts-developing-bgd/7527" target="_blank" rel="noreferrer noopener">tied their payment terms</a> to achieving their development roadmap.



<h3 class="wp-block-heading">Compound innovation</h3>



We’d like to see more initiatives that link the fate of service providers to the success of protocols.&nbsp;



As a first step, we recently posted our<a href="https://www.comp.xyz/t/gauntlet-compound-renewal/3541" target="_blank" rel="noreferrer noopener"> proposal to renew</a> our service agreement with Compound and added a clause around the concept of a “first tranche insolvency refund.”



There remain many details to figure out as we move forward, but let us be clear — this isn’t a protocol-funded backstop like the<a href="https://docs.aave.com/developers/v/1.0/developing-on-aave/the-protocol/safety-module-stkaave" target="_blank" rel="noreferrer noopener"> stkAAVE pool</a>, which is intended to maintain protocol solvency.



Instead, what it means is simply that 30% of the contract will be put up against our work. It’s an idea to provide true alignment with our customers, to hold ourselves accountable for what matters to them — driving growth at safe risk levels.



Governance allows the community to weigh in on every change we make, and if the community wants to take on more risk than we propose, they can, but they would forfeit this alignment.



<h3 class="wp-block-heading">Traders and degens at heart</h3>



Many of us came from quantitative trading. We dream of markets and live for risk. At trading firms, your compensation is almost entirely variable, and we’re applying this ethos to our work in crypto.



Merely aligning incentives via escrow barely scratches the surface of how we could leverage this incredible technology not just to decentralize finance, but innovate on it as well.



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Contributors Need To Be More Accountable to the DAOs They Serve

Jack Kubinec

<div id="highlights-block_62e2bc808b6b8" class="highlights">
 <ul>
 <li>Crypto should watch its exposure to other markets and let algorithms handle lending, industry experts say</li>
 <li>“We have seen a significant inflow of crypto companies coming to us asking for risk management solutions over the past month and a half,” an industry exec told Blockworks</li>
 </ul>
 
</div>



For crypto builders hoping to move fast and break things, talk of risk management tends to really kill the vibe.



But <a href="https://cms.blockworks.co/tag/terra/" target="_blank" rel="noreferrer noopener">Terra</a>’s collapse wiping $2 trillion in nominal value from crypto markets, combined with <a href="https://cms.blockworks.co/tag/three-arrows-capital/" target="_blank" rel="noreferrer noopener">Three Arrows Capital</a> (3AC)’s loan default leaving a slew of lenders strapped for cash, many in the space are calling on crypto firms to manage risk more effectively.



Conversations with market participants reveal there is no silver bullet to mitigate risk, but simple corrections could limit the extent of future market downturns. Embattled crypto firms are also receptive to making changes.



Prior to the recent credit crisis, many crypto builders thought of risk management primarily in terms of hack prevention, Adam Zarazinski, the CEO of crypto analytics firm Inca Digital, told Blockworks.&nbsp;



“If you’re looking at risk management and compliance just through the forensics lens, you’re looking at the market with blinders on,” Zarazinski said. “There’s a lot more data other than just Chainalysis.”



Zarazinski’s clients are now thinking more broadly about risk.



“We have seen a significant inflow of crypto companies coming to us asking for risk management solutions over the past month and a half,” Zarazinski said.&nbsp;



Most companies asked for cross-market surveillance to guard against risky exposure and natural language data from social media that can identify market trends early.



<h3 class="wp-block-heading">Widespread leverage across crypto ramps up risk</h3>



Last week, Galaxy Investment Partners CEO Mike Novogratz admitted he was &#8220;<a href="https://www.bloomberg.com/news/articles/2022-07-19/novogratz-says-he-was-darn-wrong-on-risks-of-crypto-leverage" target="_blank" rel="noreferrer noopener">darn wrong</a>&#8221; about leverage risks in crypto and surmised that few could have seen the extent of dangerous exposure in the crypto space.&nbsp;



Hindsight is 20/20, but some in the industry believe portions of the recent crash were preventable.



“Terra wasn’t a shock to anyone who spent time looking at the technology. People had been raising alarm bells for a long time,” Steven Goldfeder, CEO of Offchain Labs, said. “The information was out there” on which crypto firms were not trustworthy.



Meanwhile, US government officials continue to drag their feet on crypto regulation. California Rep. Maxine Waters announced Wednesday negotiations for a US stablecoin bill will be delayed until after the summer congressional recess.



“I hope people are more mindful and do further diligence,” Annabelle Huang, managing partner of Amber Group, said, “instead of saying, ‘Hey, he’s a crypto influencer, let me park my money with him,’ or ‘Just because my friends gave my money to him, it’s safe to [invest].'&#8221;



Court filings show <a href="https://cms.blockworks.co/tag/voyager/" target="_blank" rel="noreferrer noopener">Voyager Digital</a> gave over-leveraged hedge fund Three Arrows Capital an unsecured $650 million loan, leading Voyager to declare bankruptcy when 3AC defaulted.&nbsp;



Voyager and other investors in the $10 billion fund were drawn in part by <a href="https://cms.blockworks.co/with-litigation-likely-venture-fund-defiance-takes-aim-at-three-arrows-capital/" target="_blank" rel="noreferrer noopener">3AC’s reputation as a savvy dealmaker</a>.



<h3 class="wp-block-heading">Remove the human element to help stay afloat</h3>



Huang comes from a traditional finance (TradFi) background and hopes crypto will pick up TradFi’s conservative borrowing practices. “If you have two to five times leverage, you risk being wiped out in a day,” Huang said.&nbsp;



She also emphasized that collateral should be handled algorithmically to control for human error.



“A lot of the losses in the crash from some of the lending platforms likely resulted from the fact they exercised human discretion or extended favor to counterparties during the recession,” Huang said.



Ex-employees reported Celsius’ compliance department only contained three people, a tiny number for a crypto bank at one point handling $25 billion in assets.&nbsp;



Bolstering risk management will require bear-market investment from crypto companies.&nbsp;



Each of the companies Blockworks spoke to said lenders especially should look at bringing on additional full-time risk management staff.



“Companies are a little nervous to spend money but they all know they need more risk management,&#8221; Goldfeder said.



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