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07 February 2023       Hedgeweek

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By Travis Williamson and Steven D’Mello 
Albourne Partners

Following the collapse of FTX, counterparty due diligence has become even more crucial for all active trading strategies. Managers have been trying to find suitable counterparties, while accessing enough liquidity to reasonably execute their strategy.

In the long run, we may see regulatory pressure that forces separation of execution, custody, and financing in digital asset markets to mitigate systemic counterparty risks. 

However, an early interim solution that is emerging to help manage counterparty risk is the increasing usage of off-exchange settlement which permits trading without pre-funding transactions on exchange by using leverage provided by the custodian, with settlement occurring on a daily basis. 

Mitigating Risks Going Forward:

  • Avoiding usage of centralized counterparties through trading over the counter (OTC): While there is settlement risk, OTC is wallet to wallet with no ongoing counterparty risk. Triparty OTC is likely to be sought by certain managers to reduce settlement risk. DeFi is also peer-to-peer and wallet to wallet, but regulatory solutions are needed to enable institutions to confidently access it. Decentralized protocols are still subject to substantial security risks (i.e., hacks). Therefore, more maturation of the smart contract security process is required before we see institutions substantially use decentralized exchanges.
  • Potentially, there could be a shift towards centralized exchanges that offer more transparency. Proof of reserves involve having the exchange identify its wallets to verify that the exchange has sufficient assets to meet its liabilities. However, proof of reserves may lack granularity on the liabilities side of the balance sheet. Therefore, currently, there is no better alternative than audited financial statements. A combination of proof of reserves and audited financial statements would provide more transparency into counterparty health than currently present.
  • Increasing usage of off-exchange settlement, trading on a T+0 or T+1 basis helps mitigate some of the risk.
  • Reducing counterparty risk by sweeping assets off exchange into segregated trust accounts and by diversifying exposure across multiple counterparties may also be prudent.

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