The Business of Risk

It seems everyone is amazed right now at the spectacular collapse of many digital asset lending providers.

But what got us here? It’s not necessarily fraud, Ponzi schemes, or a lack of demand. The primary cause seems to be poor risk management.

Let’s dive into what this means.

Banks Are in the Business of Risk

Digital asset technology has the potential to improve existing financial services and create entirely new financial products. Often, when one part of the digital asset market falters, the media is quick to throw the baby out with the bathwater.

As crypto and digital asset builders look toward the future, they often forget lessons from the past. Banks have been navigating the uncertain tides of financial services for centuries. While a bank is not exciting to our generation anymore, the business works and continues to function at a massive scale. Their stability is due in large part to their risk management strategies.

Today, Bank of America (BOA) trades at a price-to-earnings ratio below 10. What does that mean? You can effectively buy the bank back once over from its earnings in less than a decade.

How does it do that?

It gets paid to bear and manage various risks:

• Credit risk
• Market risk
• Liquidity risk
• Operational risk

Why Is Credit Risk Important?

The highest risk banks worry about is credit risk.

When banks lend to a business or other entity without collateral, they are concerned about the borrower’s likelihood of repaying the loan.

In the good old days, various factors unrelated to financial fitness were brought into the equation, including a person’s character, references, and even fidelity because… well… if their spouse can’t trust them, why should the bank?

Nowadays, banks use quantitative models based on measurable factors such as credit scores, education, and career path to accept or decline a loan. It’s no longer about your relationship with a specific bank or banker, but what you can prove about your creditworthiness.

This process is still imperfect and can certainly be improved, but many new digital asset lenders couldn’t be bothered to follow this script. They’d prefer to live Back to the Future—simultaneously in 1980 and 2050.

In traditional finance, very large deals—say, $600 million—without collateral would probably be syndicated.

What is syndication?

Syndication is when multiple banks group together to split a loan among themselves. Why do they do this? Even if everyone is comfortable with the borrower’s credit, they’re still concerned about having too much exposure to a single counterparty.

As the proverb goes:

“If you owe someone money, they own you. But if you owe someone a lot of money, you own them.”

Credit risk wasn’t the only unfortunate mistake made this cycle. The other came in the form of market risk.

Let’s Break Down Market Risk

Recently, digital asset firms have gone from zero to hero within a couple of years, only to crash back to zero in a matter of days.

When was the last time a financial institution achieved this distinction in living memory?

Even Long-Term Capital Management (LTCM), the hedge fund built by former Nobel Prize laureates, operated for four years and “only” reached the low single-digit billions before blowing up.

How do banks usually manage this? Don’t they trade all the time?

Well, yes—but they are on the sell side, meaning they primarily facilitate trades for clients and collect a spread.

Think of them as the hot potato trader. A client wants to buy, so the bank sells and is temporarily exposed to market risk. The bank then wants to offload that position as quickly as possible for a profit, motivating it to find another buyer. The better and faster it can do this, the more “riskless” the trade becomes, locking in bid/offer spreads on both sides.

That’s why banks sometimes highlight the number of consecutive profitable trading days—it demonstrates the consistency and effectiveness of proper risk management.

How About Liquidity Risk?

Another less-discussed—but extremely important—risk in fixed income and lending is liquidity risk.

The main issue isn’t whether you have money or assets. It’s whether you have them when you need them and in the right form.

Think of a widget assembly line. Different parts arrive at different stations. If you’re missing a wheel, it doesn’t matter if you have five car seats that are worth the same amount. The assembly line still stops.

Let’s Build From Here

The irony in all this is that had all lenders stuck to overcollateralized lending settled on a blockchain, they would have had far fewer issues.

Protocols such as Aave, Compound, and DAI scaled up and down through tens of billions of dollars during the last few months and continued operating without a hitch. I’m unaware of anyone lending through those protocols losing a single penny, despite BTC and ETH falling well over 60% from their peaks.

Not only did many centralized operators manage to blow up during this crypto bear market, but they also caused tremendous reputational damage to the industry as a whole.

Unlike a marketing service or a social app, the cost of failure for financial institutions is extraordinarily high, and many actors were not treating their customers’ funds with the care and consideration they deserved.

How long will it take before users trust crypto lenders again?

The industry had an opportunity to show the world how much better financial services could be. Instead, it managed to shoot itself in the foot and draw the ire of otherwise enthusiastic consumers who could have become passionate ambassadors for Web3.