Managing Counterparty Risk in Cryptoasset Trading
Should FIs opt for exchange or OTC-based execution when seeking to manage counterparty risk?
For some financial institutions, over the counter (OTC) trading of cryptoassets may be the preferred means of execution. OTC trading, dominated by institutional investors, accounted for 5 per cent of crypto transaction volume in 2017, before climbing to 35 per cent in 2021.
OTC trading desks facilitate cryptoasset trading between two parties without revealing information about the trade to the public via an exchange order book.
The OTC desk acts as a matchmaker, enabling high-volume transactions between buyers and sellers. During an OTC trade, the two parties agree on a purchase price before they complete the transaction. The trades can be crypto-to-crypto or fiat-to-crypto.
The core challenge for institutional investors associated with OTC cryptoassets trading is the management of counterparty settlement risk. There is no centralised repository globally or regionally for the straight-through processing and management of OTC-traded cryptoasset transactions. As a result, counterparties to the transactions must independently assign risk tolerance scores to the company fronting the other side of the transaction – buy or sell – to be able to determine on a trade-by-trade basis the level of risk that must be reflected in the spread offered via the request-for-quote. However, this discretion can mean that risks are not always entirely accounted for, meaning that trading in cryptoassets will always carry some inherent degree of risk. Additionally, OTC trading with one counterparty can mean a firm is ultimately putting all of their eggs in one basket when it comes to transacting in cryptoassets.
In order to mitigate this counterparty risk, while seeking to achieve best execution, FIs may have no choice but to partake in exchange trading, and hold cryptoassets across a myriad of centralised and decentralised exchange accounts, on-chain wallets and custodial solutions. However, in doing so, FIs may forego access to quality data, as highlighted in yesterday’s post, and surrender trade execution quality.
For example, if an FI tries to buy 1,000 Bitcoin on a regular crypto exchange, the chances of finding someone selling that amount at any given time on a single exchange are slim. The FI will have to opt to split the purchase across several sellers, meaning that some of the purchases may be executed at a significantly higher price due to volatility. At the same time, the FI will still face some counterparty risk from the cryptoasset exchanges that it routes orders to. Several crypto exchanges globally are still unregulated and poorly secured. As we saw with the high-profile collapse of the FTX crypto exchange in 2022, which was the third-largest cryptoasset exchange at the time, it is not uncommon for such events to occur. However, not putting all their eggs in the basket of an OTC transaction and spreading it across several, potentially unregulated, exchanges at the expense of execution quality may be one of the few options an FI has when seeking to trade in cryptoassets, especially if liquidity is shallow.
Intermediaries such as FalconX, Noble Bank International, Bosonic and Cboe Digital offer OTC-traded cryptoasset counterparty settlement risk management services. For example, in September 2023, Cboe’s US-regulated clearing house helped clear a trade between Nonco US, a subsidiary of one of the largest over-the-counter (OTC) providers in Latin America, and DV Chain, an affiliate of Chicago-based proprietary trading group DV Trading. However, in OTC crypto trading, there is still a lack of standardised regulatory frameworks, with no formal documentation that universally governs how OTC deals between sellers and buyers are stipulated or upheld. General anti money-laundering and know your client checks that are currently prevalent are arguably not sufficient protection against counterparty risk. As such, there is still a general mismatch between custodians and intermediaries willing to service OTC-traded cryptoassets, and institutions seeking exposure to cryptoassets in this way, potentially affecting further maturation of the industry.
Whether FIs seek to gain exposure to cryptoassets predominantly through exchange trading or OTC trading, inherent volatility and counterparty risks associated with cryptoassets must be managed accordingly. FIs can mitigate this risk by using a combination of both OTC and exchange trading, as outlined above, although they should be aware of the benefits and challenges of both.
Ideally, FIs need institutional-grade management tools that provide a holistic overview of their OTC and exchange trading activities, along with a wider array of counterparty risk-management platforms and APIs that can instil greater institutional confidence toward cryptoasset trading.