February 2, 2022

Defining crypto and the future of finance

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Welcome to Crypto for Advisors! In this week's newsletter:

What's the best path forward for crypto following the failure of FTX in 2022? Regulation will obviously play a key role. But general due diligence and risk management by investors will also be critical. CEO of Digital Asset Research (DAR), Doug Schwenk, thinks that vetting crypto exchanges can open doors to more institutional investment, as Chris Robbins writes today.

Later, we'll also take a look at counterparty risk in crypto, the chance that one of the parties involved in a deal might not make good on its promises, causing the other party financial harm.

- Henry Bond

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Better Exchange Due Diligence Could Help Define Crypto's 2023

(Ezra Bailey/GettyImages)

The crypto industry lost a lot in 2022, but there's plenty of optimism it will rebound stronger and better in the years to come.

One reason for that optimism is more risk-conscious investing and better due diligence, according to Doug Schwenk, CEO of Digital Asset Research (DAR), a securities analyst operating within the digital assets space.

For most of the past five years, DAR has preached the need for advisors and investors to vet their counterparties within the digital assets space.

As a free service, DAR offers a monthly general vetting of exchanges. January's Crypto Exchange Vetting evaluated over 450 exchanges, clearing 18 with a "Vetted" status: Binance.US, bitbank, Bitfinex, bitFlyer, Bitso, Bitstamp, Bittrex, BTC Markets, CEX.IO, Coinbase, Coincheck, CrossTower, Gemini, itBit, Kraken, LMAX, Okcoin, and Zaif.

DAR's big business is working with institutional investors to conduct detailed due diligence on opportunities within the digital assets space.

Today, more of those investors are buying exchange vetting and counterparty diligence services from DAR, according to Schwenk. And instead of vetting one or two counterparties at a time, they are often looking at lists of 10 or more, implying that more investors are considering diversifying around counterparty risk by using multiple exchanges.

That makes sense given the failure of FTX in 2022. But fortunately, FTX was not on DAR's vetted exchange list ahead of its collapse.

The opaque relationship with crypto hedge fund Alameda Research was a red flag, according to Schwenk. Attempts to get FTX to clarify its relationship with Alameda were dismissed.

He said other concerns included the likelihood that FTX's native FTT token was actually a security and that FTX was potentially running afoul of securities laws.

Moving forward, the path towards more maturity and trust in digital assets will be paved by transparency. After 2022's failures, investor and consumer expectations for transparency are going up.

– Chris Robbins

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Decrypting Crypto

What Is Counterparty Risk in Crypto?

(Gino Crescoli/Pixabay)

Counterparty risk is the possibility that one of the parties involved in a transaction might fail to fulfill its end of the bargain, thereby causing the other party to incur losses.

Since exchanges are the major gateways to the crypto market, new and experienced crypto participants often deposit their funds with them. Users trust that these exchanges will have plenty of coins available whenever any user initiates a withdrawal.

Unfortunately, as FTX's collapse has shown, this trust has cost many people their crypto wealth if the exchange misappropriates customer funds and cannot cover withdrawals.

So how do you avoid counterparty risk?

Confirm the validity of the crypto exchange: It is worth mentioning that the most important trait the ideal exchange has to offer is transparency. There has been a widespread call for exchanges to offer proof-of-reserves, which would show they have enough assets to offset any liabilities.
Opt for self custody: The best bet for crypto participants is to opt for self custody – the act of utilizing non-custodial services and solutions such as a software wallet like MetaMask or a cold storage solution like Ledger or Trezor wallets.
Beware of defi solutions susceptible to counterparty risks: It is important to note, while decentralized finance limits counterparty risks to an extent, other elements within the DeFi space still expose risks that stem from the possibility of counterparties failing to fulfill their end of the deal.

– Andrey Sergeenkov

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Disclaimer: The information contained in this newsletter, and any information linked through the items contained herein, is not intended to provide sufficient information to form the basis for an investment decision. You should seek additional information regarding the merits and risks of investing in any cryptocurrency or digital assets.