Issue 5
Bitfinex Alpha | ISSUE 5
Thought leadership | Research | Market Analysis
Welcome to issue 5 of Bitfinex Alpha!
Risk in a financial system never disappears; rather, it is merely transferred within the system.
Traditional Finance (TradFi) is reliant upon the functioning of too-big-to-fail institutions burdened by mountains of debt. TradFi also centralizes enormous amounts of risk through Central Clearing Counterparties (CCPs) which are critical trade settlement infrastructure.
During periods of market volatility, quantitative easing (QE) is required to bail-out these institutions and protect the financial system from potential collapse.
QE erodes the scarcity value of government debt such that policymakers will increasingly turn to policies of financial repression to coerce investors and savers to buy government debt at nominal interest rates below the rate of inflation.
Ultimately, TradFi is trapped in a cycle of systemic risk, QE, and financial repression.
Conversely, DeFi brings real time transparency on liquidity flows leveraging smart contract functionality and natively digital bearer assets, avoiding the buildup of systemic risk which plagues TradFi.
DeFi is the financial system of the future.
Could Bitcoin, with its volatility, be today’s TradFi best bet to exit its endless cycle of systemic risk, QE, and financial repression?
If you’ve been reflecting on the world’s financial system issues these days and wondering if there may be a potential solution for it, you are at the right place. We believe you will gain new insight and knowledge in the latest Bitfinex Alpha issue—a collaboration with fintech and crypto researcher John Dwyer.
Bitfinex Alpha aims to bring you exciting and mind-opening topics around cryptocurrency and blockchain, with valuable insight into the market in each issue of Bitfinex Alpha.
John Dwyer is a contractor for Bitfinex where he provides crypto research services. He first bought Bitcoin in 2013 and invested in the Ethereum financing in July 2014. Previously he was Global Digital Assets Research Lead at Celent (the fintech research division of Oliver Wyman). This followed a career in investment banking, where he ran equity capital markets businesses at Macquarie Capital (specializing in natural resources) and Goldman Sachs.
The views and opinions expressed in the note belong solely to the authors and do not reflect those of Bitfinex.
RegCap @ Zero
Mitigating the risks of TradFi with Bitcoin and DeFi
By John Dwyer
26 November 2021
RegCap is an abbreviation of “regulatory capital” which a financial institution must hold on its balance sheet to absorb losses, restrict excessive financial asset growth (i.e. bubbles), protect depositors, and promote overall public confidence in the financial system.
New regulatory capital frameworks were the biggest policy initiative post the Global Financial Crisis (GFC) in 2008 and are considered the primary tool to mitigate future financial crises.
RegCap plays a major role in future capital flows from regulated institutions into Bitcoin. However, Bitcoin’s role as globally fungible collateral combined with a new resilient DeFi financial system has the potential to make RegCap an anachronism in the age of digital assets.
Introduction
What is RegCap?
What is Systemic Risk?
Systemic risk is the risk of severe instability across the entire financial system including its total collapse. Macro-prudential regulation addresses such risks to the financial system. Pre GFC, the priority was micro-prudential regulation which addresses resilience of individual financial institutions rather than the financial system itself.
In prior reports, we explored how Bitcoin provides a new form of globally fungible collateral which will offer interest rates which can redefine risk-free interest rates benchmarks and ultimately will re-price global risk assets.
Here we will explore the topic of risk in two areas:
DeFi – A Financial System Without Systemic Risk
Risk Definitions
Let’s start with some definitions of key types of risk to earnings or capital of financial institutions.
Credit Risk: this is the risk of owning a credit obligation due to the issuer failing to meet the terms of the obligation; it is closely related to default risk. Credit risk is measured by calculating the difference in yield (“credit spread”) over the risk-free government rate of the same maturity.
Interest Rate Risk: traditional risk assets are inversely and non-linearly correlated with interest rates. In Bitcoinization, we explored this with a particular focus on bond duration. Given interest rates are at extremely low levels, the sensitivity of traditional risk asset prices to any increase in interest rates is at its most extreme,
Liquidity Risk: this relates to the inability to sell assets quickly and with minimal loss of value in the secondary markets. It also includes the inability of a financial institution to manage unplanned decreases in funding sources. This was a particular feature of the GFC as unsecured interbank lending markets ceased to function.
Counterparty/Default Risk: financial markets are highly complex and interconnected with collateral and leverage. Therefore, financial institutions manage large numbers of counterparty exposures which can be with corporations, financial institutions, governments, and individuals.
There are various other risks such as those related to FX, transaction execution, compliance, model risk, cyber security, and reputation which we are not going to go into detail. Instead, we will focus on the asymmetry of risk which has emerged within TradFi and how this risk can be amplified across the financial system.
Asymmetric Downside Risk of Credit Markets
Global credit markets are worth approximately $129 trillion[1] versus global equity markets which are approximately $106 trillion. Credit markets are larger than equity markets, closely interlinked with derivatives exposures, and highly sensitive to any increase in interest rates, inflation, or weakening of the credit environment.
Endogenous and Systemic Risk
Endogenous risk is created by the financial system itself when it magnifies realized volatility through negative feedback loops throughout the financial system.
This magnification of realized volatility during crises coincides with reduced capacity of the financial system to bear this additional risk. This happens quickly due to the non-linear response of financial assets, particularly credit, to changes in interest rates or market confidence.
A key assumption of micro-prudential regulation is that if each financial institution is secure then so is the financial system itself. Counterintuitively, if individually prudent behaviour is replicated across the markets by other market participants, then this amplifies a financial crisis.
Understanding CCPs can explain this.
Central Clearing Counterparties (CCPs)
Central Clearing Counterparties (CCP) are systemically important Financial Market Infrastructures (FMI) within TradFi.
Regulation has mandated the use of CCPs for clearing over the counter (OTC) derivatives to replace the bilateral relationships between counterparties which existed previously.
CCPs place themselves between a buyer and a seller of a trade avoiding the complex web of exposures of bilateral settlement. CCPs guarantee the obligations agreed between the counterparties, who are clearing members of the CCP. If one counterparty fails, the other is protected via the default management procedures of the CCP.
Matched Book…But Default Risk Exposure
CCPs run a ‘matched book’ whereby any position taken on with one counterparty is always offset by an opposite position with another. Hence, the CCP does not take on market risk.
However, the CCPs are greatly exposed to default by a counterparty as this leaves their book unmatched and subject to market risk. CCPs manage this risk by taking collateral (“margin”) from counterparties at the start of the transaction with net payment obligations being settled daily by payment of “variation margin” to prevent the build-up of large exposures.
Increase Margin Requirements at Worst Time
When market volatility increases, CCPs raise the variation margin required from their members to manage risk. The GameStop debacle was an example of this when the Depository Trust and Clearing Corporation, a US CCP, required its clearing members to post 30% more collateral for trades in GameStop stock given the increased volatility the stock was experiencing.
The point is that CCPs alter collateral requirements in response to various factors including market volatility, trading volume, the dominance of buying or selling activity by a member, and so on. The bigger each of these, then the greater the risk and the more collateral required.
Homogenous Trading Behaviour
Collateral requirements can apply to all CCP members creating homogeneity in trading behaviour amongst these different trading firms – or said another way, they will all be seeking to “raise liquidity” or sell assets to meet collateral requirements simultaneously. This exacerbates market volatility at the worst possible time.
CCPs Mutualize Default
Set out below are the options a CCP has in order to deal with default by one of their members.
Ultimately, default is managed by either using the capital of other clearing members or the equity of the CCP. Such steps are likely to be highly procyclical as default by a clearing member indicates that there is acute financial stress in markets and the remedies adopted by a CCP would only make this stress more acute for the remaining members.
Summary - CCP-Driven Procyclicality During Crises
Risk Does Not Disappear
Risk in a financial system does not disappear; rather it is transferred and CCPs centralize risk in TradFi. However, there are various other stress points which pose systemic challenges.
TradFi Has Multiple Points of Stress
Risk Off vs. Risk On
When realized volatility explodes then the correlation of all risk assets leads to one, risk asset prices rapidly adjust lower, and sanctuary is sought in cash - primarily the US dollar. Highly leveraged assets perform the worst during high volatility and become illiquid while demand for cash (liquidity) outperforms. Those with cash also have the most options during crises: volatility, optionality, leverage, and liquidity are all interlinked.
The macro prudential reforms post the GFC which have shifted towards centralized clearing risk accelerating these dynamics during financial crises. In extremis, TradFi is short optionality, short volatility, highly leveraged, and illiquid—the antithesis of Bitcoin HODLers.
The above explores what happens if the TradFi system fails. Whilst this is a possible scenario, it is only an extreme outcome. So, let’s explore what happens to TradFi in the meantime if it sustains itself well into the future.
Options for Reducing Debt/GDP
Policy makers face the challenge of how to reduce Debt/GDP ratios to manageable levels. There are a limited number of options available:
Economic growth is challenging given COVID and the indebted nature of the global economy. Default and austerity are politically unacceptable given their huge social cost. Therefore, the only viable option is Financial Repression which is the strategy which prevailed globally post World War II and was in place in most advanced economies from 1945-1980.
Financial Repression
Financial Repression is policy makers’ use of taxes, controlled interest rates, and macro prudential regulation[6] to control the price and availability of credit.
State-Control of TradFi
Financial Repression is about governments controlling the price and availability of credit. It keeps the cost of debt below inflation and limits who gets access to this credit. This is the playbook for restoring Debt/GDP ratios to manageable levels in the years ahead.
Policy makers will coerce regulated financial entities (and individuals) to buy government debt yielding a negative real return. In short, it is about transferring wealth away from savers.
QE = Base Money
We can’t ignore quantitative easing (QE) as that is central to the pristine collateral argument for Bitcoin. We will contextualize the possible outlook for QE in the years ahead but will keep this brief given the volumes which have been written about this elsewhere.
Base Money = Settlement Finality
Global Base Money (or MO) is approximately $29 trillion[9] and represents the ultimate asset for settlement finality in TradFi. It represents physical national currency in circulation plus commercial bank reserves. Most of the Base Money in existence has come from the creation of bank reserves via QE post the GFC.
Global Credit at $123 Trillion
In simple terms, the global economy needs to produce the cashflow to pay off the principal and interest for the total credit balance outstanding of approximately $123 trillion. These credit assets are held by financial institutions within TradFi, and major impairment of these credit assets weakens these institutions and can trigger the systemic risks highlighted earlier.
Future QE = Huge and Unknowable
Further, global credit of $123 trillion is a conservative number for forecasting future QE. It excludes governments’ unfunded liabilities, most notably Medicare and Medicaid in the U.S. which are estimated to be in the tens to hundreds of trillions[10]. In short, QE and fiscal stimulus are here to stay and likely to be bigger than anyone expects.
Corporate Credit Canary
Corporate credit has seen a huge expansion to $40 trillion globally[11] and is broadly owned by institutional investors. However, should corporate credit be downgraded to sub-investment grade (aka “high-yield” or “junk”) then this creates a major supply issue for the market.
Forced Sale of Sub-Investment Grade Corporate Credit
Investment mandates of many credit funds limit their ability to hold sub-investment grade paper. Therefore, these credit funds would be forced sellers of corporate credit which has been downgraded to sub-investment grade. The market’s capacity to absorb this will be limited and will create further volatility.
TradFi is TrappedFi
Bringing this all together, TradFi is trapped in a cycle:
Bitcoin
Bitcoin is the exit strategy from TradFi and its characteristics create perfect collateral:
Bitcoin Yield Curve
The next phase of digital asset adoption will include yield attracting new constituencies of investors. During periods of stress in TradFi when demand for U.S. Treasuries increases, the yield on U.S. Treasuries decreases.
It remains to be seen but it is possible that during future periods of systemic stress in TradFi, when the haven of Bitcoin is sought by investors instead, then the yield demanded by Bitcoin HODLers to lend out their Bitcoin collateral increases the yield achievable.
Collateral Characteristics: U.S. Treasuries vs. Bitcoin
Pioneering with Perpetual Swaps
Perpetual swaps (“perps”) were pioneered by BitMEX and are traditional futures contracts without an expiration date. They allow counterparties to post collateral and gain leveraged long and short exposure to an underlying asset without taking custody.
Managing Risk without CCPs
Where there is leverage, there is risk. This risk does not disappear rather it is merely moved around the financial system. In DeFi (excludes CME), derivatives markets lack central counterparty clearing (CCPs) between derivatives counterparties. Therefore, BitMEX pioneered a process for managing liquidation of collateral should a counterparty’s position face bankruptcy.
Automatic Liquidation
Liquidation is performed automatically before one side of the contract reaches bankruptcy and occurs when the maintenance margin reaches a pre-specified value (the “liquidation price”). If contracts are liquidated at a profit, then the excess contributes to the insurance fund. If contracts are liquidated at a loss, then contributions are required from the insurance fund.
Auto-Deleveraging
If the insurance fund is depleted (either globally or for a particular contract), then auto-deleveraging occurs. Here, opposing traders’ positions are ranked by profit and leverage and are closed out at the bankruptcy price – the most leveraged traders are penalised first.
New Model for Risk Management
This is a new model for managing risk from leverage and collateral in decentralized derivatives markets. It emerged from centralized exchanges like BitMEX but has spread into DeFi through the FutureSwap, Perpetual Protocol, MCDEX, dydx and others. This model is not perfect, but it does mitigate systemic risk buildup experienced in TradFi.
DeFi Mitigates Systemic Risk
Regulatory Capital – Common Equity Tier 1 Capital
To conclude, we will look at regulatory capital of banks as it impacts regulated financial institutions and their capacity to hold Bitcoin and other digital assets in the future. The main form of capital banks are required to hold in their capital structure is Common Equity Tier 1 Capital which broadly includes ordinary shares and retained earnings.
Risk Weighted Assets
The Tier 1 Capital Ratio compares the bank’s core capital to its risk-weighted assets (RWA) which are the assets that the bank holds which are evaluated for risk (mostly credit and market risks). These assets are assigned a risk weighting depending on their perceived risk of loss and this risk-weighted asset number is used to determine how much capital the bank requires to absorb losses. A simple worked example is the easiest way to explain this.
Key Takeaways
Macro prudential regulation has a major impact upon capital flows into sovereign debt, Bitcoin, and other digital assets for regulated financial institutions.
Concluding Remarks
TradFi is trapped in an endless cycle of systemic risk, QE, and Financial Repression. This ensures monetary/fiscal policy expansion coupled with macro prudential regulatory tightening.
Conversely, think of Bitcoin like a bank which holds your assets securely without the traditional counterparty risk of TradFi and which is open 24/7/365. Yes, it is certainly volatile. However, as we enter the second leg of this bull market it will demonstrate mostly upward volatility.
Bitcoin is the best form of globally fungible financial collateral ever and has spawned the growth of a financial system which mitigates the build-up of systemic risk which plagues TradFi. Consequently, the idea of regulatory capital cost is a legacy concept from TradFi which is anachronistic in the Digital Age.
RegCap Goes to Zero in the Age of Digital Assets
Summary
John was Global Digital Assets Research Lead at Celent (fintech research division of Oliver Wyman). This followed a career in investment banking where he ran equity capital markets businesses at Macquarie Capital (specializing in natural resources) and Goldman Sachs.
The views and opinions expressed in the note belong solely to the author and do not reflect those of Bitfinex.
About the Author
References
[1] https://www.sifma.org/wp-content/uploads/2021/07/CM-Fact-Book-2021-SIFMA.pdf
[2] https://www.fsb.org/2020/11/2020-list-of-global-systemically-important-banks-g-sibs/
[3] https://en.wikipedia.org/wiki/Systemically_important_financial_market_utility
[4] We explored Bond duration in our prior report Bitcoinization
[6] See risk weighted assets calculations later
[7] https://en.wikipedia.org/wiki/Regulation_Q
[8] https://securitiesce.com/definitions/6042-regulation-t/
[9] https://cryptovoices.com/basemoney
[11] https://www.icmagroup.org/Regulatory-Policy-and-Market-Practice/Secondary-Markets/bond-market-size/
Bitfinex Alpha | ISSUE 5
Thought leadership | Research | Market Analysis
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