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Crypto, Contagion, and Coinbase: Why Risk Management Is Key

Why Risk Management Is Key
Last week, Coinbase wrote a blog post detailing its risk management practices and how they relate to recent events. Here’s what those practices mean for Alto CryptoIRA users.

We’ve received a lot of questions about the recent failures of high-profile crypto investment and lending firms like Celsius and Three Arrows. They want to know if Coinbase, as an integration partner with Alto CryptoIRA®, is at similar risk.

Last week, Coinbase published a blog post addressing these issues head-on. In it, the authors examine the roles of leverage and inadequate risk management in the collapses of firms such as Celsius and Three Arrow. But perhaps most notable for CryptoIRA users, the post looks at how these events relate to Coinbase and its own risk management practices.

While it should be noted that assets held in an Alto CryptoIRA account are not subject to Coinbase’s lending practices, it’s worth taking a closer look at:

  • The role of leverage in recent crypto failures
  • Why risk management is critical
  • The principles Coinbase applies to risk management

Leverage and Its Role in the Recent Crypto Contagion

Over the past few months, there’s been much talk of contagion spreading through the crypto industry. However, the phrase “contagion” is a bit misleading. As the Coinbase post’s authors note, the issues faced by Celsius Network, Three Arrows Capital (3AC), Voyager Digital, and others “were foreseeable and actually credit specific, not crypto specific in nature.” 

Rather, they say that too much leverage—not crypto itself—was the true culprit. (That and poor risk management controls, which we’ll discuss later.) 

“The issues here were foreseeable and actually credit specific, not crypto specific in nature.”

So what is leverage? Quite simply, leverage refers to using credit (debt) to fund larger investments than a person or entity could afford on their/its own. Doing so makes it possible to achieve greater gains; however, it also means substantially greater risk.

We’ll use Celsius as an example to explain how leverage works. Celsius offered users jaw-dropping returns in exchange for putting up their crypto as collateral to make investments in even riskier assets.

In other words, Celsius invested more than they had, which worked during last year’s bull market. But as macroeconomic conditions shifted and prices began to fall, so did the values of those investments. Not only that, the value of the crypto used as collateral to secure credit also fell. This triggered margin calls, causing a liquidity shortage, which in turn resulted in the halting of withdrawals. Suddenly, investors were unable to access their funds.

But while being over-leveraged may have been the catalyst for these events, insufficient risk management made them possible.

A Cautionary Tale About the Importance of Risk Management

The same week Coinbase published its blog detailing the company’s risk management practices, 3AC’s founders broke their silence on the hedge fund’s collapse. In the wide-ranging Bloomberg exclusive, they admitted to making several key mistakes. Among these were:

  • Failing to anticipate a bear market, which they attributed to their bullish views on crypto
  • Allowing their close relationship with Terra Labs founder Do Kwon to cloud their judgment, leading to significant exposure to Luna
  • Continuing to take out loans that required minimal collateral even after Luna imploded
  • Locking too many of their funds in illiquid investments, leading to a shortage of liquidity

For Three Arrows, the perfect storm of these and other mistakes proved fatal. As of the July 22 publish date, Bloomberg reported that creditors were seeking $2.8 billion in loan money. 

But 3AC is not alone. Celsius Network, Voyager Digital, and a host of others all found themselves in similar situations. So then what, you ask, is Coinbase doing to avoid these same mistakes?

How Coinbase Approaches Risk Management

Beyond clarifying that Coinbase had no financial exposure to Celsius, Three Arrows, and Voyager, the authors of last week’s blog post revealed five principles Coinbase uses to understand and manage counterparty credit risk.

Before investing in or partnering with another company, Coinbase’s risk team believes it is essential to:

  • Conduct rigorous due diligence on a prospective counterparty’s finances, business, behaviors, and structure.
  • Stress-test their exposures from a variety of perspectives by running Monte Carlo simulations and other analyses to ensure alignment.
  • Understand how things can go wrong by digging deep to find and mitigate potential failure points.
  • Anticipate internal deficiencies by managing “known unknowns” and planning for what they call “unknown unknowns.”
  • Anticipate external deficiencies and develop mitigation strategies while simultaneously limiting risk.

By implementing carefully crafted risk management practices guided by the principles above, Coinbase says it is able to “effectively manage counterparty and liquidity risk” for its clients, shareholders, and the market. And this responsible approach to risk management is something they stress as essential to “helping to fund crypto’s next wave of growth.”

At Alto, we share the belief that thorough due diligence is imperative, whether partnering with another business, choosing an IRA provider, or making an individual investment. That’s why we chose to integrate Alto CryptoIRA with Coinbase to offer tax-advantaged investing in 200+ cryptocurrencies. 

To learn more, read Coinbase’s full post, “Institutional Insights: Our Approach to Crypto Financing.”