We consider token owners’ and the protocol’s perspectives when discussing crypto dangers. We can get a better idea of the protocol’s long-term viability and the broader crypto landscape by identifying the protocol’s primary sources of risk exposure. There are two ways to think about risk: systematic and idiosyncratic.
Systematic risks influence the market, and the protocol cannot be adequately handled alone. On the other hand, idiosyncratic risk is crucial to the design of tokens and mechanisms and may be regulated to some degree by the protocol. As with any form of investment, a cryptocurrency investment poses a certain degree and several types of risk.
A sort of idiosyncratic risk is financial risk. It’s a way of describing the potential for a token to go bankrupt during use and how much of a risk that is. There are two primary sources of financial risk for stablecoins: cash flow and collateral.
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Cash flow
Cash flow is one of the most straightforward and readily analyzed sources for risk in risk analysis. This information is derived from changes in the protocol’s cash flow over time and the protocol’s capacity to weather an economic crisis. Similarly, comparing a token’s cash flow and growth stats to those of other protocols might reveal which tokens in the market are in better financial health and hence more stable.
Investors will have greater faith in protocols with better cash flow in the long run, which will increase token purchases. That’s especially critical when dealing with stablecoins, whose value is tied directly to an agreed-upon monetary amount. Investors purchase stablecoins based on their intended use of the token and the token’s long-term reliability.
To assess financial risk from cash flow, it is typical to break down the incoming and exiting cash over set periods and evaluate their growth. Depending on the protocol’s architecture, sources of revenue and expenses like interest, trading, and operating may be further subdivided. Significant variations in the proportions of each category may imply fundamental alterations in the protocol’s financial success.
Collaterals
On the other hand, collaterals are another critical source of financial risk for stablecoins. Stablecoins in the token market use collaterals or computational techniques to keep their value steady.
The sorts of collaterals utilized strongly influence stablecoin buyers’ judgments, which significantly affects the financial risk exposures. The stablecoin risk may be assessed by looking at a variety of factors, such as whether the reserve is made up of on-chain assets (other tokens), off-chain assets (currency and cash equivalents), a mix of the two, or algorithms with no reserve or just a portion of the reserve available.
What do they do?
Stablecoins like DAI and LUSD, backed by on-chain assets, frequently have the maximum level of transparency since the collateral data can be accessed. How the collateral pool is structured may be studied in terms of asset types and collateralization ratios, as well as whether there have been substantial changes in the collateral pool structure over time.
A stablecoin’s collateral pool must be reasonably stable, with no substantial fluctuations in the percentage of each asset type, to be classified as having minimal financial risk exposure. If asset values suddenly fall, the value of the collateral reserve should still be enough to provide an acceptable collateralization ratio. Still, it should not be set so high that it discourages investors from retaining the token.
Secured loans, short-term treasury bills, corporate bonds, and other investments may be used as collateral for stablecoins backed by off-chain assets like cash and commercial paper. When a reserve pool’s fraction of cash is more significant, it reduces the financial risk exposure of these tokens since it is better able to cope with unanticipated scenarios requiring high liquidity of assets.
On the other hand, if the collateral value suddenly drops, tokens backed by assets that cannot be exchanged for cash may not stabilize to their pegged value. Some protocols may not provide a clear breakdown of the components of their fiat reserve, which is a crucial factor to keep in mind. To make the figures more enticing to investors, they don’t disclose the percentage of cash on hand but rather the percentage of cash and cash equivalents. Financial risk will rise due to this lack of transparency, which will cause uncertainties and a lack of trust among investors.
A final stablecoin group utilizes algorithms that change the quantity of the coin to keep its token price anchored at a specific value. On-chain and off-chain reserves back some of these tokens, while others are uncollateralized. The collateral structure of these algorithmic currencies necessitates a specialized examination. If these tokens are entirely unsupported, we may concentrate on their capacity to maintain a steady price and their financial flows.
In addition to the design and mechanism of the token, the token’s performance is an essential aspect in determining financial risk. As a stablecoin’s market share grows, so does the number of applications it may be put to. This has an impact on the token’s transaction volume and earnings.
Risk analysis for stablecoins, like many other financial assets, is a complicated procedure with no clear distinctions or criteria. We may encounter various challenges in deducing the degree of risk present. The financial risk exposures of a protocol may be summarised by looking at the primary sources of risk from financial performance, collaterals, and token performance. A complete risk analysis must consider several elements and may need the creation of new metrics that are particular to the protocol in question.
Final thoughts
Financial risk is a long-term notion that is difficult to foresee if there are unexpected changes in token design after governance voting or new regulations are introduced. Financial risk may be impacted in both directions by specific measures.
A constant cash reserve may be provided through over-collateralization, but it also results in significant quantities of idle money, which may limit the token’s long-term scalability. Because of this, we must be aware of these limits, understand the relationships between various hazards, and make prudent decisions when choosing risk exposure levels.