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Three Observations

Three Observations: Dec 2022 - Wrong Way Risk

1. Wrong Way Risk has re-entered investor lexicons. The term represents the hazard from a lender accepting collateral whose value is correlated to the borrower’s risk of default. While this concept is seemingly self-evident, we see time and time again that financial innovations incubate wrong-way risk. This is often in novel ecosystems (like crypto), propagating through hidden feedback loops. This is a concept we have written about previously.

2. Exhibit A is the collapse of centralized crypto businesses, most topically FTX and many related counterparties. Wrong way risk was assumed through posted collateral (by FTX) being comprised of tokens or instruments (FTT, SRM) issued by the borrower, in exchange for leverage (taken on by a related party, Alameda). This is a big no-no, especially for an institution that can be subject to a crisis of confidence.

In short, FTX posted as collateral tokens they had created. These tokens had a low-float clearing price (most were ‘locked’ and held by the issuer). When faced with a stress situation (a competitor calling into question the token’s value), they were subject to significant devaluation. The very marks they projected in their laughable financial control documents seemed oblivious to this risk, let alone a basic understanding of liquidity dynamics. Strange behavior for a market maker. Even stranger to see a grave-dancer engaging in similar (albeit likely less risky) behavior:

3. Wrong way risk is not confined to the realm of crypto; as the FT Alphaville nicely summarized it, we see it in other speculative pockets of the market. Softbank is a public holding company that manages investment vehicles, allowing its Founder/CEO – whose veritable entire net worth is tied to near correlation 1 investments with said investment vehicles – to assume significant levered position in said investment vehicle. Textbook wrong way risk, and something that skeptics have been quick to point out for years.

According to the FT, Masa Son’s levered position in the Vision Fund 2 is ~5bn USD in the red, in large part due to the fund’s investment performance. Given the related party nature of the transaction, don’t expect a capital call from SB to exacerbate the situation. Unlike the case of FTX, there isn’t a competitive counterparty that can ‘pull the rug’ on Softbank, but capital market sentiment can change quickly, as can investor capital inertia. This is case-and-point a clear example of wrong-way-risk. Investors are learning the lesson of peaking around the corner.


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