Zombie Coins and Credit Risk
How zombie coins disrupt conventional credit risk notions and tools that allow investors to quantify risk
"I used to avoid people like they were zombies before they were zombies. Now that they are all now zombies, I kinda miss people."
– Jesse Eisenberg as Columbus, “Zombieland”
Cryptoland introduces a distinct blend of credit and market risks. Unlike traditional regulated banks, centralized cryptocurrency exchanges are privately operated without government oversight, contributing to a certain credit risk landscape. Amidst this, “zombie coins” emerged – cryptocurrencies that have sat dormant for an extended period – disrupting conventional notions of credit risk. Here we delve into cryptocurrency credit risk, explore zombie coins, and introduce the Market Implied Probability of Default model as a dynamic risk assessment tool.
Credit Risk
Following the Global Financial Crisis (GFC) of 2008, governments have implemented a strategy known as quantitative easing. This involves injecting new money into the economy through central banks. Central banks oversee a system where banks exclusively create specific IOU notes, which are deemed legal tender by the government and are accepted as payment for taxes. The credit risk associated with these IOUs is tied to the sovereignty of the country itself.
In cryptoland, many centralized exchanges (CEXs) are privately owned and not regulated. This means that customers who entrust their funds to these exchanges face credit risk from private, unrated entities rather than from a government. Specifically, if a CEX decides to restrict user withdrawals for an extended period, it effectively fails to fulfill its IOU commitment. This situation is exacerbated by the high volatility of cryptoasset market prices. Delays in withdrawing and redeeming funds can lead to financial loss or additional expenses.
Research shows that, historically, approximately 48% of CEXs have shut down and, on average, an exchange's lifespan has been approximately 451 days. Centralized exchanges introduce complications due to cyberattacks, where malicious actors infiltrate the exchange's systems and abscond with cryptocurrencies. While exchanges maintain reserves to cover losses from cyberattacks, these "guaranty funds" often cannot fully reimburse all affected users. Even if the exchange recovers from the attack, users may still suffer financial losses.
Zombie Coins
In every crypto market cycle, most cryptocurrencies undergo substantial value depreciation, often exceeding 90% from their peak levels. A recent analysis reveals that a staggering 95.5% of all cryptocurrencies have plummeted by over 99.99% from their historical highs within the 2017-2019 cycle. Many have since disappeared due to scams, lack of plans, or stagnation.
Unlike a bankrupt company, a cryptocurrency can revive from this dead state. These zombie coins, perceived as abandoned, have resurrected more than once in a short timeframe. They still exist but have lost significant value and utility, often becoming inactive or obsolete.
Zombie coins are characterized by:
Limited trading activity: They experience low trading volumes on exchanges, indicating reduced investor interest and engagement.
Stagnant development: They lack ongoing development efforts, updates, or improvements to their underlying technology.
Lack of community engagement: Communities and user bases around zombie coins tend to dwindle or become inactive over time. This lack of engagement can further contribute to the decline of these digital assets.
Obsolete use cases: Some zombie coins were launched with specific use cases or utility in mind, but over time, those use cases may have become outdated or irrelevant, leading to decreased demand.
Abandoned projects: Developers or teams abandon the project due to such various reasons as regulatory challenges, lack of funding, or shifting priorities.
Price decline: Zombie coins have experienced substantial price declines from their all-time highs, often rendering them near-worthless or significantly devalued.
Lack of investor confidence: The combination of low trading activity, stagnant development, and a lack of community engagement erodes investor confidence in these assets, making them less attractive for both traders and long-term holders.
Unlike a corporation, where a default leads to corporate restructuring and dissolution, wiping out equity shareholders, a cryptocurrency often operates and survives through a decentralized autonomous organization (DAO). DAOs are designed to enable decentralized decision-making, governance, and the execution of actions without the need for central authorities or intermediaries. Through DAO’s communities or new development teams, a zombie coin may breathe new life by initiating updates, rebranding, or introducing new use cases.
The Relationship between Credit and Market Risk in Cryptocurrencies
The linkages between credit and market risks for cryptocurrencies are more profound than in traditional assets due to the prevalence of zombie coins.
Credit risk in the context of cryptocurrencies pertains to potential gains and losses linked to the value of a zombie coin. On the contrary, market risk encapsulates the fluctuations in the value of active cryptocurrencies within a portfolio, stemming from market price changes across centralized and decentralized exchanges.
Cryptocurrencies that appear abandoned might still have a chance for rejuvenation, leading to potentially unforeseen financial implications. This underscores the importance of evaluating and assessing the risks associated with seemingly dead cryptocurrencies, as their potential revival could have a substantial impact on investment outcomes.
Market Implied Credit Risk
For cryptocurrencies, credit and market risks exhibit more quantitative and temporal differences than qualitative distinctions when compared to traditional assets like stock and bonds.
The Market Implied Probability of Default (MIPD) model underscores the connection between market risk and credit risk by estimating default probabilities solely from market prices and historical volatilities. Specifically, the MIPD model examines the frequency with which a cryptocurrency's value approaches a “zero price barrier” – the likelihood of the market price to go to zero.
Additional benefits of the MIPD model include:
Market-driven estimations: MIPD uses real-time market data to estimate default probabilities. This approach relies solely on observable market information, making it relevant and practical for assessing risk. It departs from any reliance on fundamental data, including whitepapers, and assumes that the market “knows it all”.
Incorporating complexity: MIPD accommodates complex factors that influence risk. Adjustments to underlying models can often be implemented with ease, offering flexibility and adaptability. Complex path dependencies can be incorporated in a straightforward manner.
No distributional assumptions: MIPD does not make assumptions regarding the distributions of cryptocurrency prices.
In Exhibit 1, we use a Monte Carlo simulation to obtain the MIPD of crypto price paths using only market data.
Exhibit 1: Monte Carlo Simulation of Price Paths
Exhibit 1 simulates the realistic probability distribution of cryptocurrency prices over a one-year time horizon using a historical one-year lookback time series. The MIPD is equal to the number of paths approaching the zero price barrier divided by the total number of simulated paths at the end of one year. This approach does not assume stylized distribution of the cryptocurrency prices, but rather that history will repeat in the short run.
MIPD in Action
Let’s explore some practical examples of how MIPD is applied to well-known cryptocurrencies like bitcoin and ether, as well as to exchange platform tokens and stablecoins.
MIPD of Mega-Cap Cryptocurrencies
Exhibit 2 reveals noteworthy patterns: Following bullish market conditions, both bitcoin and ether exhibited a lower MIPD, indicating reduced perceived credit risk. Conversely, following bearish market phases, the MIPD tended to escalate, signifying heightened apprehensions about potential defaults.
Exhibit 2: Mega-Cap Cryptocurrency MIPD
The MIPD metric is shaped by the interplay of historical price volatilities and prevailing market prices. In periods of low volatility, MIPD can remain relatively stable. Notably, bitcoin has consistently maintained a lower MIPD than ether, attributed to bitcoin's inherent lower volatility profile. While the FTX collapse impacted both cryptocurrencies, bitcoin’s MIPD did not rise as sharply as ether, highlighting investors' tendencies to seek refuge in more established and popular cryptocurrencies, or blue-chip assets, during times of market crisis.
MIPD of Exchange Platform Tokens
For cryptocurrencies, credit risk stems from trading platforms and exchanges that hold investor funds. If these intermediaries default or fail, users can lose their money. While cryptocurrencies themselves aren't credit-based instruments, the platforms and exchanges they rely on can generate credit risk.
Exchange platform tokens have a distinct role within their respective exchange systems. They offer benefits like lower fees, added privileges, and access to broader financial services and ecosystem engagement. Grasping the significance of these tokens is crucial when assessing credit risk.
Exhibit 3: Exchange Platform Token MIPD
Exhibit 3 explores the MIPD of four major cryptocurrency exchanges and their credit risk profiles.
Binance Coin (BNB): BNB is the cryptocurrency of Binance, the world's largest cryptocurrency exchange. BNB is used to pay for trading fees on the Binance platform and can be used in various applications within the Binance ecosystem. Notably, during events like the Luna-Terra and the FTX collapses in 2022, market confidence in Binance was evident, with a lower MIPD compared to other exchanges. However, Binance has faced increased market-implied credit risk in the first half of 2023 due to legal actions by regulators in the US and other jurisdictions.
Crypto.com Coin (CRO): CRO is the native cryptocurrency token of the Cronos Chain, developed by Crypto.com. CRO fuels various services within the Crypto.com ecosystem, including trading, staking, wallet consolidation, and Crypto.com Pay. The MIPD for CRO suggests that it has experienced higher credit risk compared to others, with its one-year MIPD rising above 70% during the FTX collapse in November 2022.
OKB (OKB): OKB is the cryptocurrency introduced by the OK Blockchain Foundation and OKX exchange. It is used for calculating and paying trading fees, participating in voting and governance processes, and receiving rewards for holding OKB. OKX focuses on a wide range of trading pairs and options trading. Interestingly, OKB has surpassed Binance to become one of the safest exchanges, with a one-year MIPD hovering at around 20% and reaching a peak of 40% in November 2022.
Huobi Token (HT): HT is the native cryptocurrency of Huobi Global, a centralized cryptocurrency exchange. HT is used primarily to alleviate transaction fees for trading activities on the exchange. It also grants users VIP-status plans, voting rights in exchange-related decisions, participation in seasonal buybacks, priority access to events, and the option to exchange for other cryptocurrencies. The MIPD for HT has seen an increase since January 2023, stabilizing in July 2023. Historically, it has carried a higher MIPD compared to Binance and OKX.
The MIPD of these platform tokens serves as a warning mechanism for default across all tradable assets. It also facilitates investors to gauge their credit risk portfolio across various exchanges. For instance, investors can reduce counterparty credit risk by rebalancing their assets on exchanges given the relative ranking of their MIPD. However, MIPD is not a substitute for exercising caution and conducting thorough due diligence before holding significant amounts on any exchange.
MIPD of Stablecoins
Stablecoins are digital currencies that are pegged to the value of another underlying asset, typically the US dollar, with the primary purpose of mitigating the inherent price fluctuations observed in traditional cryptocurrencies. Stablecoins serve a range of functions, including facilitating efficient trading in cryptocurrency markets, enabling decentralized applications, supporting borrowing and lending activities, facilitating payments and remittances, and serving as a reliable settlement layer.
Approximately 75% of recent cryptocurrency trading involves stablecoins, indicating their substantial role within the crypto ecosystem. A significant run on a major stablecoin could severely disrupt this ecosystem and represent the ultimate tail-event in cryptoland.
Let’s focus on fiat-collateralized stablecoins, which are issued by a centralized entity that is responsible for the creation and redemption of the stablecoin. Typically, these stablecoins are backed by fiat currency or debt instruments, ensuring their value stability.
Exhibit 4: Stablecoins MIPD
Unlike traditional banks, which are subject to strict regulations and government-backed insurance, stablecoin issuers can suffer from depegging due to regulator, credit, and market events. Therefore, the MIPD for fiat-backed stablecoins should be close to zero, but not zero (Exhibit 4). Keeping in mind that stablecoins are not risk-free by construct, Gemini Dollar (GUSD) presents the highest credit risk in the major asset-backed stablecoins peer group shown in Exhibit 4.
Quantifying Risk
In cryptoland, the convergence of credit risk and market dynamics creates an investment landscape distinct from traditional asset classes. As zombie coins disrupt conventional credit risk notions, understanding the correlation between credit and market risks becomes paramount for well-informed investment decisions.
Drawing from the rich heritage of financial mathematics, including Louis Bachelier's "Théorie de la spéculation" and other seminal works, measuring MIPD allows us to use historical volatility and market sentiment to quantify credit risk. The MIPD approach not only evaluates the possibility of a cryptocurrency's value plummeting to zero, but also offers a comparative ranking of credit risk, arming investors with powerful insights.
