Singapore-based cryptocurrency venture capital firm Three Arrows Capital (3AC) failed to meet its financial obligations on June 15, causing major losses for centralized lending and staking providers such as Celsius and Babel Finance.

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On June 22, Voyager Digital, a New York-based digital asset lending and yield company listed on the Toronto Stock Exchange, saw its shares drop nearly 60% after disclosure $655 million investment in Three Arrows Capital.

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Voyager offers cryptocurrency trading and staking, and had about $5.8 billion of assets on its platform in March. bloomberg. The Voyager website mentions that the firm offers a Mastercard debit card with cashback and allegedly pays out up to 12% annual rewards for block-free cryptocurrency deposits.

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Most recently, on June 23, Voyager Digital lowered its daily withdrawal limit to $10,000. Reuters.

Contagion risk extends to derivatives

It remains unknown how Voyager took on such a large liability to one counterparty, but the firm is poised to sue to recover its funds from 3AC. To remain solvent, Voyager borrowed 15,000 bitcoins (BTC) from Alameda Research, a cryptocurrency trading firm led by Sam Bankman-Freed.

Voyager also received a $200 million cash loan and another $350 million USDC (USDC) revolving coin loan to secure customer repayment requests. Compass Point Research & Trading LLC analysts noted that the event “raises survivability questions” for Voyager, so crypto investors are wondering if other market participants might face a similar outcome.

While it is impossible to know how centralized crypto lending and income firms operate, it is important to understand that a single counterparty to a derivatives contract cannot pose a risk of contagion.

A crypto derivatives exchange may be insolvent and users will only notice this when they try to withdraw funds. This risk is not unique to the cryptocurrency markets, but exponentially increases due to lack of regulation and weak reporting practices.

How do cryptocurrency futures contracts work?

The typical futures contract offered by the Chicago Mercantile Exchange (CME) and most cryptocurrency derivatives exchanges, including FTX, OKX, and Deribit, allows a trader to leverage their position by posting margin. This means trading a larger position than the initial deposit, but there is a catch.

Instead of trading Bitcoin or Ether (ETH), these exchanges offer derivative contracts that tend to track the price of the underlying asset, but they are far from being the same asset. So, for example, it is not possible to withdraw your futures contracts, let alone transfer them between different exchanges.

Moreover, there is a risk that this derivatives contract will break away from the actual price of the cryptocurrency on regular spot exchanges such as Coinbase, Bitstamp or Kraken. In short, derivatives are a financial bet between two entities, so if the buyer doesn’t have enough margin (deposits) to cover it, the seller won’t take the profit home.

How do exchanges deal with derivatives risk?

An exchange can deal with the risk of insufficient margin in two ways. “Refund” means taking profits from the winning party to cover losses. This was the standard until BitMEX introduced an insurance fund that gets rid of every forced liquidation to deal with such unexpected events.

However, it should be noted that the exchange acts as an intermediary, because for each transaction in the futures market, a buyer and seller of the same size and price are needed. Whether it is a monthly contract or a perpetual futures contract (reverse swap), both the buyer and seller must post margin.

Crypto investors are now wondering if a crypto exchange could become insolvent, and the answer is yes.

If an exchange does not properly handle forced liquidation, every trader and business involved can be affected. A similar risk exists for spot exchanges when the actual number of cryptocurrencies in their wallets is less than the number of coins reported to their customers.

Cryptooshala is not aware of anything out of the ordinary regarding Deribit’s liquidity or solvency. Deribit, along with other crypto derivatives exchanges, is a centralized organization. Thus, the information available to the general public is far from ideal.

History shows that the centralized crypto industry lacks reporting and auditing practices. This practice is potentially harmful to every person and business involved, but as far as futures contracts are concerned, the risk of infection is limited to the participants’ exposure to each derivatives exchange.

The views and opinions expressed here are solely those of author and do not necessarily represent the views of Cryptooshala. Every investment and trading move involves risk. You should do your own research when making a decision.