The Singapore-based crypto venture firm Three Arrows Capital (3AC) failed to meet its financial obligations on June 15 and this caused severe impairments among centralized lending providers like Babel Finance and staking providers like Celsius.

On June 22, Voyager Digital, a New York-based digital assets lending and yield company listed on the Toronto Stock exchange, saw its shares drop nearly 60% after revealing a $655 million exposure to Three Arrows Capital.

Voyager offers crypto trading and staking and had about $5.8 billion of assets on its platform in March, according to Bloomberg. Voyager’s website mentions that the firm offers a Mastercard debit card with cashback and allegedly pays up to 12% annualized rewards on crypto deposits with no lockups.

More recently, on June 23, Voyager Digital lowered its daily withdrawal limit to $10,000, as reported by Reuters.

The contagion risk spread to derivatives contracts

It remains unknown how Voyager shouldered so much liability to a single counterparty, but the firm is willing to pursue legal action to recover its funds from 3AC. To remain solvent, Voyager borrowed 15,000 Bitcoin (BTC) from Alameda Research, the crypto trading firm spearheaded by Sam Bankman-Fried.

Voyager has also secured a $200 million cash loan and another 350 million USDC Coin (USDC) revolver credit to safeguard customer redemption requests. Compass Point Research & Trading LLC analysts noted that the event “raises survivability questions” for Voyager, hence, crypto investors question whether further market participants could face a similar outcome.

– Unsecured derivatives and options trading on Deribit
– $650 million of unsecured debt with Voyager
– Offering protocols/portfolio companies 8-10% APY on their cash balances

What else?

— Dylan LeClair (@DylanLeClair_) June 22, 2022

Even though there is no way to know how centralized crypto lending and yield firms operate, it is important to understand that a single derivatives contract counterparty cannot create contagion risk.

A crypto derivatives exchange could be insolvent, and users would only notice it when trying to withdraw. That risk is not exclusive to cryptocurrency markets, but is exponentially increased by the lack of regulation and weak reporting practices.

How do crypto futures contracts work?

The typical futures contract offered by the Chicago Mercantile Exchange (CME) and most crypto derivatives exchanges, including FTX, OKX and Deribit, allow a trader to leverage its position by depositing margin. This means trading a larger position versus the original deposit, but there’s a catch.

Instead of trading Bitcoin or Ether (ETH), these exchanges offer derivatives contracts, which tend to track the underlying asset price but are far from being the same asset. So, for instance, there is no way to withdraw your futures contracts, let alone transfer those between different exchanges.

Moreover, there’s a risk of this derivatives contract depegging from the actual cryptocurrency price at regular spot exchanges like Coinbase, Bitstamp or Kraken. In short, derivatives are a financial bet between two entities, so if a buyer lacks margin (deposits) to cover it, the seller will not take the profits home.

How do exchanges handle derivatives risk?

There are two ways an exchange can handle the risk of insufficient margin. A “clawback” means taking the profits away from the winning side to cover the losses. That was the standard until BitMEX introduced the insurance fund, which chips away from every forced liquidation to handle those unexpected events.

However, one must note that the exchange acts as an intermediary because every futures market trade needs a buyer and seller of the same size and price. Regardless of being a monthly contract, or a perpetual future (inverse swap), both buyer and seller are required to deposit a margin.

Crypto investors are now asking themselves whether or not a crypto exchange could become insolvent, and the answer is yes.

If an exchange incorrectly handles the forced liquidations, it might impact every trader and business involved. A similar risk exists for spot exchanges when the actual cryptocurrencies in their wallets are shorter than the number of coins reported to their clients.

Valideapp has no knowledge of anything abnormal regarding Deribit’s liquidity or solvency. Deribit, along with other crypto derivatives exchanges, is a centralized entity. Thus, the information available to the general public is less than ideal.

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

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