The Great “Crypto-Swap”: Flywire (FLWY)

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A new generation of blockchain-based financial products BRINGS traditional risk management to crypto

Cryptocurrencies are coming to a bank account near you. Over the past year, a growing group of tech startups are offering traditional products, like bank accounts, payments and loans, that are based on the tools and technologies of cutting edge cryptocurrencies. Take the Boston-based payments processor Flywire (FLYW). This $4.5 billion enterprise provides traditional and emerging payment products to specific markets like education, healthcare and travel.

Decentralized smart contract platform Ethereum now hosts roughly 1.3 million financial transactions per day. A decentralized lending application called Maker claims something close to $7 billion in assets. Asset trading platform Sushiswap boasts about $4 billion in total liquidity.  

Institutional investors are finding such crypto-backed financial products attractive. Fidelity Digital Assets, The Fairfax County Pension Fund, and Franklin Templeton all announced significant crypto-services investments in the past quarter. 

But one factor has slowed the deployment of emerging crypto-financial products: Risk. Cryptocurrency exchange Gemini may offer a “savings account” that yields up above 7%. But what’s the actual risk those funds face? 

Nobody could say for sure. Until now. 

Researchers – and that very much includes us – are finding that as exotic crypto-backed financial products become more mainstream, the traditional financial research that has defined such mainstream financial products is surprisingly insightful when managing the risk of crypto tools. 

The Federal Deposit Insurance Corporation (FDIC) and The Federal Reserve both publish excellent bank failure and historic accounts of financial panics. Bank collapses from the American Civil War eerily mimic similar collapses in cryptocurrencies today. 

The psychology and causes of such historical financial panics have been deeply studied by economists. Of hundreds of research papers on historical financial collapses that we are exploring using intelligent machines, two basic themes emerge that drive instability in emerging financial institutions: Financial panics are either “random manifestations of mob psychology or mass hysteria, rooted in the individual and collective psyches,” as Gary Gorton, professor at the Yale School of Management, wrote back 1988. 

Or financial collapses are driven by outside events that alter the “perception of risk.” 

Gorton says that five major historic panics were directly related to the convertibility of deposits into cash. Six were based on the issuance of uncertain financial certificates. The rest were based on bad earnings reports, negative government forecasts, and odd-sounding factors like sunspots.  

“Anything that causes depositors to anticipate a run will lead to a run,” wrote Gorton. 

Bank failures over the past century offer powerful insights to today’s crypto investors.

Such historic risk narratives should sound all-too familiar to today’s crypto currency investors. “Throughout much of its history, the current value of Bitcoin has been driven primarily by speculative interest,” wrote John P. Kellher, cryptocurrency architect for LevelK, a distributed computing firm based in Boston.

The Crypto Credit Risk Score 

The analysis of the history of financial risk brings powerful tools to modern crypto investing. Simple estimates like Expected Loss (EL) can anticipate potential risks. More complex, Economic Capital (EC), analysis can explore the range of potential future losses. Deeper scholarly analysis can also yield results: Robert Merton’s early near-binary credit models yield insights. More sophisticated work by Black & Cox (1976), Leland (1994), and Anderson & Sundaresan (1996), can bring all sorts of extra factors, like stochastic volatility, into the crypto-research tool kit. 

Simple scores can quantify the challenges companies face in swings in mob perceptions of value. They can anticipate feeble earnings reports, unfavorable government regulations and other external challenges. Managing the exposure of glitzy emerging cryptocurrencies becomes much simpler. 

Trendy currencies, like BakeryToken (BAKE), are clearly far too exposed to changes in mob psychology. After all, a currency named after the company scrip used by Canadian bakeries to pay employees in the early 1900’s hardly engenders investor confidence. The crypto extensions of start-ups, like Rari Governance Token (RCT) or Telos (TLOS), do not have the means to survive lean earnings or changes in regulations. 

Credit uncertainty has been part of Coinbase’s uncertain reaction by investors.

Surprisingly, historically-based risk metrics also reveal significant weakness in the largest and best-capitalized crypto companies. Payments giant Coinbase (COIN) becomes a far more dubious investment, when examined for the simple probability of default over the next 12 months. 

Even though this Delaware-based enterprise, with no headquarters, is the largest crypto-currency exchange by volume, it carries a surprising amount of crypto assets on its balance sheet. So-called “crypto assets held” jumped from $33.9 million in 2019, to $316.5 million in 2020. And potential competition from truly ginormous payment processors, like Visa or MasterCard, further erode credit viability. 

Equity investors sense the weakness in Coinbase. After its stock began trading earlier this year, company equity has dropped in value by roughly 30%. Our back-of-the-envelope risk tools indicate that deep profits should be capturable using a simple credit default swap. 

Coinbase, as the stock, still feels overpriced at around $230 per share. 

Sorta Liking Crypto

Newly relevant financial history is also teaching investors that risk is better managed in the crypto economy by smaller, more targeted operations. Back to Flywire (FLYW). Like most tech start-ups, it loses plenty of money: $15.8 million in operating income was lost last quarter on about $131 million in sales. 

But in terms of quantifiable risk, Flywire faces far less exposure than other cryptocurrency firms. The company’s tight focus on known markets limits its exposure to bad news. And its lack of crypto holdings reduces the emotional rollercoaster that history shows bedevils emerging financial services. 

Flywire merges as a low-risk, long-term point of entry into the crypto economy. If history is any indication, an operation like Flywire will have time on its side.