Proof of Solvency: A New Risk Management Standard

Solvency for an exchange simply means having assets in excess of what is owed to customers. In accounting terms: solvency means assets are greater than liabilities. Every customer account balance is a liability to an exchange, because it must be repaid on demand. When exchange liabilities exceed its assets, you have a situation where accessing the crypto in your account could be jeopardized. Insolvent exchanges that undergo ‘bank runs’ go bust.

We’re seeing a lot of exchanges show their “proof of reserves” lately, which is nothing more than showing just one side of a balance sheet. Imagine I want to brag to you about my net worth: look at all the expensive cars, houses, and toys I have! Aren’t they neat, I’m very rich if you just look at these.

But wait, all of it was bought on debt. I have almost no equity in any of it. I don’t actually own them and you have no idea if my assets are sufficient to service the liabilities balance on the other side.

All you did by sharing your assets was misleadingly show me vanity metrics. The exchanges doing this are being intentionally deceptive with this practice; it provides a sense of confidence while saying nothing about the exchange’s solvency. It’s a marketing tactic, not a risk assessment. Solvency is what matters: and that is assets MINUS liabilities.

Insolvency isn’t always because the exchange was lending out assets it didn’t own (rehypothecation); sometimes it’s because margin liquidations didn’t happen effectively, which could leave some accounts with negative balances. Negative balances can only occur when a leveraged account has positions move against it before the risk engine can liquidate it.

A strong risk-management system protects against negative account balances. Two risk checks must be met when placing a trade: you must meet an initial margin requirement to establish a position, and then you must meet a maintenance margin requirement to maintain your positions. If your equity falls below the maintenance margin, your positions are liquidated to bring you into compliance. If this is executed correctly a negative balance should never happen.

This process isn’t uniform, some exchanges allow more leverage and lower margin requirements than others. Exchanges are incentivized from a short-term profit-maximizing standpoint to be liberal with leverage and lax risk controls to let you trade more. However, over the long run, this cavalier approach can lead to ruin. Black swans happen with surprising regularity, and exchanges that have poor risk controls get exposed when this happens. If there’s a 1% chance for a 100 different bad things to happen in a year, there’s a basically a 100% chance one bad thing will happen. You can’t model these fat tails, so you must create a risk system robust enough to handle these events.

We take risk-management very seriously. We offer up to 20x leverage on some tokens, so it’s not a luxury that we have strict controls to stay solvent, it’s a requirement. We intend to survive our favorite black swan (our favorite black swan is always the next one).

Most risk-management systems only do an account-level check before order placement; no consideration is given to the health of the exchange in this process. There isn’t any vetting of whether the exchange itself is still solvent from this new position on its books. When you have a large amount of accounts on your system with leverage and large PnLs, you must assure structural solvency is in place too if you intend to survive the swans.

RabbitX has a unique way of accomplishing this real time with each transaction; it’s something we refer to as Real-Time Proof of Solvency (RTPS). This is how it works.

Every time an order is submitted, the check is both bottom up (account level) and top down (exchange level).

We use a distinctly different and very high-performance database. When an order is submitted, the database is forked, the transaction is simulated on a virtual branch, and the sum of all trader’s equity (account balances including PnL) must be less than the sum of all the DEX’s onchain assets, always. We do a full risk check before and after every order placement, trade, funding, and withdrawal.

With our model, all risk checks are done atomically within the same transaction. It copies state in memory, runs everything in memory, and if the order is accepted it commits the state back in memory, all in a single transaction. This process allows us to offer high leverage with uncompromising safety. The internal consistency of the database eliminates a whole class of bugs that might plague other exchanges. We can process thousands of transactions per second while offering high leverage to traders because of the tech that underpins our risk management. Built different.

RabbitX has both a technological and cultural edge. Our ethos of stringent risk management and trader asset protection is our first priority. Literally. Our risk-management process corroborates it.

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Check out another one of our popular posts --> Rehypothecation: How Exchanges Play Roulette With Your Crypto

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