Tokenized Risk Assessment:

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Contacts:

Tom Lombardi, Head of Product

[email protected]

Christine Cai, FRM, Director of Business

[email protected]

Christian Lantzsch, Director of Research

[email protected]

Sefton Kincaid, CFA, Managing Partner

[email protected]

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Purpose

This document provides a detailed overview of Cicada’s Tokenized Risk Assessment (TRA) methodology for stablecoins, including, fiat backed, crypto backed and algorithmically based stablecoins. This document should serve as a foundation for users of Cicada’s research to glean additional context on Cicada’s risk scoring methodology.

When rating tokenized yield bearing products on blockchain-based platforms, Cicada analyzes the underlying Asset Quality, observing the reserve assets, liquidity, counterparties, leverage and base currency instruments, collateral, and historical performance data. We also examine issuer and Operational Workflow to understand the chain of events to tokenize various financial assets. Next, we analyze Management’s capital and legal structures, transaction documents, and legal opinions to assess the effectiveness of structural enhancements that may support higher or lower ratings in the event of heightened structural dependencies. Lastly, we examine key External Factors of regulation and network adoption and diversification.

All of Cicada’s risk ratings work employs judgement. Our stablecoin risk framework is designed to capture a multitude of asset, operational, counterparty, and market risks into account. While our methodologies are rigorously tested, the unique nature of tokenized asset structuring, supporting collateral, and varying legal systems introduces idiosyncratic risks. In our judgment, these factors may reduce the effectiveness of certain risk mitigations, and we account for this in our ratings process to ensure a more accurate reflection of the risks involved. Consequently, there may be times when certain components are de-emphasized or deemed irrelevant. We invite those with further questions related to our ratings to reach out to members of the Cicada team.

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Overview

Application

The approach laid out in the following methodology applies to new stablecoin ratings as well as existing ratings we assess on an ongoing basis for our partners. New ratings involve an assessment of both historical performance and forward-looking risk factors while existing ratings are periodically updated based on underlying business, legal, market, or regulatory trends.

This methodology does not include an exhaustive description of all risk factors that our analysts may consider but standardizes the input of key information into a benchmarking process whereby users of our research will have a better understanding of the relative risks across various tokenized product offerings.

Tokenized Risk Assessment (“TRA”) Taxonomy

The stablecoin TRA begins with a standardized risk framework (as depicted below in Figure 1) predicated on four core pillars of risk specific to stablecoins: Asset Quality, Operational Workflow, External Risk Factors, and Management Policy. We combine the assessment of these risks into a generic ratings output (Cicada’s “TRA Ratings”) that can be standardized across various tokenized product offerings.

Figure1: Stablecoin Tokenized Risk Assessment Taxonomy

We employ a scorecard system to depict our assessment of bottom-up risk analysis to allow clients of our research a snapshot into key strengths and/or weaknesses. Our methodology utilizes a 1-5 numerical rating scale, with investible ratings falling between 3.0 to 5.0, which can be mapped to traditional probability of default-based risk ratings.

We have witnessed investment analysis and compliance as the most pressing needs for our ratings work, but ratings are designed to be utilized by various user types across any organization integrating digital assets.

Information richness is paramount in any risk assessment and our guiding principle in providing a rating. As such, we focus on downside protection (also known as Expected Loss) analysis across our Stablecoin and Credit frameworks that we expect to reasonably map to long-term rates of expected losses witnessed in traditional assets.

Stablecoin TRA Methodology

Asset Quality

For stablecoin issuers, underlying Asset Quality is the most important pillar in our Methodology due to its direct impact on the stability and overall viability of the stablecoin. In particular, a primary purpose of a stablecoin is to maintain its peg, typically the US dollar. High-quality assets are paramount in achieving a peg, with quality defined from multiple lens. Value preservation is not just a long-term balance sheet analysis, but also a short-term market-based liquidity analysis. High-quality assets are typically, but not always, more liquid, allowing for easier redemptions and maintaining a peg during market stress. Reserve assets must also have strong fundamentals and reduce base currency mismatches at a minimum or have some means to offset these mismatches via overcollateralization. Finally, an analysis of the counterparties that hold and transfer the assets along the tokenization value chain.

Figure 2: Asset Quality Criteria & Weightings

High quality assets play a crucial role in risk mitigation. Among the associated asset quality risks certain stablecoin issues take are credit risk, market risk, counterparty risk, interest rate risk, smart contract risk, and currency risk. The acceptance or explicit reduction of these risks, programmatically or via off-chain legal documentation, Terms and Conditions, or Management Agreements are a key part of our analysis incorporated in Asset Quality but also magnified in our review of Operational Workflow and Management Policies.

We analyze the Asset Quality component holistically, meaning the criteria of Asset Quality are interrelated. An example would be a 100% US Treasury Bill-backed stablecoin vs. a 100% Crypto-backed overcollateralized stablecoin. The degree of collateralization, Quality, and Liquidity are reasonably interdependent factors affecting the asset base supporting instant redeemability of a stablecoin, maintenance of a peg, and ensure long-term viability.

Operational Workflow

Issuers of stablecoins should specialize in risk transformation by taking either on- or off-chain assets, and responsibly wrapping into a tokenized package that removes barriers and increases utility. A well-designed operating workflow is essential for managing liquidity and handling redemptions to maintain a peg.

Figure 3: Operational Workflow, Criteria & Weightings

Tokenholder Rights are paramount to ensuring legal or algorithmic recourse mechanisms are in place, preserving a peg, and consequently adding user value. We incorporate an analysis of minority tokenholder’s rights to assets under the legal framework or smart contract governing the stablecoin. Next, we map each stage of the stablecoin workflow from purchaser of the tokenized dollars to seller of the underlying treasuries, as an example. A fundamental understanding of the workflow is paramount to understanding legal frameworks and tokenholders rights in the event of conflict or a depegging event.

An analysis of the redemption mechanics is vital to bring in outside parties (payment providers, market makers, etc.) and build an economic network. The proper economic incentives bolsters a stablecoin’s ability to maintain a peg over the near term but also build a flywheel effect of profit-motivated participation longer term. We analyze this with particular emphasis on institutional relationships and the facilitation of efficient arbitrage mechanisms to maintain a peg.

A stablecoin is only viable if its unit economics—the financial benefits to the parties involved—can stand up over time. Currently, most successful fiat stablecoins take 100% of the net interest margin of the asset base. But with the launch of competing yield-bearing stablecoins and algorithmic stablecoins, relative unit economics are increasingly important from a user adoption perspective and to analyze relative to the longer-term incentives and stability of ecosystem participants.

Management Policies

Stablecoins have various degrees of centralization risk so the quality of the underlying management matters in the context of operational dependencies investors may have on the stablecoin Issuer. Fortunately with blockchains, a degree of trust can be inherited through on-chain proof of reserves, but most stablecoins ultimately inherit trust from legacy legal systems and, as a consequence, a benchmarking of Management Policies remain important.

Figure 4: Management Policies, Criteria & Weightings

The criteria underlying Management Policies is largely focused on asset verification and transparency as the bedrock of trust. In the ethos of blockchain, “trust but verify.” We benchmark Management’s policies related to transparency by the degree to which tokenholders can directly (on-chain) or indirectly (reputable auditor) verify the reserve assets supporting the stablecoin. This includes judgement with respect to the scope, quality, and consistency of reporting. Management reputation, even in a “decentralized” stablecoin setting, goes into our analysis.