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CONTENTS
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CONTACTS
Tom Lombardi, Head of Product
Christine Cai, FRM, Director of Business
Christian Lantzsch, Director of Research
Sefton Kincaid, CFA, Managing Partner
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This document provides a detailed overview of Cicada’s Tokenized Risk Assessment (TRA) methodology for structured products, including, off-chain assets, crypto-native and hybrid structured products. This document should serve as a foundation for users of Cicada’s research to produce additional context on Cicada’s risk scoring methodology.
When rating tokenized yield-bearing products on blockchain-based platforms, Cicada analyzes the underlying Asset Quality, evaluating the underlying risk in reserve assets, liquidity, counterparties, leverage, portfolio diversification, and base currency instruments. We also analyze and benchmark the Transparency & Management via an analysis of reporting quality, consistency, and transparency. Next, we examine key External Risk Factors of custody and asset security, secondary trading, insurance/loss reserves, and user adoption. Lastly, we examine the issuer’s Operational Workflow to understand the chain of events to tokenize various financial assets.
All of Cicada’s risk ratings work employs judgement. Our Structured Product risk framework is designed to capture a multitude of asset, operational, and market risks. 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.
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.
The approach laid out in the following methodology applies to new structured product ratings as well as existing ratings we assess on an ongoing basis. 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.
The traditional structured products market in the US alone is a multi-hundred-billion dollar investment market, with figures varying based on different industry definitions and inclusions. ABS, MBS, and CMBS are the largest institutional-grade examples of structured products, but definitions of structured products goes beyond the large securitization markets to include custom strategies. Generally, the structured product category is expansive and includes yield enhancement products, principal protected products, participation products, and hybrid security products, to name a few. The global market for structured notes alone—not counting other types like CLOs or ABS—was estimated at over $3 trillion outstanding in recent years, with annual issuance hitting $1.5 trillion in 2021, according to S&P.
Structured products are tailored strategies to meet the specific needs of investors by combining various financial instruments to create a unique risk-return profiles. The primary purpose of structured products is to offer investors a customized investment solution that aligns with their specific goals, whether it's maximizing returns, managing risk, or accessing asset classes that might otherwise be out of reach. These products are essentially bundles of financial products, often including a fixed income component for capital stability and derivative components designed to enhance return profile, allowing investors to achieve outcomes that standard investments can't provide on their own.
As such, structured products allow investors to tailor their risk exposure and potential returns according to their investment objectives, which can be particularly appealing for retail investors who lack the expertise or resources to create such portfolios themselves. Given the large gap between crypto and traditional capital markets, structured products can provide unique access to markets or asset classes that are difficult to enter directly, offering a way to diversify portfolios and potentially increase risk-adjusted yields.
Counterbalancing their inherent benefits, structured products are often complex and difficult to understand, which can lead to misinterpretation of their true value and risks. Further, intricate structures and payoff mechanisms can obscure potential downsides. For example, most structured products in traditional securities markets add illiquidity risk due to many lacking a secondary market, making them challenging to sell them before maturity. This can result in unforseen returns or losses if an investor needs to exit early. Some crypto-backed structured products benefit from secondary liquidity, but not all.
Counterparty risk and the financial stability of the structured product issuer are also crucial. If the issuer defaults, investors could lose their principal, even if the product is marketed with guarantees and high yields. Conversely, a fully on-chain structured product governed by battle-tested smart contracts can reduce some or all of these risks. On-chain structured products can also help solve for increased transparency, a known problem with traditional structured products. These traditional financial market participants may lack complete information regarding fees, pricing, and underlying assets, making it difficult for investors to assess the true cost and overall risk. That being said, transparency is not solved by simply tokenizing an asset. A full legal workflow analysis is needed to analyze such risks.
In summary, structured products offer customized investment solutions with potential benefits like access to new markets, differentiated return profiles, and capital protection. However, they also introduce complex risks that investors must carefully understand and consider before investing.
The structured products TRA begins with a standardized risk framework (as depicted below in Figure 1) predicated on four core pillars of risk specific to structured products: Asset Quality, Transparency & Management, External Risk Factors, and Operational Workflow. We combine the assessment of these risks into a ratings output (Cicada’s “TRA Ratings”) that can be standardized across similar tokenized product offerings.
Figure1: Structured Product Tokenized Risk Assessment Taxonomy
We employ a proprietary scorecard framework to present the results of our bottom-up risk analysis, offering clients a concise snapshot into key strengths and/or vulnerabilities inherent to each assessment. Our methodology utilizes a 1-5 numerical rating scale that can be mapped to traditional probability of default-based risk ratings commonly used by rating agencies such as Moody’s and S&P. Ratings of 3 or less, those deemed to have significant risks of default, are not considered.
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 Credit, Stablecoin, and Structured Product risk frameworks. We expect these frameworks to reasonably map to long-term rates of expected losses witnessed in traditional assets over time.
For structured product issuers, underlying Asset Quality is the key ratings component within our methodology due to its direct impact on the stability and overall viability of the structure. In particular, a primary purpose of a structured product is to deliver a pre-defined return or a range of returns, with a fixed income component generally providing strong downside protection. As such, asset quality is paramount in achieving such downside protection. 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, though not always, more liquid, and the anticipated growth in the secondary liquidity of tail assets across blockchain capital markets could support asset quality improvement over time.
Next, an analysis of the counterparties that hold and transfer the assets along the tokenization value chain is assessed, with counterparties with public credit ratings scoring highest along with structures that minimize reliance on intermediaries by leveraging smart contracts that have demonstrated reliability through both volume and time-tested performance.
Figure 2: Asset Quality, Criteria & Weightings
High quality assets play a crucial role in risk mitigation. Among the associated asset quality risks certain structured product issuers take are credit risk, market risk, counterparty risk, structural 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.