It was probably hard to hedge financial risk to EA

By Stan van Wingerden @ 2023-01-19T10:41 (+63)

Summary

• Hedging essentially means reducing the risk of your assets. [Link]
• Deciding whether or not to hedge (future) cashflow requires making a risk-reward tradeoff. [Link]
• Both the risks and the rewards of your hedges are uncertain & hard to guess for a variety of reasons. [Link]
• I think it was probably hard / expensive to safeguard EA crypto funds against the big crypto downswing, but this depends on the circumstances (which I know little about). [Link]

Intro

The financial situation of EA has significantly worsened over the last few months. This is not only due to the FTX debacle, but also due to a broad downswing in cryptocurrency and tech stock prices. It’s worth investigating whether the financial risk of these events to EA organisations could have been mitigated somehow. This risk has many components, but the main financial risk issue to EA organisations I’m discussing here is the combination of multi-year $-denominated spending plans with future donations without fixed $ values.^[1] These cases show up all the time, be it from expected donations from companies or from broad financial exposure to different sectors, so one might wonder if EA organisations could have hedged some part of these future donations.^[2]

This post deals with what it means to reduce risk through hedging (crypto) exposure, why one would want to, and why doing so might be undesirable or difficult in practice. I’ve tried to keep it non-technical, as it is intended to help a discussion on whether or not EA charities should have hedged their crypto exposure.^[3] I think most of this might still apply to stocks, but I’m no expert in that so I’m not discussing that. Definitely do not take any of this as financial or legal advice.

What is hedging?

Hedging essentially means reducing the risk of your assets. This can be done in a variety of ways, the most common of which use derivatives to place a bet that pays off if the price of the underlying crypto token goes down. For example, if you have 1 Bitcoin worth ~17000$ today but possibly less in 2024, you can agree with someone you trust to sell this bitcoin to them in 2024 for 17000$. This agreement to sell in the future functions as a hedge against price decreases of bitcoin: even if bitcoin drops in value, you’d still get 17k in 2024. (On the flip side, if bitcoin were to increase in price you would miss out on that as well.) One way to think about a hedge is as an insurance policy against bad market situations.

You could also of course sell the bitcoin now in order to get rid of the risk in 2024. I’m going to ignore this possibility and focus instead on hedging future income, as I feel that those situations are most relevant to EA. In the above example, this would mean  the bitcoin donation is made in 2024, you don’t have access to it beforehand, but you want to get rid of the bitcoin price risk in the meantime.

A more uncertain but potentially more valuable hedge would use assets that are correlated with the amount you’re expected to be donated. If you both 1. expect to be donated large amounts of money by some company deeply involved in cryptocurrency and 2. expect the health of this company to be strongly related to the price of Bitcoin, then you can ‘hedge’ your expected future donations by taking on a bitcoin short. After all, if the company goes under, then you expect the price of bitcoin to drop, and therefore your hedge should pay off in that scenario, allowing you to still receive some money in the place of your missed donations. Compared to the above example of hedging a to-be-donated bitcoin, this example is not a strictly risk-lowering hedge, as your correlation assumptions can turn out to be wrong. Still, this kind of hedging can be a good idea, as it can in principle allow you to cover hard-to-cover risks. Because this type of hedging is more complicated and less applicable to charitable organisations, let’s put a pin in this and return to it at the end of this piece.

This is a secret sneak preview of the later sections, but hedges: 1. have inherent risk themselves 2. can be really costly and 3. aren‘t always possible. For example, it can be hard to hedge some rarely traded crypto token, or some token with little circulating supply, as it can be difficult to find someone who wants to take the other side of your hedge. 

Why hedge?

You’ll want to hedge if you want to reduce risks from your assets or your (future) income. For example, let’s say you run a charity with fixed $ liabilities for next year but only Bitcoin assets to pay for those $ liabilities. Let’s further say that you can only cover your liabilities if one Bitcoin is worth at least 15k$. In this case, you definitely want to hedge your bitcoin exposure, as there is a real risk of insolvency if bitcoin prices go down.

In this example, you’d probably still want to hedge even if there was no risk of insolvency, but this is not as clear. If all your liabilities are covered, it might make sense to not pay money for the hedge and instead just sell your bitcoin when you need it. You’re taking on risk, and that risk can make multi-year planning harder. But it would also cost some money to hedge, so the risk might be fine to take depending on the circumstances. 

In short, determining whether hedging is a good idea requires making a risk-reward tradeoff. If you can get screwed by a price change, you might want to pay up & hedge. If you do not mind the risk at all, you might not.

Why not hedge?

There are many different reasons why you might not hedge your exposure even if it’s a good idea to do so on the surface. Some of these reasons are good; I tried to make all of them understandable. 

You’re not sure how much you’ll be donated

It’s not immediately clear how to hedge expected future income. If your organisation has received between 10-20 Bitcoin yearly for the last 5 years, and you want to hedge next year’s donation, what should you do? If you’re hedging 15 BTC, you might have hedged too much if you’re only receiving 10 BTC, meaning you’re now net short bitcoin. Losing money on an inadvertent short position might not be an acceptable outcome for your organisation. Even fixed and legally binding donation commitments might not be lived up to (in the case of bankruptcy, for example), meaning you’re not just guaranteeing profits through hedging: you’re taking on a different kind of risk, ideally smaller but potentially more problematic.

There are potential solutions to this, but a. detailing those would be a technical diversion I don’t want to write, b. those solutions have their own issues anyway, and c. this gets real complicated, which is only made worse by the fact that

You don’t necessarily know how to hedge

Hedging expected exposure is not straightforward in practice, figuring out how to do it might cost a lot of your valuable time, and you might not even get it right. Furthermore, the maths can be a bit weird, and it can be hard to determine whether the coin you want to hedge even has derivatives in the first place. Do you want to hedge your token using other correlated tokens? Or using some broad index of similar tokens? Of course, you choose not to reinvent the wheel and pay a professional to think about these questions for you. This is probably a good idea, and I'll get to this option later, but it probably comes with a cost increase.

Your legal team could be against it

Even if you knew exactly how to hedge your financial position/future donation prudently, it might not be legal to do so. I know very little about the combination of derivatives & charity law, but I can imagine taking on a large derivatives position as a charity would make your legal counsel real nervous for a couple different reasons. Will the government see hedging your current assets as speculation? Are you allowed to speculate? Will they see it as speculation when you hedge 100% guaranteed future income? What if it’s only 50% guaranteed? Will you face audits if you ‘lose’ a lot of money on hedges? If you remember the bit about none of this being legal advice, you can probably tell I have no idea about the answers to these questions. Maybe the answers are easy, maybe they’re difficult, maybe it’s not the expertise of your legal counsel. But I can see potential legal issues raising the risks and the barrier of entry of hedging. 

Your accountant could be against it

If you’re hedging future income, you could run into liquidity issues. I can think of two ways this might happen:

1. Hedges cost money which you need to pay now, and if you're hedging yourself rather than using an intermediary you also need to post collateral. This collateral is not necessarily a cost, as you can get this money back (minus potential losses/profits from the short) once you’ve got rid of the hedge, but it is money that you can’t use for anything else. Ignoring collateral requirements, you still might not currently have the money to pay for the hedge, and even if you do, that money might be better spent elsewhere. 
2. In order to keep your perpetual/future hedge, you might need to quickly post more collateral in the future. If you’re shorting crypto you’ll lose money as the underlying crypto increases in value, and at some point your posted collateral might not be enough to cover these losses. In this case you’d need to deposit more collateral to keep the hedge. I can imagine this possibility being particularly concerning to an accountant, considering that the hedge is supposed to reduce risk, not cause acute liquidity problems. One could avoid this issue by fully backing the potential losses of your short position, but that would make point 1 worse.^[4]

Alternatively, you might hedge using options, but a glance at crypto options books shows that the cost of this would probably be about 10-20% of your total position per year.^[5] (This option is generally only really available for Bitcoin and Ethereum.)

Your counterparty / hedging venue can go bankrupt

Let’s say you’ve solved all of the above issues, and want to hedge your crypto exposure. What venue would you choose to do so? This is an important question, as crypto exchanges have collapsed in the past, and if the market crashes you expect both 1. your hedge to pay off and 2. the odds of your counterparty going bankrupt to increase. But 2. would mean your money from 1. is worthless, so this is worth thinking about.

Would you go for the biggest exchange in Canada? Or would you go for the biggest exchange globally? Or do you go for the exchange run by the guy who you’ve heard about, who is trying to be the respectable face of crypto? ..Or maybe their local independent & locally regulated entity?^[6]

Using an intermediary might offer a way out, but there you face a choice between a. using some trading firm, whose counterparty risk can again be hard to assess or b. dealing with a major bank (to whom the problem of hedging risks of non-public entities is well-known), but those only started being involved in bitcoin options very recently (March 2022).^[7] Regardless, I expect both of these possibilities to increase the cost of your hedge.

Your donor might not like it

Imagine a donor who makes regular payments to your charity in a token of a project that they’re deeply personally involved with. They might not like you hedging away the risk inherent in that donation arrangement. "It’s not your responsibility to hedge these risks”, they might say, "it's not your money, anyway." If they thought it’d be a good idea to sell some of the token they would’ve done it. Regardless of whether they’re right about those points, the hit to personal relations from hedging might make it not worth it. 

There’s an easier way out

I guess this is the common thread of all these points: it’s hard to quantify what the risks and rewards of hedging are. There are many choices to be made and tradeoffs to be considered, and it may be easier to just start planning with next year’s crypto money when it arrives. Another possibility is to steeply discount future crypto cashflow & make long term plans with the fraction you expect to receive. This could potentially be 80% of the gain with <10% of the hassle. It might turn out not to be -- but how could you have known that at the time?

Should EA charities have hedged?

I hope I made clear that there is a lot of uncertainty involved in making these decisions, and whether or not hedging is a good idea highly depends on the circumstances. 

My personal opinion is that even though the risk to many EA orgs was (partially) financial in nature, it is not very clear that hedging would have effectively covered that risk due to the reasons stated above. That said, if organisations planned next year’s expenses using the current $ value of some cryptocurrency token they held but did not sell, then there might have been room for improvement and covering the associated risk could have been a good idea.

To get more speculative, maybe the most useful thing that could have been done to cover financial risk is to hedge using correlated assets. A catastrophic collapse of FTX would move the bitcoin price down, so maybe shorting bitcoin would have been a good idea to safeguard some $ assets against the collapse of FTX. I’m not sure this is a good idea, and I don’t think this option was available to EA charities as all of the above issues with hedging apply even more so in this case. But given the stakes involved it could be useful to think about in what shape or form such financial risk management could have taken place,^[8] if at all possible.

Acknowledgements

Thanks to Alexander Gietelink Oldenziel, Lorenzo Buonanno and two anonymous reviewers for their comments.

1. ^{^}

   Rather, the donation amount you’ll receive next year is based on the unknown future price of some stock or cryptocurrency token.

2. ^{^}

   Note that most of this piece does not apply fully to the FTX situation, as the risk there has a substantial legal & reputational component as well. There’s a longer discussion to be had about how those different types of damage compare; this piece is not the place for that.

3. ^{^}

   For a great & more technical primer on risk, read this piece by Michael Dickens.

4. ^{^}

   There are other ways around this issue, but they would all cost money. 

5. ^{^}

   20% is the price at the time of writing of buying at-the-money puts for next year. One could hedge using out-of-the-money puts for cheaper, but this requires being specific about the size of the downswing you'd want to protect against. This could be worthwhile, though, as the price of the 10k puts is only about 3% of your assets, but might mean crypto prices decrease by 40% but your hedge paying out nothing. Using future information, realistically the cheapest price you could have paid for hedging against the FTX collapse using Bitcoin or Ethereum puts would be 10% of your assets yearly, as that's the price you'd pay for puts that would have been in-the-money following the ~30% downswing in prices of Ethereum and Bitcoin resulting from the FTX collapse. (These prices were very likely lower when bitcoin was less volatile, but I expect them to be in the same order of magnitude.)

6. ^{^}

   Not all of these are actually venues where you could've hedged. I give these examples to show the hard-to-guess risk involved in this choice.

7. ^{^}

   Dealing with a bank if possible would also help with some of the legal/accounting issues described in this document, but I have no idea about the size of the cost increase of this option. Knowing very little about how banks approach these kinds of deals, I think there's probably a cutoff for what hedge size banks start getting interested. A blind guess would be this cutoff is at least >1 million $.

8. ^{^}

   Apart from the main option of dealing with a major bank, one radical & unrealistic idea would be to start a hedge fund that a. Determines what unwanted exposure EA organisations have (for example, to tech stocks and cryptocurrency) and then b. shorts those directly if possible, and shorts correlated assets if not. This might not be cost-effective, as this would normally be a loss-making exercise and I expect capital requirements for effective hedges to be pretty steep. And again, even if this would perfectly have covered EA’s financial risk, it would not have solved any of the legal and reputational issues of the FTX collapse.