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7 Unique Challenges in Cryptocurrency Risk Management

The increased institutional interest in investing in cryptocurrencies raises complex risk management considerations that are unique to this rapidly-emerging alternative asset class. Crypto risk managers must hurdle a variety of obstacles, ranging from insufficient data to inadequate regulation to liquidity, modeling, valuation and clearing and settlement complexities.

Friday, March 19, 2021

By Peter Went


Cryptocurrencies have long been heralded as the future of finance, but it wasn't until 2020 that traditionally conservative and risk-averse institutions became proactive investors in this complicated alternative asset class.

Over the past year, the two most well-known cryptocurrencies - Bitcoin (BTC) and Ethereum (ETH) - have drawn a lot of interest and experienced significant price volatility. But rapid growth in the diversity of digital currencies means that risk management is certainly not just about the "big boys." In 2018, there were around 1,500 cryptocurrencies, while today there are more than 4,500.

When risk managers consider the question on how to optimally manage cryptocurrency risks, they often draw on similarities between financial instruments and cryptocurrencies. However, there are at least seven challenges distinctive to cryptocurrencies of which risk managers must be aware.

1. Diversity

The first challenge risk managers need to address is that cryptocurrencies are qualitatively diverse and not interchangeable. The bewildering array of cryptocurrencies differ across multiple dimensions, particularly with respect to security, programmability and governance characteristics.

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Peter Went

Put simply, there is no "cheapest-to-deliver" cryptocurrency. So, when measuring, managing and monitoring risks, one must consider the various differences in features across cryptocurrencies.

The original cryptocurrency, BTC, is a relatively simple construct. It's designed to send, receive and store value in a virtual and cryptographic format - with functions replicating that of money and gold.

The second most widely-traded cryptocurrency, ETH, extends the core functionality of BTC by adding on more complex, self-executing "smart contract" capabilities that can be used to digitally replicate complex financial instruments, transactions and performance contracts. ETH, moreover, has even been used to create exchanges.

Adding to the complexity are cryptocurrencies like stablecoins, whose value is tied to fiat currency (such as USD). These digital assets provide a fixed exchange in value by essentially exchanging national currencies into non-stable cryptocurrencies.

The landscape is further complicated by the specifics associated with the issuance and governance of cryptocurrencies. For example, transaction tracking and validation responsibilities are divided between cryptocurrency issuers and users.

2. Valuation difficulties

To manage the risk of any financial instrument, one of the first steps is to quantify and determine its exposure using customary market-wide methodologies. But cryptocurrencies are different: there is no consensus valuation approach, there are no commonly accepted metrics, and reported pricing information may differ substantively across venues.

To determine a reasonable value for a cryptocurrency, risk managers need to appreciate the widespread use of complex and occasionally inconsistent valuation approaches.

Some analysts tackle the valuation challenge from a functional perspective by treating cryptocurrencies as currency in circulation - or fiat money such as USD or EUR. But this approach builds on a distorted assumption that suitably glosses over fundamental legal differences between cryptocurrencies and traditional financial instruments. Specifically, cryptocurrencies are not legal tender, do not benefit from legal safeguards or implicit or explicit government backing, and cannot be legitimately used to settle transactions with finality.

The most popular technique to value cryptocurrencies is to estimate the addressable market - or the current market capitalization - for each cryptocurrency. However, this approach does not capture the actual and potential value cryptocurrencies can create from the way they are being used.

Consequently, some analysts take the process a step further by valuing cryptocurrencies from a network perspective: appraising the number of possible users and forecasting series of probable scenarios for usage based on programmability structure or governance features. Since this valuation approach is both model and assumption driven, it may not stand up to high levels of scrutiny - but does offer an additional level of understanding of the potential exposure and risk levels of cryptocurrencies.

Other analysts (particularly on the institutional side) value these digital assets by the cost of electricity consumption needed to create, store and verify each different cryptocurrency. While these valuation outcomes introduce some comparable standardization, and consider underlying and defining features of the individual cryptocurrencies, they can be skewed by widely-differing electricity costs across major mining centers.

3. Regulatory and legal dilemmas

Unlike financial instruments, cryptocurrencies are not regulated products and do not benefit from the standard legal protection afforded traded financial instruments. This leads to convoluted legal risks and inserts uncertainty, which can meaningfully influence both investability and risk management for these digital assets.

There is still no international consensus on how to best regulate cryptocurrencies, particularly with respect to policing product development and trading. Government stances have been inconsistent and, sometimes, downright erratic. Some countries have banned creating, selling, owning and trading in certain cryptocurrencies, but concurrently allow and incentivize the proliferation of others.

Other countries are developing forward-looking and wide-raging regulatory standards for issuance, trading, reporting and transparency. Since these standards typically apply only within one jurisdiction, governments are inadvertently creating islands with some rudimentary legal protection in an ocean of unregulated cryptocurrencies.

For many, this basic legal protection is an opportunity to test the potential of cryptocurrencies; for others, the lack of uniform regulation perpetuates the legal, compliance and regulatory challenges standing in the way of the evolution of these assets.

Risk managers need to be aware that transacting in different cryptocurrency markets can carry an array of unusually complex legal and compliance hazards.

4. Data and modeling obstacles

Risk managers who need to model future cryptocurrency exposures and risks may not have the necessary data. Indeed, inadequate transaction data limits one's ability to model the factors that drive cryptocurrency risk and returns, and to compute fundamental measurement metrics - like stress testing, VaR and ES.

Cryptocurrencies are highly volatile and are available to trade 24/7 all across the globe. The detailed but narrow data set of actual transaction prices that cryptocurrency markets provide seems inadequate for modeling purposes. In fact, since we are far from a consensus on price, return or an equilibrium-generation function for cryptocurrencies, modeling and forecasting these digital assets is akin to a guessing game.

That is why many risk managers turn to statistical tools (like spectral decomposition) to model their cryptocurrency exposures and to identify factors that can be fed into pricing, risk and trading models. However, these modeled prices are not real prices, and their usefulness - particularly for stress testing purposes - is debatable.

5. Illiquidity and trading costs

The cryptocurrency market is generally less liquid and more expensive than traditional markets. The supply of many cryptocurrencies is controlled, with new units released according to a pre-set timetable, and it should thus come as no surprise that the high volatility of cryptocurrency prices is liquidity driven.

It's likely that cryptocurrency markets will continue to struggle with limited liquidity and high volatility, making effective price discovery an ongoing challenge. Gapping, moreover, continues to be a problem in these markets, constraining the ability of investors to exit from their cryptocurrency positions. Complicating matters further, there is also mounting evidence that certain exchanges routinely manipulate prices, trade against customers and front-run large trades.

Part of the issue is that there is also no uniformity on the treatment of cryptocurrency trading. Some exchanges incorporate the inherent features of cryptocurrencies, while others offer bilateral trading, with some replicating the core features of electronic trading platforms. It's therefore critical for risk managers to understand the mechanics of specific trading venues.

6. Custody, clearing and settlement problems

Besides further regulatory clarity, institutional interest in cryptocurrencies depends on continued developments in providing prime brokerage and institutional-grade custody solutions. Today, specialized financial institutions and fintechs offer highly-bespoke solutions that range from simple digital wallets to a complex array of functionalities intended to satisfy institutional investors.

Institutional custodial solutions for cryptocurrencies are both legally and technologically complicated. Part of the complexity is driven by the public- and private-key encryption that systems use to track and verify transactions cryptographically.

Since they are easily and publicly accessible, these cryptographic keys need to be safeguarded. Custodial solutions therefore must include multilayered security features that appropriately manage and control how custodial systems can access, use and verify these keys.

When these security measures are inadequate, disastrous results can ensue. Indeed, several cybertheft episodes - such as the demise of Mt. Gox - were caused by poorly-designed security features that allowed easy access to protected cryptographic keys.

The situation is made more complicated by the fact that there is no collective standard for clearing and settlement of cryptocurrency transactions, exposing traders to substantive counterparty credit risks. Cryptocurrency payments settle as soon as the system authenticates the transaction. (Authentication can be immediate or with some limited delay.) However, the final settlement for trading in cryptocurrency depends on the features of the cryptocurrency, the exchange where the transaction takes place and the specifics of the custodial solutions.

Moreover, since cryptocurrencies are not considered legal tender and cannot be legally used to settle a trade involving cryptocurrencies, these digital assets have to be exchanged for legal tender for settlement purposes.

The actual cost of exchanging cryptocurrencies for fiat money can materially impact how exposures should be valued and managed, as well as what additional risks need to be factored in when quantifying cryptocurrency exposures. Here's a simple example: a transaction exchanging BTC with ETH has to be settled in USD, requiring the exchange of BTC to USD and then USD to ETH; each leg of such a transaction carries a cost.

How the precise mechanics play out, and what the actual risks may be, depends on the unique relationship between the different players. The asynchronous nature of settling cryptocurrency trades is a substantive problem, particularly since the mechanics and logistics differ widely across exchanges - and even between users of the same digital wallets and custodial solutions. This further complicates the estimation of the underlying risk exposures and heightens the severity of counterparty credit risks.

Corruption is a final consideration in this "challenge category." Cryptocurrencies have been at the center of several money-laundering schemes, partly because of fraudulent custodial solutions and partly because flawed design features in the custodial standards have been exploited. These types of criminal activities require constant vigilance.

7. Cryptocurrency derivatives are very risky

Cryptocurrency futures trading continues to gain traction among investors and traders. However, unlike derivatives on financial instruments or commodities, these cryptocurrency derivatives are generally used to increase exposure, rather than to reduce risks.

By design, cryptocurrency derivatives available to trade are often exchange-the-difference contracts - also known as a contracts-for-differences. CFDs are contracts between investors and brokers that are cash-settled, based on the value of the underlying (e.g, cryptocurrency) asset; investors typically use CFDs to make price bets about whether the price of the underlying asset or security will rise or fall.

Interestingly, both the Commodity Futures Trading Commission (CFTC) and the Securities and Exchange Commission (SEC) prohibit U.S. residents from opening CFD accounts on domestic or foreign platforms. Generally speaking, though, dodgy market participants take advantage of the low awareness of the differences between various types of crypto derivatives - and may even promote fraudulent instruments and investments.

In short, risk managers must manage these hazards without the benefits of traditional derivatives trading.

Parting Thoughts

As an asset class, cryptocurrencies have slowly emerged over the past decade, and are now increasingly attracting institutional investors. The rise in demand requires a more professional assessment of the underlying sources of risks and opportunities. The calls for better risk management are part of the maturation of the market, which should ultimately include, for example, replacing self-regulation and automated governance with effective supervisory and regulatory structures.

Whether cryptocurrencies will replace fiat money to some limited extent or not remains to be seen. But one truth is clear: the road toward a digital currency requires a clear, comprehensive and global set of standards.

Risk managers need to be aware of risks that are unique to this emerging asset class.

Peter Went (PhD, CFA) lectures at Columbia University on disruptive technologies, such as artificial intelligence and machine learning and their impact on financial services and financial risk management.


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