Six Risk Management Methods to Reduce the Inherent Risk of Cryptocurrency

My previous article, “What Are the Inherent Risks Associated with Cryptocurrency?”, examined such  risks from both a currency and a business perspective.

This article looks at risk management methods in which the high inherent risks of cryptocurrency can be reduced, instilling more confidence and trust in transactions. The methods are wide ranging and, if applied in total, could confirm the acceptance and permeance of cryptocurrency, a currency for the 21st century.

Regulatory Approval

The most material reduction of inherent risk associated with cryptocurrency could be achieved by regulatory measures, which seems very ironic since cryptocurrency is a decentralized currency with no regulatory governance or framework. Some regulatory approval, if achieved, could improve and imply both acceptance and credibility in the eyes of the cryptocurrency community. The best location to start would be the home of the world’s most popular the reserve currency, the U.S. dollar. However, not all U.S. regulators are created equal. For cryptocurrency to gain traction in the United States, it must navigate diverse and differing regulatory frameworks including:

  • Financial crimes-related regulations like the Bank Secrecy Act (BSA), USA PATRIOT Act, and the Office of Foreign Assets Control (OFAC).
  • State banking departments.
  • The SEC.
  • The Commodity Futures Trading Commission (CFTC).
  • The Internal Revenue Service (IRS) and FBAR and FACTA reporting requirements.

The best outcome would be regulatory confirmation from all the above. But given the vested interests of each of these regulatory bodies, a seal of approval from at least two of these organizations should be sufficient in adding credibility and trust.

Alliances and or Acceptance and Adoption by a Major Trusted Global Organization

As many institutions embrace new technology, what better differential is there than to support a leading edge digital currency or at least provide support to its customers as an offering. To be first to market in pioneering a suite of offerings encompassing cryptocurrency would enhance reputation and lead to a culture predisposed to technology innovation.

A successful effort would entail greater accountability towards the consumers, portraying the improved availability, the enhanced reliability of cash exchange, and offering an affordable level of effective consumer protection. A level of acceptance will be more likely when consumers have access to innovative offerings and services through digital technology that would be cost effective and simple to utilize.

The path does not have to traveled alone. Consider the strategic partnerships formed by companies such as Coinbase and BitPay that serve as bitcoin “wallets” and payment processors for merchants. By holding the digital wallets that receive bitcoin payments from customers, and then immediately paying those merchants the cash value of those bitcoins, Coinbase and BitPay effectively enable merchants to accept cryptocurrency payments without taking on the risks of holding bitcoin on their books. Forging these types of strategic partnerships and solutions is the key to driving acceptance and trust in the currency.

Structural Mitigants

Reserve Requirements for Exchanges

Enhancement of the ecosystem could include more robust cryptocurrency exchanges. These are organizations that facilitate the trading of traditional currency for cryptocurrencies. In the traditional sense, cryptocurrency exchanges operate not only as exchanges, but can also act as broker-dealers as well as custodians. If these exchanges were to hold reserves sufficient to survive any major downturn or crash—adopting the same principles as a clearing house—it would add an extra layer of protection in times of volatility and market uncertainty.

Insurance Products

The provision of a fund that would offer investor protection, such as FDIC insurance,  could help mitigate default risk and be incorporated as part of an account package, perhaps supplemented by a personal insurance policy.

Mature Ecosystem

The use of cryptocurrency has increased enormously and so too has consumers’ ability to harness the powers of technology. The mobile phone—especially in emerging markets—has increased both knowledge, transferability, and know-how. Mobile payments have increased due to the rise of Internet banking and increased consumer usage of alternative payment methods like Amazon gift cards, Apple Pay, Google Wallet, and PayPal. These advancements have paved the way for the acceptance of cryptocurrency.

As the cryptocurrency market continues to grow and mature, we may see liquidity increase. This would lead to tighter bid/ask spreads and significantly reduced exchange fees. It also would reduce price volatility, which would decrease exchange rate risk and lessen the pressure on risk-averse merchants and consumers to immediately convert cryptocurrency back into fiat currency. Increased liquidity would help cryptocurrency develop characteristics that are more like widely accepted fiat currency. The recent  introduction of cash-settled Bitcoin futures products (derivatives) by the two largest U.S. futures exchanges, the Chicago Board of Exchange (CBOE) and Chicago Mercantile Exchange (CME) should serve this purpose in addition to acting as a currency hedge.

Risk Management Framework

The importance of risk documentation cannot be overstated, with all involved in the ecosystem maintaining consensus regarding risk management guidelines, standards, procedures, and industry best practices.

A standard risk management framework would cover policies, standards, and procedures relating to cyber, fraud, operational credit, physical security assets, IT security and data, third-party vendor, and anti-money laundering, and a business continuity and disaster recovery program. The framework needs to be enterprise wide,  as all these risks are highly correlated with each other. To be effective and actionable, the risk framework needs to be supplemented in large part by real-time information gathering and scenario planning. Special mention and attention must be spelled out for software upgrades, given the huge reliance on technology changes and development.  More importantly, every participant of the ecosystem chain should be risk assessed as to the adequacy and efficacy of the implementation of its documentation to aid confidence and reduce risk.

Any application of common standards like CCSS (Cryptocurrency Security Standard), which was introduced in 2014 to provide guidance specific to the secure management of cryptos, should be supported by all to engender confidence. (The CCSS is currently the go-to standard for any information system that handles and manages crypto wallets as part of its business.)

Education

Training and education can go a long way in mitigating risks and improving confidence—confidence which continues to diminish with all the cryptocurrency horror stories on social media because of the three principal concerns below:

  • Spoofing payment information/phishing/user address.
  • The hacking of a payment gateway.
  • Cyrptojacking.

A comprehensive education package with insight on the latest security methods backed up by anti-malware, backups, cold storage, strong and frequent password protection, and regular updates of software can help mitigate cyber and fraud risks and improve confidence.

Passing Thoughts

This list is not intended to be exhaustive and homes in on material risk management techniques. The application of these techniques is very dependent on resources and the operating environment. Cryptocurrency is here to stay. One must be smart about the risks pose and manage accordingly.

The author: John Thackeray MBA is a chief risk officer who has held risk positions in both Europe and the U.S. He now runs his own consulting company (https://www.risksmartinc.com) which specializes in the writing of risk documentation.