By: Jacob Kosoff, Henry
Lee, Ph.D., and Aaron Bridgers, CFA
Cryptocurrencies
have entered the mainstream conversation as digital currencies such as Bitcoin and
Ethereum have skyrocketed in value, easily outpacing the gains of many other
assets. Armchair investors have become enamored with Bitcoin, making it one of
the most searched topics in 2017.[1] This
public frenzy has the financial industry scrambling to serve the growing demand
to access and trade cryptocurrency. Similar to the real estate bubble that led
to the financial crisis of 2008, investors and the industry do not fully
understand the assets they are pursuing.
Unlike the
real estate market, cryptocurrencies are so new that most traditional financial
services companies do not yet provide access to the cryptocurrency market.
Instead, this market is largely serviced by fintech companies that offer
convenient user experiences for opening accounts or trading. However, these
companies are still learning how to help less-sophisticated clients manage the
unique risks regarding cryptocurrencies. Cryptocurrency firms are also still
learning how to perform basic tasks expected of the financial services
industry, such as custody or inheritance transfer.
This article
seeks to impart a high-level understanding of cryptocurrency and the unique
risks that this new asset class poses to traditional financial services
companies that participate in this market.
What is a Cryptocurrency?
Cryptocurrency
is tradable digital money created from a combination of cryptography,
distributed computing software, a worldwide network of computers, economic
incentives, and consensus algorithms, to make digital information scarce. Digital
scarcity is a fundamental characteristic of cryptocurrency, otherwise the data
representing the currency could be copied an unlimited number of times and the
unlimited number of copies would make the digital currency worthless. For the purposes of this article, digital
scarcity only works within a network, and only works when the participants
within that network can come to a consensus around the validity of
cryptocurrency transactions. The consensus method used must ensure that digital
money cannot be double spent, which prevents the cryptocurrency version of
counterfeit money. Most cryptocurrencies use a technology commonly referred to
as a “blockchain” to track ownership, create digital scarcity, and prevent double
spend.
Is Cryptocurrency a Form of
Money?
The Federal
Reserve defines money as a group of safe assets that households and businesses
can use to make payments or to hold as short-term investments.[2]
Bitcoin and other cryptocurrencies meet that basic definition. In a recent
article, the St. Louis Federal Reserve stated that Bitcoin is more like
tangible cash than a ledger entry related to a checking account.[3] Like
cash, Bitcoin has no intrinsic value, it has a limited supply, and does not
require an intermediary to exchange with other participants on the Bitcoin
network. However, the U.S. Internal Revenue Service (IRS) treats
cryptocurrencies as property and collects applicable capital gains taxes.[4]
Why are Cryptocurrencies
Important?
Bitcoin was
the first cryptocurrency and remains the most heavily traded cryptocurrency.
Bitcoin started as an esoteric way for a small group of tech-savvy
crypto-explorers to circumvent using traditional fiat currency. Bitcoin and
other cryptocurrencies have grown into a massive market worth tens of billions
of U.S. dollars. This creation of value has created significant public interest
in owning and trading cryptocurrencies. Traditional financial services firms
have largely not been intermediaries for the cryptocurrency market, but recent
trends indicate that many traditional firms are exploring the possibility of
accessing cryptocurrency markets.
What are the Categories of Cryptocurrency
Risks?
Cryptocurrencies
are an inseparable combination of financial instruments, supporting technology,
and a Web-enabled network. Therefore, when it comes to cryptocurrencies, the
financial risks cannot easily be separated from technology risks. The
cryptocurrency market requires financial risk management to avoid
cryptocurrencies that are not a going concern, to properly diversify
portfolios, to avoid asset bubbles, and to manage liquidity. The cryptocurrency
market requires technology risk management to properly protect private keys and
to sustain cybersecurity. Cryptocurrency markets also require managing the
risks associated with emerging financial markets such as uncertain legal
status, undefined protocols for estate planning, and custody best practices.
Managing Cryptocurrency
Financial Risk
If Bitcoin
and other cryptocurrencies were considered a form of foreign currency, then the
exchange rate relative to the U.S. dollar would be extremely volatile. During
the three-month period from December of 2017 to February of 2018, Bitcoin fell
over 50%. Moreover, the website Bitcoin.com reported that 46% of the
cryptocurrencies that held initial offerings in 2017 have already failed.[5] This
means that financial services companies will have to exercise prudent fiduciary
responsibility through educating investors, providing appropriate disclosures,
and carefully supervising portfolio recommendations that involve
cryptocurrencies.
The
cryptocurrency market also has a high amount of liquidity risk. According to
the crypto-media company CoinDesk, the total cost of making a $1 million bitcoin
transaction can run between $10,000 to $100,000 more than the listed spread on
an exchange.[6] Centralized
cryptocurrency exchanges, such as Coinbase or Kraken, have been unprepared to
handle the growing demand of cryptocurrency, resulting in bottlenecks and
liquidity issues. Liquidity concerns are confounded as investors cashing out of
cryptocurrencies may find it hard to deposit their proceeds due to safeguards
related to money laundering and fraud prevention.
Managing Cryptocurrency
Technology Risk
Investors
and financial institutions cannot separate the enabling technology and the
related technological risks from the cryptocurrency. The popularity and relevance
of the underlying blockchain technologies supporting each cryptocurrency will
inevitably impact the value of the cryptocurrency. If the underlying blockchain
technology becomes obsolete, then the related cryptocurrency may lose all
value. The risk of obsolete technology is a new risk consideration for
financial assets and has traditionally been associated with hardware or
software.
Moreover,
the use of blockchain creates unique risks in managing custody because
proof-of-ownership is a function of a private key—a precise string of
characters which may be long and cryptic. If an investor loses a private key
then the cryptocurrency cannot be exchanged or used. Losing a private key
causes the value of the related cryptocurrency to be lost forever. With a
blockchain, there is no central authority; no one with the superuser password;
no one who can overwrite changes that were made. Whoever has the private key
has total control of the assets. This elevates the stakes of cybersecurity and
there is no FDIC backstop for cryptocurrency deposits lost due to cyber breaches.
Managing Cryptocurrency
Emerging Market Risk
Cryptocurrencies
are an “emerging market” in the sense that they are new, and as such, not all
of the normal functions of mature financial markets have been established. For
example, it is difficult to establish who legally owns an amount of
cryptocurrency because private keys can be compromised. Financial institutions
may solve this problem by creating a central digital-vault for storing private
keys and tracking ownership through traditional bank ledgers off of the
blockchain. However, this solution creates additional complexity around
cryptocurrencies as well as a single point of failure that could lead to large
losses. Furthermore, a central digital-vault would make cryptocurrencies become
dependent upon services provided by custody banks, therefore the cryptocurrency
would lose the advantage of being a decentralized peer-to-peer medium of
exchange.
Another risk
related to the maturity of the cryptocurrency market lies in the legal
frameworks of various jurisdictions across the world. Cryptocurrencies are
geographically everywhere, which means any large country can introduce
political and regulatory risk into a cryptocurrency network. This has led to
wild swings in value as countries like China cause legal uncertainty in the
cryptomarkets.[7] Countries
that outlaw cryptocurrencies may also seek to block access through their
routers, while other countries may have a poor technological infrastructure,
making transactions difficult. Moreover, legal issues such as the protocol for
inheritance-related transfers of cryptocurrency have not been firmly
established and could present problems if estate disputes require adjudication.
Conclusion
Cryptocurrencies
are an emerging market and the future of cryptocurrency could unfold in many
different ways. It remains to be seen how this market will evolve and whether
cryptocurrencies will become mainstream or be relegated to certain niches; how
traditional financial services firms will adapt to them and include them, or
forfeit the space to non-traditional firms; and whether governments and
regulators will embrace them, tolerate them, or delegitimize them. If
traditional financial institutions join this burgeoning market, they should
apply sound risk management practices with respect to financial, technological, and emerging market
risk.
The opinions expressed in the article
are statements of the authors and are intended only for informational purposes,
and are not opinions of any financial institution and any representation to the
contrary is expressly disclaimed.
[1] https://trends.google.com/trends/yis/2017/GLOBAL/
[2] https://www.federalreserve.gov/faqs/money_12845.htm
[3]
https://www.stlouisfed.org/open-vault/2018/april/three-ways-bitcoin-regular-currency
[4] https://www.irs.gov/newsroom/irs-virtual-currency-guidance
[5]
https://news.bitcoin.com/46-last-years-icos-failed-already/
[6]
https://www.coindesk.com/solving-liquidity-challenge-decentralized-exchanges/
[7]
http://fortune.com/2018/02/05/bitcoin-china-website-ico-block-ban-firewall/