Understanding the Risks of Cryptocurrency in Financial Services

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/