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How To Understand Risk in Crypto

by Pragati Shrivastava
, How To Understand Risk in Crypto

Cryptocurrencies have become mainstream in the past two years and they have easily outpaced the gains of many other assets. For example, Bitcoin has an RoI of over 10,000% in the past decade. While the number of investors doubles almost every year, the financial industry has studied the risks associated with it and most investors and industry managers do not fully understand cryptocurrency assets and how they work, which often makes them shy away from crypto investing.

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These companies are still learning how to help less-sophisticated clients manage the unique risks regarding cryptocurrencies. Custody, inheritance transfer, and escrow services are still new and institutions are assessing the pros and cons within their risk assessment. In this article we’ll explore the risks that are unique to cryptocurrencies and explain why this poses a challenge to existing traditional finance companies.

Cryptocurrency and Financial Risk

An inseparable combination of financial assets carries a different class of risk. They cannot be easily separated from technology risks because the underlying foundation of Bitcoin and other cryptocurrencies is built on technology. In 2017, during the Bitcoin bull-run, many altcoins and cryptocurrencies were launched and the market required financial risk management to properly diversify portfolios, avoid asset bubbles, and manage liquidity. With over 5,000 cryptocurrencies on the many crypto markets, it is very difficult to track all of them and give a risk assessment, especially if you are a sole investor without enterprise resources.

The technology risk is higher compared to other assets because of the sheer amount of tech associated with those 5,000 cryptos. Additionally, to become involved in the crypto markets, people need to be diligent about protecting their private keys and sustaining cybersecurity. Beyond that, the financial risks are about the same as emerging financial markets, including but not limited to uncertain legal status, undefined protocols for estate planning, and custodial best practices.

More financial risk comes from the fact that Bitcoin and other cryptocurrencies do not have a stable exchange rate. Against hot currencies like USD and EURO, Bitcoin’s value is relatively volatile. From November through December 2017, Bitcoin gained over 500% in value; then from December 2017 to February 2018, the price dropped by over 50 percent.

It’s important to note that this situation was not a blanket event across other cryptocurrencies, in fact, 46% of the cryptocurrencies that held initial offerings in 2017, failed outright. That’s not a stellar review for cryptocurrency, is it?

Then why bring it up?

Because it shines a light on the importance of doing your due diligence so you don’t get scammed. Bitcoin has been around for just over a decade. While there is volatility, those who entered the market early have seen a steady incline to this asset’s value. Those who bought at its 2017 peak weren’t paying attention to their portfolio.

Financial institutions that deal with cryptocurrencies exercise measures like detailed analysis and research for cryptocurrencies so they can exercise prudent fiduciary responsibility through educating investors, providing disclosures and carefully supervising users’ portfolio.

Another associated risk is a high amount of liquidity risk. Most cryptocurrency exchanges are not prepared enough to handle the growing demand of cryptocurrency which results in bottlenecks and liquidity issues. For traders to cash out their returns, liquidity is a concern for most cryptocurrency exchanges. Traders may cash out if they find it hard to deposit their proceeds due to challenges in security infrastructure, and safeguards related to money laundering and fraud prevention.

Cryptocurrency and Technology Risk

Some might argue that cryptocurrencies gained popularity too soon and that the technology, while exciting in concept, has had some major hurdles that are still being dealt with. Some of these issues include transaction speed, network bottlenecks and difficulty in scaling for mass adoption.

Consumers, retailers, and enterprise-level business need solutions, not new problems. While blockchain technology is the new shiny thing, the overlaying cryptocurrency built on the blockchain, or the development of apps to access the blockchain can often influence the price of each token asset.

And what happens if the blockchain loses support or the underlying technology becomes obsolete?

As mentioned earlier, due diligence is vital and researching the developers and executive team of any crypto project is vital to maintaining the integrity of your investment portfolio, but also holding onto your money.

Financial assets like index funds and stocks have traditionally been associated with devices connected to the internet but blockchain technology has opened us up to the possibility of transferring value with/without the internet.

Blockchain powers the case of managing custody because proof-of-ownership is a function of a private key. If investors lose their private key, the cryptocurrency stored in the wallet is lost forever. With financial transactions in fiat currencies, there is no technology risk involved. And in case of online digital transactions, there is a centralized authority. With cryptocurrencies, however, there is no central authority and no admin controls. This is why exchanges must invest in security infrastructure and cybersecurity to keep users’ assets safe.

Cryptocurrency and Emerging Market Risk

Cryptocurrencies can be compared to emerging markets and many functions of traditional financial markets have not yet been established in cryptocurrencies.

Financial institutions can tackle emerging market risks by creating a central digital-vault for storing private keys and tracking ownership through traditional bank ledgers off of the blockchain. This adds to the complexity involved in cryptocurrencies and even a single point of failure that could lead to large losses.

Another risk lies in the legal framework of regulation for various countries. Countries that outlaw cryptocurrencies may also seek to block access to cryptocurrencies through the internet. Cryptocurrencies are an emerging market and the future may unfold in many different ways. It remains to be seen how cryptocurrencies will evolve.






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