Understand the risks associated with cryptocurrency, both from a currency and a business perspective.
A defining feature of a cryptocurrency, is that is not issued by any central authority, rendering it theoretically immune to government interference or manipulation. In order to understand the risks of cryptocurrency, one must first understand the features of the platform (Blockchain) on which the cryptocurrency is based. Blockchain is a digitized, decentralized, public ledger of all cryptocurrency transactions. Constantly growing as ‘completed’ blocks (the most recent transactions) are recorded and added to it in chronological order, it allows market participants to keep track of digital currency transactions without central recordkeeping. Each node (a computer connected to the network) gets a copy of the blockchain, which is downloaded automatically.
This technology platform has the following characteristics.
- Irreversible: After confirmation, a transaction cannot be reversed, there is no safety net.
- Anonymous Neither transactions nor accounts are connected to real-world identities, everything is digitalized with access by means of the internet.
- Global Speed: Transaction are nearly instant in the network and are confirmed in a couple of minutes. Since they happen in a global network of computers they are completely indifferent of your physical location. There are no third parties involved in verification or validation.
- Secure: Strong cryptography and the magic of big numbers makes it impossible to break this scheme.
- No Gatekeeper: The software that everybody can download is for free. After you installed it, you can receive and send Bitcoins or other cryptocurrencies.
Thus, posing the following inherent idiosyncratic material risks of the currency.
Business risk
Loss of confidence in digital currencies: the nascent nature of the currencies is subject to a high degree of uncertainty. Online platforms have generated a large trading activity by speculators seeking to profit from the short-term or long-term holding of digital currencies. Cryptocurrencies are not backed by a central bank, a national or international organization, or assets or other credit, and their value is strictly determined by the value that market participants place on them through their transactions, which means that loss of confidence may bring about a collapse of trading activities and an abrupt drop in value.
Cyber/Fraud risk
Since Cryptocurrency is essentially a cash currency it has attracted a large set of the criminal community; these criminals can break into crypto exchanges, drain crypto wallets and infect individual computers with malware that steals cryptocurrency. As transactions are conducted on the internet, the hackers target the people, the service handling and storage areas, through means such as spoofing/phishing and malware. Investors must rely upon the strength of their own computer security systems, as well as security systems provided by third parties, to protect purchased cryptocurrencies from theft.
Moreover, cryptocurrency is highly reliant upon unregulated companies, including some that may lack appropriate internal controls and may be more susceptible to fraud and theft than regulated financial institutions. Furthermore, the software needs to be regularly updated and maybe suspect at times. Sourcing the blockchain technology to vendors may result in significant third-party risk exposure.
There is very little in the way of recovery, If the keys are stolen to a user’s wallet, the thief can fully impersonate the original owner of the account and has the same access to the monies in the wallet that the original owner has. Once the Bitcoins are transferred out of the account and that transaction has been committed to the block chain, those monies are lost forever to the original owner
Operational risk
With a centralized clearinghouse guaranteeing the validity of a transaction comes the ability to reverse a monetary transaction in a coordinated way; no such ability is possible with a cryptocurrency. This lack of permeance is further demonstrated as Bitcoin accounts are cryptographically secured, access to monies contained in an account almost certainly cannot be restored if the “keys” to an account are lost or stolen, and subsequently deleted from the owner.
Regulatory/compliance risk
Some countries may prevent the use of the currency or may state that transactions break anti money laundering regulations, notwithstanding the global implications. Due to the complexity and decentralized nature of the Bitcoin and the significant number of participants — senders, receivers (possibly launderers), processors (mining and trading platforms), currency exchanges, a single AML approach does not exist.
Market risks
The market risks are idiosyncratic as the currency trades only on demand. There is a finite amount of the currency which means that it can suffer from liquidity concerns and limited ownership may make it susceptible to market manipulation. Furthermore, given its limited acceptance and lack of alternatives, the currency can appear more volatile than other physical currencies, fueled by speculative demand and exacerbated by hoarding.
Thus, posing an inherent material risks to the business
Many of the individual inherent risks of the currency also manifest and affect the business adding an extra layer of risk.
Further risks would include the costs involved in mitigation with respect to regulatory risk compliance Anti-money laundering and privacy laws, would have to be complied with on an individual business level as well as a global level, involving a myriad of balances and checks. Furthermore, institutions could find themselves taken to task by various jurisdictional law enforcement agencies each with their own agenda, in failing to comply with the many differing local and state laws.
The competition risk is great as the businesses will need to accommodate and expand their offering to be all inclusive with regard to payment transmissions, involving a substantial revision to all ready past due systems and infrastructure. Moreover, these systems enhancements would also need to be continuously kept up to date and be compatible with the business’s delivery system and that of its many third-party providers.
The taxation risk is material as US individuals can seek to circumvent tax regulations like the FBAR (Report of Foreign Bank and Financial Accounts) submission by storing monies abroad anomalously. Institutions that support this circumvention either unwittingly or not can find themselves subject to sanctions and or fines. Further business liabilities could also arise from the conversion or de conversion of the currency and the reporting of these instructions.
There is no doubt that cryptocurrencies are here to stay as technology advances. Public acceptance and confidence will take some time, but the risks will remain the same, some appearing to be more material and elevated than before for both the currency and the business.
The sequel to this article, next month, will examine the risk management techniques to mitigate these risks.
Read more at: FEI
