Even though cryptocurrency has been touted as the future of finance, it wasn’t until 2020 that conventional and risk-averse institutions began actively investing in this complex alternative asset class.
This year, the two most popular cryptocurrencies, Bitcoin (BTC) and Ethereum (ETH), have been the subject of much attention and have seen their value fluctuate significantly. Risk management is not only about the “big boys” because of the fast expansion of digital currencies. Cryptocurrencies in 2018 were roughly 1,500 in number; presently, that number has risen to 4,500.
It is very uncommon for risk managers to draw comparisons between cryptocurrencies and financial instruments when assessing how to manage cryptocurrency risks. But there are four unique problems that risk managers must be aware of when it comes to trading in this new asset.
Table of Contents
1. Difficulty assessing the value
Risk management begins with quantifying and determining an asset’s exposure following market-wide procedures. A consensus valuation technique does not exist in the cryptocurrency market; no consistent measures exist, and published price information may fluctuate significantly across venues.
Risk managers need to be aware of the widespread usage of complicated and often inconsistent valuation methods to come up with a realistic value for a coin.
Using a functional approach, some analysts attempt to value cryptocurrencies by treating them like real-world money, such as USD or EUR. When it comes to cryptocurrency, there are basic distinctions in the law between cryptocurrencies and other financial products, which this approach glosses over. It is important to note that cryptocurrency is not a kind of legal cash and, as a result, does not have an implicit or explicit official endorsement.
Cryptocurrencies may be valued by looking at the market capitalisation of each coin and determining how much of that market it can reach. Instead of looking at the actual and future value that cryptocurrencies may produce, this method just looks at the current state of affairs. It’s good to take note of these insights, even if you’re just starting in the world of crypto assets. There are genuine platforms like BitiQ and helpful publications like the BitiQ review, done by the crypto media ZV Chain, to help you get started.
Due to the complexity of this, some analysts look at cryptocurrencies from the perspective of their network, which allows them to estimate the number of potential users and forecast various possible scenarios for their use in light of their programmability structure or governance features in greater detail. Even though this valuation method relies heavily on models and assumptions, it provides an extra degree of insight into the possible exposure and risk levels of cryptocurrencies.
To appraise these digital assets from a different perspective are other experts, notably those working on the institutional side of the market. Although these valuation results provide some similar uniformity and incorporate the underlying and defining characteristics of the various cryptocurrencies, they might be affected by wildly varying energy prices across key mining locations.
2. Administrative and legislative quandaries
Because cryptocurrencies are unregulated, they do not have access to the same legal safeguards as traded financial items. This creates complicated legal issues and introduces ambiguity, which may have a significant impact on the stability and risk management of these digital assets.
Cryptocurrency regulation is still a hot-button issue throughout the world, especially when it comes to product creation and trade. The government’s positions have been unstable and inconsistent at times. Certain cryptocurrencies are illegal to create, sell, own, or trade in certain countries, while they are permitted and encouraged in others.
It is becoming more common for other nations to adopt forward-looking and wide-ranging regulatory requirements for the issuing of securities, trading, reporting, and transparency. Governments are unintentionally establishing islands of legal protection in a sea of uncontrolled cryptocurrencies by applying these norms solely inside a single jurisdiction.
With this fundamental legal protection, many see this as a chance to test the potential of cryptocurrencies; for others, the absence of universal regulation reinforces the problems that stand in the way of their development.
Transacting in multiple cryptocurrency marketplaces may involve a variety of exceptionally complicated legal and regulatory concerns, which risk managers need to be aware of.
3. Information and design dilemmas
Risk managers may not have the requisite data to estimate future cryptocurrency exposures and hazards. One can’t model cryptocurrency risk and return variables or calculate basic measurement metrics like stress testing, VaR, or ES since one does not have enough transaction data.
Everywhere in the world, you may trade cryptocurrencies 24 hours a day, seven days a week. Cryptocurrency marketplaces contain a rich but limited data set of real transaction values, making them unsuitable for model building. Modelling and projecting these digital assets is comparable to a guessing game since there is no agreement on their price, return, or equilibrium-generation function.
As a result, many risk managers use statistical methods (such as spectral decomposition) to analyse their cryptocurrency exposures and find variables that may be input into pricing, risk, and trading models. There is some debate over the value of this simulated pricing, especially for stress testing.
4. Illiquidity and exchange expenditures
There is less liquidity and higher prices in the cryptocurrency market than in regular marketplaces. Many cryptocurrencies have a pre-determined supply and release schedule; thus, it should come as no surprise that cryptocurrency values are very volatile.
The lack of liquidity and excessive volatility in the cryptocurrency markets is expected to remain, making price discovery a constant problem for traders. The issue of gapping in these markets, on the other hand, continues to hamper investors’ ability to exit their crypto holdings. There is emerging evidence that some exchanges habitually manipulate prices, trade against users, and front-run major deals, adding insult to injury.
There is also a lack of uniformity in the treatment of cryptocurrency trading as a part of the problem. It is possible to find exchanges that contain cryptocurrencies’ fundamental qualities, as well as others that enable bilateral trading, with some resembling the main elements of electronic exchanges. Therefore, risk managers must be familiar with the mechanics of individual trading venues.
The unique interaction between the various individuals has a significant impact on how the mechanics play out and what the real hazards may be. As the mechanics and practicalities of settling cryptocurrency deals varied greatly among exchanges and even across users of the same digital wallets and custodial solutions, this is a significant concern. There is a significant increase in risk exposure and the severity of counterparty credit risk due to this.
Because of shady custodial solutions and design flaws in custodial standards, cryptocurrencies have been the focus of various money-laundering operations. Constant attention is a need while engaging in illicit activity of this kind.
Cryptocurrencies have evolved as a new asset class over the last decade and are now drawing more institutional investors as well. There is a need for a more thorough examination of the underlying sources of risk and opportunity because of the increased demand. Some of the requests for greater risk management are a step toward a more mature market, which should eventually replace self-regulation and automation with competent supervisors and regulators.