The purpose of this article is to outline and explain the risks associated with cryptocurrency. The sequel to this article, next week, will examine the risk management techniques to mitigate these risks.
Cryptocurrency is a digital currency in which encryption techniques are used to regulate the generation of units of currency and verify the transfer of funds. A defining feature of a cryptocurrency is that it is not issued by any central authority, rendering it theoretically immune to government interference or manipulation.
In order to understand the risks, one must first understand the features of the platform (such as blockchain) on which the cryptocurrency is based. Blockchain is a digitized, decentralized, public ledger used for 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: Transactions 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 free. After you install it, you can receive and send bitcoin or other cryptocurrencies.
Thus posing the following material risks:
Loss of confidence in digital currencies: The nascent nature of the currencies subjects them 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.
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 may be 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 to a user’s wallet are stolen, the thief can fully impersonate the original owner of the account and has the same access to the monies in the wallet as the original owner. Once the bitcoin is transferred out of the account and that transaction has been committed to the blockchain, those monies are lost forever to the original owner
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.
Some countries may prevent the use of the currency or may state that transactions break anti-money laundering (AML) regulations. Due to the complexity and decentralized nature of 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.
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.
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 previously. The sequel to this article will examine the methodologies and techniques used to mitigate the risks.