Can crypto risks be managed?
Posted by John Reed on
Much talk about risk management in crypto. Does anyone know what risk management is? Or are they magic words like “Open sesame” or “WD-40” or “elbow grease?”
There are five ways to manage risk:
• avoid it, e.g., refuse to own any crypto
• shift it to someone else, e.g. purchase a crypto insurance policy (there is no such thing)
• hedge it, i.e., invest an equal amount in an asset that moves in the opposite direction when crypto moves—a way to lock in the current price—being long and short in the asset simultaneously which is much more complicated to do that it is to say, in part, because you need a completely trustworthy counterparty
• mitigate it, like installing a fire sprinkler system in a building to reduce fire risk
• diversification Wikipedia says,
“In finance, diversification is the process of allocating capital in a way that reduces the exposure to any one particular asset or risk. A common path towards diversification is to reduce risk or volatility by investing in a variety of assets. If asset prices do not change in perfect synchrony, a diversified portfolio will have less variance than the weighted average variance of its constituent assets, and often less volatility than the least volatile of its constituents.”
Is transparency a risk-management tool? Look at the list of risks below and ask yourself if any amount of transparency would reduce or eliminate that risk. Also, crypto is generally sold as a privacy product. Privacy is the opposite of transparency. Many buy it precisely to AVOID transparency.
Transparency is just a snap shot of assets including financial accounts in traditional currencies and physical assets like barrels of oil or fields of wheat. It tells you what was there at a point in time, not necessarily what was there the next day. The secrecy of crypto may render crypto transparency a contradiction in terms, an impossibility.
Due diligence is a best practice, but it also may be incompatible with crypto privacy.
To manage risk, you need to first name all the pertinent risks. The following may be a partial list of crypto risks:
A. Market risk—the risk that the asset will fall in value—in the case of an asset sold daily on exchanges, the asset should be “marked to market”—shown at its current market value daily or continuously
B. Credit risk—the risk that someone who owes you something will pay it when due—many who believed they were depositors found out to their great outrage was that their deposits were unsecured loans to the crypto company in question.
C. Hacking risk—the risk that criminals will steal your crypto by getting your password or by defeating security measures or by an inside job
D. Political risk—the risk that government will enact laws or regulations that diminish the value of your crypto
E. Litigation risk—the risk that someone will sue you and prevail or merely cost you large amounts via due process without winning their case
F. Fidelity risk—the risk that employees of a company your trust are dishonest and embezzle or steal from you
G. Management risk—the risk that the managers of the company you trust with your money will incompetently handle it
H. Inflation risk—applies only to assets denominated in a currency the quantity of which can be increased too much
I. Deflation risk—applies to non-currency-denominated assets when the amount of currency available to purchase the assets is diminished too much
J. Casualty loss—loss of your crypto password
K. Currency risk—the risk that the crypto you own will fall in relation to your functional currency which is the currency of where you live
One phrase you hear in discussions of risk management in crypto is the need for “guardrails.” I do not know what that means. Neither does anyone else.
Another phrase you hear is that they have hired a “compliance officer.” That has no meaning until you answer the question “Comply with what?” Accountants auditing public corporations check for compliance with GAAP and FASB and law compliance. IRS auditors check your compliance with the Internal Revenue Code. Crypto, famously, notoriously, is regulated by no one and therefore has no accepted standards with which compliance can be compared.
Two rules that already apply to anyone handing assets of value are those against “money laundering” and “know your customer” rules. Again, these are inimical to the privacy motive of many, if not most, crypto customers.
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