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Technology

6 Risk Management Methods to Reduce the Inherent Risk of Cryptocurrency


by John Thackeray

Cryptocurrency is here to stay and executives must be smart about the risks posed and manage accordingly.

©mokee81/ISTOCK/THINKSTOCK

This article looks at 6 risk management methods in which the high inherent risks of cryptocurrency can be reduced and thus install more confidence and trust in the currency transactions. The methods are wide ranging and, if applied in total, could confirm the acceptance and spread of cryptocurrency, a currency for the 21st century.

1. Regulatory Approval

The most material reduction of inherent risk associated with cryptocurrency is that of regulatory approval, which seems very ironic since cryptocurrency is a decentralized currency with no regulatory governance or framework. Some regulatory approval, if achieved, could improve and imply both acceptance and credibility in the eyes of the cryptocurrency community. To achieve this, the best starting point would have to be the place of the reserve currency, the US dollar, but beware in the US, not all regulators are created equal and for cryptocurrency to gain traction in the United States, it must navigate five diverse and differing regulatory frameworks: These are listed below:

  • Financial crimes-related regulations like the Bank Secrecy Act (BSA), USA PATRIOT Act, and the Office of Foreign Assets Control (OFAC)
  • State banking departments
  • The SEC
  • Commodity Futures Trading Commission (CFTC)
  • Internal Revenue Service (IRS) (FBAR, FACTA reporting)

The best outcome would be to have regulatory confirmation from all the above but given the vested interests of each of these regulatory bodies, a seal of approval from at least two of these organizations should be sufficient in adding credibility and trust.

2. Alliances and or Acceptance and Adoption by a Major Trusted Global organization

As many institutions embrace new technology, what better differential is there than to support a leading edge digital currency or at least provide support to its customers as an offering. To be first to market in pioneering a suite of offerings encompassing cryptocurrency would enhance reputation and lead to a culture predisposed to technology innovation.

The responsibility would be all encompassing with a greater accountability towards the consumers in the gaining of better knowledge, portraying the improved availability, the enhanced reliability of cash exchange, and offering an affordable level of effective consumer protection. This level of acceptance will be more likely when consumers have access to innovative offerings and services through digital technology which would be cost effective and simple to utilize.

Moreover, it does not have to be a path travelled alone, i.e. strategic partnerships formed by companies such as Coinbase and BitPay who serve as bitcoin “wallets” and payment processors for merchants. By holding the digital wallets that receive bitcoin payments from customers, and then immediately paying those merchants the cash value of those bitcoins, Coinbase and BitPay effectively enable merchants to accept cryptocurrency payments without taking on the risks of holding bitcoins on their books. Forging these types of strategic partnerships and solutions is the key to driving the acceptance and imbibing trust in the currency.

3. Structural Mitigants

Reserve Requirements for Exchanges

Enhancement of the ecosystem could include more robust Crypto currency exchanges These are organizations that help interested individuals in trading a traditional currency (e.g. USD) for crypto currencies such as Bitcoin. In the traditional sense, crypto currency exchanges operate as not only an exchange, but can also act as a broker dealer as well as a custodian. If these exchanges were to hold a certain amount of reserves to survive any major downturn or crash, adopting the same principles as a clearing house, it would add an extra layer of protection in times of volatility and market uncertainty.

Insurance Products

The provision of a fund which would offer investor protection, like the FDIC insurance (FDIC deposit insurance covers the depositors of a failed FDIC-insured depository institution dollar-for-dollar, principal plus any interest accrued or due to the depositor, through the date of default, up to at least $250,000) could help mitigate the default risk and could be incorporated as part of an account package, perhaps supplemented by a personal insurance policy.

4. Mature Ecosystem

The use of cryptocurrency has increased enormously and so too has consumers ability to harness the powers of technology. The mobile phone especially in emerging markets has increased both knowledge, transferability and know how. Mobile payments have increased from the rise of Internet banking; increased consumer usage of alternative payment methods like Amazon gift cards, Apple Pay, Google Wallet, and PayPal; and advances in mobile payments technology have paved the way in tandem to the acceptance of cryptocurrency 

As the cryptocurrency market continues to grow and mature, we may see liquidity increase. This would lead to tighter bid/ask spreads and significantly reduced exchange fees. It also would reduce price volatility, which would decrease exchange-rate risk and lessen the pressure on risk-averse merchants and consumers to immediately convert cryptocurrency back into fiat currency. Increased liquidity would help cryptocurrency develop characteristics that are more like widely accepted fiat currency, and as such the introduction of cash-settled Bitcoin futures products (derivatives) by the two largest US futures exchanges, the Chicago Board of Exchange (CBOE) and Chicago Mercantile Exchange (CME) should serve this purpose in addition to acting as a currency hedge.

5. Risk Management Framework 

The importance of risk documentation cannot be overstated with all involve in the ecosystem maintaining consensus around risk management guidelines, standards and procedures to which they can align themselves to good industry best practices.

A standard risk management framework would cover policies, standards and procedures relating to cyber, fraud, operational credit, physical security assets, IT security and data, third party vendor and anti-money laundering would be needed encompassed by a Business Continuity and Disaster Recovery Program. The framework needs to be an enterprise wide level, as all these risks are highly correlated with each other. To be effective and actionable, the risk framework needs to be supplemented in large parts by real time information gathered and scenario planning. Special mention and attention needs to be spelled out for software upgrade, given the huge reliance on technology changes and development.  More importantly every participant of the ecosystem chain should be risk assessed as to the adequacy and efficacy of the implementation of its documentation to aid confidence and reduce risk.

Any application of common standards like CCSS (Cryptocurrency Security Standard) d which was introduced in 2014 to provide guidance specific to the secure management of cryptos should be supported by all to engender confidence. (This standard is currently the go to standard for any information system that handles and manages crypto wallets as part of its business.)

6. Education

Training and education can go a long way in mitigating the risks and improving confidence, confidence which continues to diminish with all the horror stories on social media, because of the three principal concerns below.

  • Spoofing payment information/phishing/user address
  • Hacking a payment gateway
  • Cyrptojacking

A comprehensive education package with an insight on the latest security methods backed up by anti-malware, backups, cold storage, strong and frequent password protection and regular updates of software can help mitigate the cyber and fraud risks and improve confidence. This list is not intended to be exhaustive and homes in on the material risk management techniques. The application of these techniques is very dependent on resources and the operating environment. Cryptocurrency is here to stay, one must be smart about the risks posed and manage accordingly.

John Thackeray is the CEO of risksmartinc.