Challenges Facing Cryptocurrency Risk Management

Enterprise Security Magazine | Monday, January 10, 2022

The growing institutional interest in cryptocurrency brings a slew of risk management issues specific to this fast-emerging alternative asset class.

Fremont, CA: Cryptocurrencies have been publicized as the future of finance for a long time, but it wasn't until 2020 that traditionally conservative and risk-averse institutions became active participants in this complex alternative asset class. The two most well-known cryptocurrencies, Bitcoinand Ethereumhave attracted a lot of attention and witnessed significant price fluctuation over the last year. However, as the number and variety of digital currencies grow, risk management is no longer limited to just Bitcoin and Ethereum.

When it comes to determining how to manage cryptocurrency risks best, risk managers frequently draw parallels between financial products and cryptocurrencies. However, there are some challenges that risk managers must be aware of when dealing with cryptocurrencies, such as:

Data and modeling challenges

Cryptocurrencies are very volatile and can be traded 24 hours a day, 7 days a week, all over the world. Cryptocurrency marketplaces give a detailed but limited data set of real transaction prices, which appears insufficient for modeling purposes. Many risk managers use statistical tools (such as spectral decomposition) to estimate their cryptocurrency exposures and identify factors that can be integrated into pricing, risk, and trading models.

Valuation problems

One of the first steps in managing the risk of any financial instrument is to assess and determine its exposure using standard market-wide procedures. On the other hand, cryptocurrencies are unique in that there is no consensus valuation technique, no widely acknowledged measures, and published pricing information might differ significantly between sites. Risk managers must understand the widespread use of sophisticated and sometimes conflicting valuation methodologies in order to determine a realistic value for a coin.

Regulatory and legal issues

Cryptocurrencies, unlike financial instruments, are not regulated items and do not have the same level of legal protection as traded financial instruments. This creates a tangle of legal hazards and uncertainties, which can have a significant impact on the investability and risk management of digital assets. There is still no international agreement on the appropriate way to govern cryptocurrencies, particularly in terms of product development and trade.