Crypto currencies, such as bitcoin and ethereum, are growing rapidly and the opportunities for profit are enormous. But these markets are also highly risky and investors using crypto currencies shoulder this risk. The situation should make risk management a main area of focus for crypto investors.
Risk in the crypto currency markets shows up in a variety of ways including many different forms of financial, tax and other operational risks. Much of the counterparty credit risk found in crypto currency markets comes from undeveloped crypto market infrastructure. We just don’t have the same plumbing in crypto currency financial markets as we do in fiat based financial markets. Fiat economies have developed the rule of law, deposit insurance, and credit ratings, but none of these these exist in crypto currency markets. Crypto currencies also don’t rely on any central authority, so dispute resolution is much more problematic, if not impossible. If your crypto currency wallet gets hacked, for example, you have little (or no) recourse to recover your loss.
Interestingly, the lack of financial market infrastructure also presents profit opportunities. Many financial services businesses operating in developed fiat economies could be replicated by clever entrepreneurs to crypto economies. The opportunities are huge.
Consider the cryptocurrency investor who makes a deposit on Bitfinex or Poloniex, and then lends their crypto currency to traders on the exchange in return for interest. How can this investor estimate the chances the exchange will remain solvent, and how can the investor estimate the chances of their account suffering a loss in the event the exchange gets hacked? At present, there are very few ways to quantify the risks of such events. The crypto currency investor is left to rely on message boards, online posts, and a poll of their friend’s opinions. These methods are unscientific, and won’t give the investor reliable metrics they can use to make investment decisions. The average crypto currency exchange depositor simply relies on their own “gut feeling” along with some basic rules of thumb about portfolio management to make risk management decisions (don’t put all your eggs in one basket).
As far as I know, there doesn’t currently exist any method of obtaining deposit insurance for a crypto exchange or hosted wallet balance. In developed fiat economies, deposit insurance makes it cheap for consumers to assess the credit risk of counterparties, but the cryptocurrency world doesn’t currently have this same infrastructure. I believe that creating a rating agency for crypto currency credits is required for crypto currency finance to reach a more sustainable path.
One of my main goals as an investor is to better assess the creditworthiness of my cryptocurrency counterparties, and then use this information to make better investment decisions. As an investor, the degree of credit risk matters to me. Mostly all crypto currency investments have counterparty risk, but few ways exist to assess this risk. In fiat currency economies, we can rely on rating agencies, deposit insurance, and many different forms of information to make credit decisions. But this this same market infrastructure does not currently exist for most crypto currency finance.
To enlighten the market, the first step should be to define a credit event. When is a counterparty in default? Below, I outline five categories of credit events: Bankruptcy, Acceleration, Default, Failure to Pay, and Restructuring.
Bankruptcy occurs when a relevant regulator declares the organization to be bankrupt.
Acceleration covers the situation, other than a Failure to Pay, where the relevant obligation becomes due and payable as a result of a default by a reference entity before the time when such obligation would otherwise have been due and payable.
Default covers the situation, other than a Failure to Pay, where the relevant obligation becomes capable of being declared due and payable as a result of a default by the reference entity before the time when such obligation would otherwise have been capable of being so declared.
Failure to Pay
Failure to Pay is defined to be a failure of the reference entity to make, when and where due, any payments under one or more obligations. Grace periods for payment are taken into account.
Restructuring covers events as a result of which the terms, as agreed to by the reference entity and the holders of the relevant obligation, have become less favourable to the holders than they would otherwise have been.
By the above definitions, I believe it would be possible to achieve consensus on whether a credit event has occurred. The process of determining consensus could be done by a system of member voting and/or a pari-mutuel pool. The result of the credit event determination process could be used to settle derivative markets such as default insurance pools. These default insurance pools could in turn be used by market participants and credit rating agencies to help determine the creditworthiness of underlying entities. The pools themselves could also be used by both speculators and hedgers to manage their investment risk.