Financial expert Brook Taube has been following the evolution of blockchain digital currencies, commonly called cryptocurrencies, since they entered the economic arena in the early 2000s. In that short time, the number of distinct cryptocurrencies had exploded to nearly 10,000 by mid-2023.
This sudden, unprecedented growth has all but outpaced regulation by governments and markets, not yet set a universally accepted code of best practices. It’s become what Taube is calling a Slalom Course. According to a 2022 CNBC poll, however, only about 38% of Americans 25 and under consider it to be a high-risk medium of exchange. On the other hand, the caution level rises with age to about 80% among those aged 58 and older.
While Taube believes that some of that fear is understandable–even the International Monetary Fund has expressed reservations about crypto–he believes fear is unwarranted in the long term.“Blockchain and crypto are here to stay. Challenges abound, but the transactional, cost, security, and transparency (where appropriate) benefits will outshine the fears.”
The key to managing that wild slalom ride safely and profitably, according to Taube, is in understanding the challenges within this new market and in managing those risks. The road to acceptance will need a clear, comprehensive, and ultimately global set of standards.
By most accounts, at least five challenges are distinctive to cryptocurrencies. None, however, are insurmountable.
Cryptocurrencies come in a dazzling variety, and the differences are extremely important. As a result, they are not interchangeable. They offer different levels of security and transparency, programmability, tokenization, and governance.
The first cryptocurrency for example, Bitcoin (BTC), still follows a simple model. It is designed for ease of sending, receiving, and storing value in a cryptographic form. It functions much like money, fiat currency–a national currency, USD, or EUR, for example. On the other hand, Ethereum (ETH), the second most widely traded digital currency, includes more complex features, such as self-executing “smart contract” capabilities for more technical, financial transactions.
Some tie their value exclusively to fiat currency, while others link their value to commodity money, the intrinsic value of precious metals, gold, silver, or platinum embedded in a coin. This connects a stable, fixed value to otherwise non-stable cryptocurrencies.
In addition, derivative products based on cryptocurrency add another layer of complexity and diversity, such as crypto-asset funds and trusts and exchange-traded products.
The issuance and governance of cryptocurrencies also vary. For example, the tracking and validation of transactions are not standardized across vendors, markets, or countries. Those responsibilities are often divided to different extents between cryptocurrency issuers and users.
The value of a cryptocurrency can be hard to nail down. No consensus valuation has been established. There are no commonly applied metrics, and pricing may differ among venues. Specifically, cryptocurrencies are not legal tender. Legal safeguards and government backing cannot settle transactions.
A common method of valuing a cryptocurrency is simply to estimate the current market capitalization for each cryptocurrency. This, however, can be highly volatile.
Other methods of valuation are entirely unique to cryptocurrency. The digital asset value can be based on the cost of the electricity used to create, store, and verify each different cryptocurrency. However, this value can be skewed by widely-varying electricity costs in different regions, geographies, or even by global fuel price instability.
To determine a reasonable value for a cryptocurrency, Taube advises risk managers to continually evaluate the widespread complexities and inconsistent valuation approaches. Be highly flexible and adaptable in all buy-sell determinations.
“Regulation will be an ongoing issue, and it will be required, but it is likely to be a slalom course around too little and too much regulation,” Taube warns. But he believes that, like all other market trading, “in the end, the benefits outweigh the fears around further development in finance and other industries.”
An international consensus on regulating the creation of cryptocurrency, trading, valuation, storage, and transfer has not yet arisen–particularly with respect to policing product development and trading. Governments have been inconsistent in evaluating which cryptocurrencies to incentivise, regulate, or even ban. Some cryptocurrency traders have called this “a stormy ocean of unregulated cryptocurrencies.”
For some, however, this spotty environment has created opportunities to test and experiment with multi-featured new cryptocurrencies and advance the ongoing evolution of these assets.
In light of these legal irregularities, Brook Taube advises traders and risk managers who engage in crypto transactions to remain wary of the unusually complex scope of legal and compliance hazards. Diverse trading may be exponentially more risky than mastering a select number.
Ultimately, this must include replacing self-regulation among traders and automated governance with new supervisory and regulatory structures to smooth cryptocurrency’s slalom ride.
While the traditional system of vaults and safes worked well over the centuries for paper and coins, custody of electronic signals and records is quite different, requiring a new kind of infrastructure for digital-only assets.
Brokerage and institutional-grade custody solutions are imperative, along with secure means of transacting and transferring cryptocurrency. These can range from simple digital wallets to complex and highly-bespoke technology. These latter are especially critical for such large volume, high value properties as hedge funds, high-net-worth individuals, and major financial institutions.
In part, the security challenge is being met with public- and private-key encryption systems that track and verify transactions cryptographically. However, these are, by nature, publicly accessible and require strong safeguards. There is no generally accepted standard for settlement and clearing of cryptocurrency transactions.
An additional challenge arises from the fact that they are not legal tender. Crypto cannot be used legally to settle a transaction. The solution is to convert digital assets to legal tender–fiat money–for settlement purposes, then back into a virtual asset.
Price Waterhouse Cooper offers a simple example: “A transaction exchanging BTC with ETH has to be settled in USD, requiring the exchange of BTC to USD and then USD to ETH. While each leg of such a transaction carries a cost…” it represents a solution to another of the challenges of Taube’s “Slalom Course.”
Market traders are continually striving for predictive models in every asset class. However, modeling future cryptocurrency activity or monitoring such parameters as Value-at-Risk (VaR), the Expected Shortfall (ES), or stress testing requires detailed reporting of current and past activity. This database, unfortunately, remains inadequate because of the still-unsettled consensus among the many parameters.
As a result, many risk managers are turning to sophisticated statistical tools like spectral decomposition to model factors that can be fed into pricing, risk, and trading algorithms. However, the outputs, prices, for instance, can be more conjectured than real. Their usefulness–particularly for stress testing exercises–is debatable.
These are only a few of the many challenges facing the ongoing evolution of cryptocurrencies. As an asset class, they have rapidly emerged over the past two decades as a source of both heart-stopping losses and astounding profits. These new opportunities clearly come with new underlying sources of risk. But the demand is rising quickly. It will require a new and unprecedented level of professional analysis and assessment.
Brook Taube warns that this calls for better risk management as the market matures. “The best and most important thing startups and crypto developers can do, Taube advises, “is to hire top-notch advisors and team members who can help them balance compliance with innovation as we continue to navigate this slalom course.”
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