Any physical, intangible, financial or non-financial investment has an element of risk associated with it and an investor can either accept the risk, try to mitigate it or avoid it entirely. However, to do any of these, the risks must first be understood.
The same applies to the investment of digital assets such as cryptocurrencies, where investors have been able to generate significant returns through various revenue streams including trading, decentralised finance (DeFi) and arbitrage opportunities.
Cryptocurrencies are extremely volatile assets and are well-known for their ability to generate potentially high returns – which could just as easily result in significant losses.
The market risk associated with cryptocurrencies is a direct result of their volatility, global political and regulatory impact, borderless demand, and an always active market. Although these risks are mostly understood by many who enter the market, little to no thought is usually given to certain other risks associated with a specific cryptocurrency.
Self-sovereignty – good or bad?
Bitcoin and other cryptocurrencies were designed to allow financial self-sovereignty, but even with this autonomy, there are major risks involved.
Investors can take self-custody of their digital assets through platforms such as offline hardware wallets or similar solutions. However, being in charge of your security has its own risks, such as a possible loss of access, if something goes wrong. Should an investor lose their private key (password) or its back-up, then their investments could very well end up joining the other 3.76 million bitcoin worth $75 billion (more than R1.3 trillion) that have been lost forever due to the private key displacement.
Many mitigate the risk associated with self-sovereignty by holding their digital assets within a trusted third-party custody solution, an over the counter (OTC) desk, or a cryptocurrency exchange. Yet the use of third-party custodians comes with its own risks, such as being a single point of failure where funds can be misappropriated by management, siphoned by hackers or have its access impaired by the virtual asset service provider itself. There are, however, a variety of reputable custody solutions available and many provide insurance to mitigate the possible financial risks.
Codes: what could go wrong?
Blockchains, cryptocurrencies and smart contracts are built on strings of code that contain rule sets associated with the relevant blockchain, cryptocurrency and smart contract. For the most part, these differ vastly from one another and their peers.
Contained in these strings of code is yet another risk; the possibility that these rule sets (referred to as protocols) contain errors. These oversights can be exploited by the unscrupulous, as we saw with the DAO hack back in 2016, where $60 million of ether (ETH) was stolen. Another example was the TerraLuna debacle that wiped $45 billion off the cryptocurrency market within a week.
Investors therefore need to conduct the necessary due diligence to holistically understand their investment, before purchasing the cryptocurrency or placing funds in a smart contract.
Rehypothecation and cryptocurrency
The integration of cryptocurrencies into the traditional financial services sector and the evolution into various yield-bearing products has brought counterparty risk to the table, as well as those associated with rehypothecation
Rehypothecation is a term derived from the traditional financial services sector and is not a new concept. This is where a financial institution invests customer funds by not directly collateralising their assets, but rather reinvesting them into other assets.
This has potential risks and rewards for both the investor and the service provider, but more so for the investor. There is, therefore, an expectation that virtual asset service providers rehypothecating funds should only be allowed to do so under very strictly regulated conditions, which are imposed on banks and other intermediaries.
An example of possible counterparty risk:
Let’s say a cryptocurrency product provided a yield of 10%. A second service provider invests funds into the same product, taking a 2% margin off the original 10% and passing the remaining yield onto their customers.
These customers then do exactly the same, until a point where the yield is no longer attractive.
In addition, if something were to go wrong with one of these intermediaries in this line of reinvestment, then it would have a knock-on effect on the ultimate retail or institutional investors.
We saw this in the case of Celsius, which filed for bankruptcy in the United States, which rippled through the cryptocurrency market.
With regulation on cryptocurrencies being in its infancy, it becomes paramount that investors read their terms and conditions and examine their investment products to determine their level of exposure from a counterparty and rehypothecation risk perspective, then decide whether this is acceptable to their risk appetite.
Additional risks that are overlooked
Lower market capitalisation and lesser-known cryptocurrencies have often seen significant profits, very similar to penny stock trading.
However, these smaller alternative cryptocurrencies are at risk of being manipulated due to their low market capitalisation and could also potentially have liquidity issues should an investor decide to sell the asset and find there is no demand from buyers.
There are also thousands of investors who have been victims of cryptocurrency scams that had nothing to do with the asset class.
Scammers were merely window-dressing their fraudulent operations under the guise of ‘cryptocurrency’, due to the general lack of understanding around the product, technology and market, and the often mistaken perception that cryptocurrencies will generate high returns within a short timeframe.
Read: Moneyweb reader embarrassed to have fallen for crypto scam
The only possible way to mitigate your risk is to consider your exposure, increase your scepticism and educate yourself.
Cryptocurrency and blockchain technology can revolutionise the financial services sector and it’s paramount that investors educate themselves to understand the technology and its associated risks, especially now that the asset class is a regulated financial product in South Africa.
The risks highlighted are not to discourage investors from investing in cryptocurrencies, but rather to encourage them to educate themselves on this unique asset class. This will allow them to mitigate their risk while reaping the potential rewards that this revolutionary technology has to offer, putting them a step ahead of their peers.
Wiehann Olivier is partner and digital asset lead at Mazars in South Africa.
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