Risk Management in the New Frontier of Digital Assets
What a year it’s been in digital assets! While the headlines skew negative, the press has often overlooked important technological and user experience enhancements across the space. However, it can’t be denied that token prices have undergone considerable swings, and this can deter widespread adoption. In fact, over 50% of institutional investors say concerns over volatility are a “significant barrier” to getting involved in the digital asset sector.
Could it be that volatility is a feature of crypto, rather than a bug?
It’s true that some token values can fluctuate wildly, but this presents great possibilities for profit. Though, if this price action isn’t fully understood or leverage is employed then significant losses can occur.
Opportunity and risk are two sides of the same coin. As with any investment, institutions need to understand the potential hazards involved with digital assets and conduct significant due diligence.
Given that this asset class is relatively new and pockets of its spreading adoption have been controversial, there are unique considerations for those contemplating digital asset enablement.
Types of Risks to Consider
Relatively light government oversight has been a double-edged sword for the digital asset ecosystem. Many unburdened teams have been able to carry out fascinating experiments. While the potential for innovation and high returns have attracted significant sums of capital, operating in a sector that is still maturing and subject to imminent regulation requires a careful approach.
Institutions enabling digital assets need to be cognizant of nefarious actors. New technologies take time to become “battle tested” and sometimes this process involves breaches which can expose assets or data. If clients can move their assets off the institution’s platform, then it’s important that they’re sufficiently educated regarding the prevalence of scammers who present get-rich-quick and phishing schemes. As we’ve seen in recent years, these can go undetected in a loose regulatory environment.
Authorities are taking steps to protect investors. In September, the White House released its first-ever comprehensive framework for the development of digital assets. Other government agencies such as the Securities and Exchange Commission (SEC) and the Office of the Comptroller of the Currency (OCC) provide frameworks, guidance, and information on the use of digital assets. Canada recently entered into consultations with crypto industry stakeholders to examine the digitalization of money as part of a formal legislative review. The European Union’s Markets in Crypto-Assets (MiCA) has retail protection at its core, as well.
While there are some guardrails in place, it remains to be seen how the new rules will come into effect in practice. A tightened regulatory environment will likely have a positive effect on institutional digital asset adoption, but it’s also important to keep in mind that any time there are changes to laws it can impact business models and the overall market landscape.
Other risks include:
Operational risk: Inexperienced users are prone to data entry errors or scams, which can result in lost funds given blockchain transactions are irreversible. However, there are new technologies that can help mitigate these hazards.
Security risk: Stakeholder education is essential. If the proper precautions are not taken, transacting with poorly coded interfaces can leave institutions open to cyber-attacks and theft. Since the digital asset space is nascent, operates relatively unregulated, and holds the potential for high returns, it’s a prime target for hackers and fraudsters.
Liquidity risk: The market is highly volatile which can lead to periods of significantly reduced liquidity. Investors should be mindful of this while evaluating assets and trading partners.
Valuation risk: Evaluating digital assets is complex and can be very different depending on the category. It’s important to ensure you’re using the right valuation method. In fact, 37% of institutional investors polled by Fidelity said that a lack of fundamentals for gauging appropriate value posed an obstacle to getting involved in cryptoassets.
Managing Digital Asset Risk
Education is a primary consideration for any organization looking to incorporate digital assets within their business. The knowledge gained by seeking to thoroughly understand the budding digital asset ecosystem provides executives with critical insights to help shape their strategy. Further, a deep understanding of the risk and rewards of engaging with this emerging asset class can form the basis for maintaining strong conviction during periods of heightened volatility.
Aquanow Principal Sebastien Davies presented a unique mindset around risk management in his Digital Dives when he said: “I think we’d be well-served to reframe the common perception of risk as something to be avoided and consider it as the fee paid for earning a return.”
It pays to be calculated. If risk is the fee paid for earning a return, you want to make sure you’re not overpaying. Some choose to avoid any risk and steer clear of digital assets altogether. However, this avoidance behavior could result in the enterprise being left behind in a rapidly changing world fueled by new technologies.
Ultimately, successful digital asset risk management stems from education and management of behavioral bias. Digital assets help diversify the traditional basket of equities, fixed income and common alternatives within a portfolio. For financial institutions, enabling clients to interact with these assets provides another source of revenue and engagement. These benefits come at the cost of additional research. Capital allocators must holistically understand the elements of an investment thesis, which goes beyond comprehension of the technology and what could go right. It also includes a sober look at the competitive, regulatory, and operational threats.
If this sounds a bit daunting, then remember you don’t have to go at it alone. Aquanow has partnered with hundreds of institutions to provide their clients access to the digital asset ecosystem. Our expertise can help optimize your journey.
Interested in learning more? We dive deeper into the trends driving digital asset adoption, how to manage risk, and everything else financial institutions need to know about the growing market in our latest report.
Download our Digital Assets Primer for Institutions to learn how to safely get in on the action.
Ready to take the next step? Contact us. Working with a trusted intermediary that is well-versed in digital assets can help protect you and your clients.