What risks are specific to the cryptocurrency sector?

In Insights

Conventional financial institutions are expected to quantify risk factors like market risk, liquidity risk, operational risk and so on.

Crypto exchanges that started as part of the fintech boom are themselves quickly becoming financial institutions, creating a need to monitor risks that are inherent to cryptocurrencies.

In this report, we will look at some of the risks associated with cryptocurrency.

A risk framework

We may consider applying a conventional risk framework to cryptocurrencies as cryptocurrencies are exchanged in an open market through crypto exchanges.

However, there are a number of issues that are specific to the decentralized nature of cryptocurrencies that do not exist in the context of traditional finance.

For the purposes of this report, we can refer to those risks specific to cryptocurrency as "decentralization risks".

Firstly, let’s look at network attacks. The 51% attack may be one of the most well known of these. When successful, network attacks enable attackers to compromise a blockchain network’s operational sovereignty.

A blockchain network that has a relatively low level of activity, or hash rate, coupled with a cryptocurrency traded at a relatively high price in the market will tend to be the target of network attacks.

A low hash rate makes an attack easier while the units of cryptocurrency stolen will give the attacker substantial profit.

51% attacks are therefore more likely to happen to the kind of cryptocurrency with a discrepancy between system-based metrics measured in hash rate and financial market-based metrics measured in price.

Besides network attack risk, there may be a risk that transactions can be reversed due to the consensus algorithm in use. An overload in activity can sometimes lead to a blockchain reorg where what was thought to be a valid block turns out to be an invalid block within the blockchain network. Bugs could also be hidden in the code, potentially disrupting the operation of a network.

This can be considered similar to decentralized liquidity risk or a kind of fund processing risk.

We saw in the Bitcoin Cash hash war last year that when hard forks are initiated too frequently or carried out against a background of fierce disagreement, the price of the cryptocurrency is significantly affected. In that sense, political conflicts around hard forks are also a risk.

When the funding runs out

Many decentralized projects are driven by development organizations. This can be problematic, as we saw when Ethereum Classic developers dissolved the ETCDEV group citing financial difficulties. The result was that the price of Ethereum Classic dropped.

In the case of Ethereum Classic, it was reported that the financial difficulties were caused by the decline of cryptocurrency prices across the market. This means that there can be a sort of interaction or chain risk between the cryptocurrency market and a decentralized token and its project.

The above are just a few examples of decentralized risks in cryptocurrency. We can conclude that risk management necessitates adding various risk elements related to the decentralized nature of many cryptocurrency projects in addition to the conventional financial risk management framework.

This content is not financial advice and should not form the basis of any financial investment decisions nor be seen as a recommendation to buy or sell any good or product. Trading cryptocurrency is complex and comes with a high risk of losing money, particularly if you trade on leverage. You should carefully consider whether trading cryptocurrencies is right for you and take the time to learn how trading works and decide how much money you are prepared to lose.

WRITTEN BY

Liquid

Providing liquidity for the crypto economy.