Source: The Banker
The spectacular fall in the value of crypto assets over the past year and November's collapse of crypto exchange FTX has highlighted the pitfalls of investing in this market. Michael Imeson explores how the risks are being managed by different players in the crypto ecosystem.
The hazards of owning crypto assets can be considerable, spanning all areas imaginable — from market and credit risk, to operational, cyber, financial crime and regulatory risk. Whether they are riskier than traditional assets, such as shares, bonds, derivatives or property, depends on a range of factors and personal views, but recent events highlight how perilous this section of the financial markets can be.
Just take market risk, the possibility of asset values moving sharply in the wrong direction. Bitcoin, the biggest cryptocurrency by market capitalisation, was worth $20,483 on
November 8, compared with $67,553 on the same day in 2021, a near-calamitous drop of 70%, according to Coinbase, the second biggest crypto exchange by trading volume. Likewise, ether, the second-biggest cryptocurrency, had a very similar percentage drop (68%), from $4181 to $1557.
This scale of collapse has occurred across the market, and is confirmed by Binance, the world’s biggest crypto exchange. It calculates that global cryptocurrency market capitalisation stands at $950bn, down from $3tn in November last year — a more than two-thirds plunge. Since the demise of crypo exchange FTX in mid-November, the market has fallen even further.
‘Crypto assets’, rather than ‘cryptocurrencies’, now tends to be the catch-all term because they are overwhelmingly used as assets to invest in, rather than currencies to transact with. The UK’s Financial Conduct Authority (FCA) defines crypto assets as “cryptographically secured digital representations of value or contractual rights that use some type of distributed ledger technology, and can be transferred, stored or traded electronically”.
Managing the downsides
Of course, crypto assets have their upsides — otherwise they would not have proved so popular. But there are also many downsides. Everyone involved needs to have a sound understanding of the risks and how to manage them — not just the investors and investment managers, but the exchanges, market-makers and other industry players.
Rathbone Investment Management, a London-based provider of investment and wealth management services to individuals, charities, trustees and financial advisers, is typical of many traditional firms in choosing not to invest in, or provide advice on investing in, crypto assets. “They are just too volatile,” says Edward Smith, Rathbone’s co-chief investment officer.
Crypto assets are ‘high beta’, which is a measure of the variation of an asset’s returns relative to the equity market. His analysis has found that cryptocurrency returns correlate with a high-beta factor — a strategy that buys the highest beta stocks in the equity market and sells the lowest, and are therefore akin to a leveraged play on equity risk.
“Investment managers thinking about adding crypto assets to their multi-asset portfolios are most interested in what they will do to the volatility of those portfolios and how they will correlate with traditional assets,” says Mr Smith. “Most cryptocurrencies have a volatility that is five- to six-times that of equity markets. So, in order for them to be an efficient introduction to our portfolios, the expected returns would have to be very high, or have a low or negative correlation with the equities and bonds in the portfolios.”
Greater fool theory
Daniel Murray, deputy chief investment officer of Swiss private bank EFG International, is similarly sceptical about crypto assets. He does not invest in them, nor does he advise his clients — high net-worth individuals around the world — to do so. “The risk is high, as we have seen this year,” he says. “The overriding challenge is that crypto assets are not generally regulated and that causes huge problems."
“For example, a paper published in the Review of Financial Studies in 2019 suggested that 25% of participants and 46% of transactions in bitcoin were for criminal purposes, which says it all,” he adds.
If cryptocurrencies were regulated, they would become “more palatable” to banks like EFG, as it would “remove one of the major risks”, according to Mr Murray. On the other hand, regulation might make them less attractive to many current investors and thus depress market values.
“I think the ‘greater fool theory’ operates to some extent in this market,” he says. “People mostly buy cryptocurrencies for speculative reasons because they think there’s someone else behind them — a greater fool with deeper pockets who’s willing to pay a higher price, even though valuing crypto assets is problematic.”
Digital asset managers
While traditional investment managers are largely wary of crypto markets, a new generation of investment companies are springing up to take advantage of the opportunities. Nickel Digital Asset Management is one of them. Based in London, the firm describes itself as an “alternative asset manager connecting traditional investors with the digital assets market”, and is authorised by the FCA and registered with the Commodity Futures Trading Commission in the US.
Nickel deploys highly sophisticated, low-latency algorithmic trading to pursue a range of arbitrage strategies in both spot and derivative markets, as well as directional products. Its four funds are only for institutional investors with a minimum of $1m to commit. “Our offering allows investors to choose an investment solution matching their personal risk/return profile, depending on where they are on the risk tolerance curve,” says Nickel’s CEO and founding partner, Anatoly Crachilov.
Investors who wish to limit the downside risk and are looking for alpha (absolute returns, without the bet on market appreciation) can choose from the two non-directional funds — Arbitrage fund
and Diversified Alpha fund. The Arbitrage fund has been running at a volatility of just 3.5% since its inception in 2019, while Diversified Alpha runs at a volatility of 6% — both well below the crypto market’s unhedged volatility, which has clocked at around 80% so far this year. The funds target returns of 8– 10% and 15–20% per annum, respectively.
Managing counterparty risk is front of mind at Nickel. The collapse of crypto exchange FTX in November is a case in point. There have been several instances of crypto exchanges being hacked, but Mr Crachilov says the security situation is improving. “Top crypto exchanges are no longer as easy a target for cyber-attacks as they used to be five years ago, as they are hugely profitable. [This] allows them to re-invest heavily in their security infrastructure,” he says.
Providing liquidity to investors is B2C2, a crypto market-maker which trades in around 30 coins. It offers a crypto-native, single dealer, over-the-counter (OTC) platform that provides electronic pricing, execution and settlement. Marc van Eijck, chief risk officer based at B2C2’s London headquarters, is upfront about recent market trends.
“The sell-off we saw in 2022 resulted in several high-profile defaults which, broadly speaking, were caused by failure in risk management,” he says. “While painful, it has been an awakening shock for the industry and it means that the industry as a whole is taking risk management more seriously, which is a good thing.”
However, the risks are many and varied. First, it is complicated to value crypto assets. Second, liquidity risk changes dramatically between exchanges and time of day. Retail investors typically trade on exchange, while institutions also leverage OTC. “Liquidity can quickly disappear as narratives change, especially on exchanges, which has an impact particularly for retail investors and liquidity providers,” says Mr van Eijck. “Unlike traditional assets, crypto trades 24/7, which means you have to manage risk on a 24/7 basis.”
Third is operational risk, which includes cyber hacking and moving assets between exchanges and custodians. Fourth, there is credit risk, with a key question being whether the borrower can post margins at any time of day and any day of the week.
Fifth is regulatory risk. “Crypto regulations are constantly changing and they’re not consistent across countries,” says Mr van Eijck.
He says that B2C2 has a robust risk framework. It incorporates a clearly defined risk appetite, a strong focus on concentration risks, stress testing, a real-time credit risk monitoring tool and capability to call margin that works round the clock. “In addition, we have transaction monitoring, customer due diligence and regulatory compliance procedures,” he says. “Our real-time system is a big benefit; we aren’t just working off the back of Excel spreadsheets.”
Risk management for exchanges
Since FTX filed for bankruptcy, exchanges are even more anxious to demonstrate the safety of their services and operations. Binance, for example, imposes strict position limits on traders to prevent them from exerting undue control over the market and manipulating prices. “Contrary to many of our competitors, we are prudent in terms of setting risk parameters,” says Catherine Chen, Binance’s head of VIP and institutional business.
“We keep a balance so that orders get filled, but don’t overload us with risk. We keep leverage within a manageable spectrum to prevent systematic risk. Clients often ask us why — considering how much bigger we are than other exchanges — are our position limits the same or smaller. Our answer is that we want to make sure the lights are always on. We are here for the long haul.”
Binance issues loans to institutional clients so they can leverage their investments, but takes a careful approach to credit risk. In recent months, a few crypto lenders have gone bankrupt and Binance wants to avoid going the same way. “We never issue collateral-free loans, unlike some of our competitors, and we usually require borrowers to over-collateralise while still allowing them to utilise the collateral,” says Ms Chen.
“We have a comprehensive operational risk monitoring procedure to avoid challenges like outages, so we can operate as smoothly as possible,” she continues. “We keep a close tab on cyber risk and financial crime risks, like money laundering and sanctions violations.”
A new exchange set to launch in early 2023 is Archax, the UK’s first FCA-regulated global digital securities exchange, brokerage and custodian. It will focus on regulated products known as ‘security tokens’ — digital assets that represent ownership of traditional assets, such as shares or bonds. But it will be possible to trade unregulated cryptocurrencies (what the FCA calls ‘speculative tokens’) such as bitcoin on the exchange.
Archax is primarily for institutional investors who want to branch out from traditional assets into blockchain-based assets. They will be able to buy and sell digital assets and use Archax’s regulated custody service for safekeeping. The platform will also operate as a primary market, with organisations able to issue new digital securities. Retail investors are not allowed to trade security tokens because of the FCA regulations, but will be able to use Archax to trade unregulated cryptocurrencies.
Risk management is a high priority, says Simon Barnby, Archax’s chief marketing officer. “As part of our regulatory requirements, we have to maintain a register of all the risks that could affect the business and show how we mitigate them,” he explains. That includes anti-money laundering and know-your-customer requirements to prevent financial crime.
“Although we cover unregulated instruments like bitcoin, we treat them in the same way as the regulated instruments, which provides protection for us and clients,” he adds.
Customer due diligence
The financial crime risks associated with crypto assets are a concern for governments and regulators. “This year there has been a significant increase in the use of cryptocurrencies in trying to evade and circumnavigate US sanctions, especially after the conflict in Ukraine,” says Andrew Pimlott, a Dubai-based senior managing director and financial crime investigator at US firm Ankura Consulting.
“The US Treasury issued a warning in September on Russia’s efforts in using cryptocurrencies to evade sanctions,” he says. In March, Bloomberg reported that the US Justice Department had created a new task force to investigate and prosecute people and financial institutions, including crypto exchanges, that aid Russians in hiding their assets from sanctions.
Mr Pimlott says: “There is a risk that ordinary crypto investors may get inadvertently involved in transactions involving illegal money, either by participating in a non-regulated crypto fund or transacting with a sanctioned individual or organisation.”
“Investors should be wary of transactions coming from countries that don’t follow the Financial Action Task Force (FATF) recommendations,” he adds. The FATF is the intergovernmental body that sets policies to combat money laundering and produced an update on this work in June.
Taming the Wild West
Official attitudes to crypto assets vary from country to country, from total or near-total bans to acceptance with the right regulatory controls in place, and even approaching positive encouragement. The US sits somewhere in the middle while tightening the rules. In its October ‘Report on digital asset financial stability risks and regulation’, the Financial Stability Oversight Council concluded that crypto asset activities could pose risks to US financial stability and should be better controlled.
“This report provides a strong foundation for policy-makers as we work to mitigate the financial stability risks of digital assets while realising the potential benefits of innovation,” said Janet Yellen, secretary of the Treasury and council chairman at the time.
The report recommends better enforcement of existing laws on the crypto asset ecosystem and closing “regulatory gaps” by, for example, giving federal regulators rule-making authority over crypto assets that are not already classified and regulated as digital securities.
The EU is also taking action. Its Regulation on Markets in Crypto Assets should come into force in 2024, giving the European Securities and Markets Authority (ESMA) and the European Banking Authority powers over companies providing crypto asset services, such as trading, lending and custody.
ESMA’s October report, ‘Crypto assets and their risks for financial stability’, said “continuous monitoring of the crypto asset market and its interconnectedness with the wider financial system” is necessary to assess “newly emerging threats”.
Fabio Panetta, an executive board member at the European Central Bank, is more forthright. In a speech in April, he said: “Crypto assets are bringing about instability and insecurity”, giving rise to “a digital gold rush” comparable to the 19th century gold rush in the US and “creating a new Wild West”. Policy makers should not allow crypto assets and the associated risks to proliferate unchecked, and “must decide how to regulate them”.
His assessment of the market may be hyperbolic, but crypto assets are definitely expanding the frontiers of finance. It is only prudent that the law keeps pace and the sheriffs keep watch.
More than just a liquidity provider, B2C2 is a digital asset pioneer building the ecosystem of the future.
The firm has unlocked institutional access to crypto by providing reliable liquidity across market conditions. B2C2’s success is built on crypto native technology and continuous product innovation, making it the partner of choice for diverse institutions globally.
Founded in 2015 and majority owned by Japanese financial group, SBI, B2C2 Ltd is headquartered in the UK, with offices in the US and Japan.
B2C2 Ltd is registered in England and Wales under company number 07995888 with its registered office at 86-90 Paul Street, London, EC2A 4NE. B2C2 Ltd is the parent company of the B2C2 group of companies. Products may be provided by different members of the B2C2 group of companies, depending on the jurisdiction of the client and the regulatory status of the product and/or B2C2 group member. B2C2 is a registered trademark.
Sign up to our news alerts to receive our regular newsletter and insights into the crypto market direct to your inbox.