Navigating Risk: Best Practices for Managing Crypto and Digital Asset Investments
The crypto and digital asset market operates 24 hours a day, 7 days a week, 365 days a year. Without proper risk management, institutional firms become susceptible to the risk of financial loss by way of misappropriation of assets.
Three Key Risk Areas
Here are three key risk areas both individuals and organizations should be aware of for best practice and proper risk management.
Counterparty Risk
Counterparty risk is the possibility of financial loss due to one party in a transaction not fulfilling its contractual obligations. Institutions can reduce this risk through diversification of their custodial, trading, and exchange relationships. Knowing your counterparties and how they operate and having more than just one also helps reduce counterparty risk. Institutions may want to consider each of the following:
- Diversify the crypto exchanges on which your organization trades. If one exchange closes its doors, you have alternatives. Additionally, many exchanges offer similar tokens and trading options, so there are multiple exchange options available to users.
- Trade only with trusted and reputable counterparties. Never send digital assets to a wallet address you don’t know and have verified with the ultimate recipient.
- Perform due diligence procedures on each counterparty. Understand the policies, procedures, and insurance policies (if any) they have in place.
- Maintain a good working relationship with contacts at each counterparty. Ask questions to ascertain how healthy or unhealthy the counterparty’s business is.
- Know who your counterparties work with. If a counterparty significantly depends on one or two other parties, it could pose vulnerabilities.
- Be aware of settlement times. Some trading desks may settle immediately, while others enforce T+1 settlement. Follow up with the counterparty if the agreed-upon settlement window is closing.
Exchange Risk
Exchange risk exists partly as the possibility that an exchange suddenly halts withdrawals. There have been a handful of examples where users of third-party digital asset custodians suffered a significant financial impact, whether it be a result of insolvency, cybersecurity vulnerabilities, or bad actors. It is critical to always perform sufficient due diligence before onboarding your assets to these third parties. Some additional advice to offset exchange risk could be:
- Never put all your eggs in one basket. Distribute assets under management across different venues.
- Set risk thresholds for holding assets on exchange. For example, hold no more than 15% of total assets under management on exchanges at one time
- Move assets off exchange to non-exchange custodial wallets or self-custody wallets. Holding your own keys to cold or offline wallets helps to establish control over your crypto.
- Develop and maintain an emergency exit strategy from each exchange. Not every crypto asset is available to custody or trade at every provider in the space.
- Establish potential off-exchange settlement relationships.
- Keep your ear to the pavement. Stay in touch with your network and be aware of the current market conditions.
Regulatory Risk
Regulatory risk exists as the uncertainty surrounding both the present and future state of the crypto and digital asset economy. Regulatory risk in crypto covers a wide range of topics, including financial reporting requirements, marketing, and products that may soon go to market. Managing regulatory risk, at its core, comes down to staying informed. Organizations should consider the following:
- Prepare for fair value measurement coming to crypto assets. The FASB is expected to approve and release its final language on this topic before the end of the year.
- Stay current on Bitcoin Spot ETF applications and/or approvals from the SEC, where a decision is expected to be made in the near future.
- Get involved and stay engaged in the ongoing conversation regarding crypto regulation, as this is undoubtedly a prevalent topic with governmental agencies and other regulatory bodies.
As digital assets continue to emerge and potentially become a part of an organization’s normal operations, it is evident that there are multiple risk components you should be aware of. As the industry matures, new risks could arise, so it is critical to stay educated and aware of economic conditions to ensure you are managing your risk profile in accordance with your organization’s policies.