Blockchain’s primary function is as a distributed ledger, with copies of the database stored across multiple computers. While it may turn out to ultimately have its greatest use elsewhere, the blockchain’s most successful implementation thus far has been with digital assets. As of mid-November, there are more than 14,000 digital currencies with a market capitalization around $2.7 trillion, according to CoinMarketCap.
If you’re considering exposing your firm or institution to this asset class, here are some of the major risk factors you should be aware of:
Volatility: For anyone holding Bitcoin, it is not a stable store of value, and that would also apply to all the other non-stablecoins on any of the networks. Prices can fluctuate wildly on any given day.
Operational risks: Recall the infamous Mt. Gox heist in 2014, which wiped out a substantial portion of the market capitalization of Bitcoin. This was not theft in the traditional sense. The Mt. Gox hack was what’s known as a suicide hack, meaning that somebody wasn’t stealing the assets — users could just no longer claim the asset on the blockchain. There was a hack on the Poly Network this year for $610 million (although the hacker returned the funds). It seems as if this problem is unavoidable. This problem might not go away even if the government were actually backing a digital asset.
Fraud: There’s been quite a lot of outright financial fraud with initial coin offerings, the method in which most new tokens come to market. The Wall Street Journal in 2018 did an analysis of 1,450 token offerings and found that 271 raised distinctive red flags, which is that in many cases, the ICOs were simply ported from one asset to the next. Someone would just take the ICO, change the name of the token and the title, and offer it as a security to market participants.
Dead coins: SEC Chairman Gary Gensler said he didn’t see a possibility of 5,000 or 6,000 digital assets competing successfully in the marketplace. He thought there would be some winners and losers. Gensler’s prediction is, of course, already correct, because even though the blockchain began to explode only in 2017 with the ERC20 standard, there are already more than 1,000 dead digital assets. Dead digital assets are not just risks, but in fact might have been expected to be volatile in value. We have seen a number of failures, even in the stablecoins space, particularly those linked to gold rather than to the dollar.
Collateralization: There have been major concerns about the collateralization behind digital assets. There was the claim among the leading digital stablecoin Tether going back to 2019 that it was always backed 100% by reserves. This turned out to not be true. Tether was fined by the government. There was also an academic study showing that Tether’s price had been manipulated in order to support Bitcoin. Many people thought until recently that the stablecoin USD coin was going to avoid some of the collateralization issues associated with Tether. But in July 2021, an auditor’s report showed the collateral was not properly stated. There are other coins, although not quite as popular, in which there haven’t been issues. Gemini, backed by the Winklevoss brothers, has been much more transparent than some of the other so-called stablecoins, for example.
Power consumption: Both Bitcoin and Ethereum are very energy- and carbon-intensive when it comes to transferring assets. Based on recent estimates, Bitcoin mining alone is generating approximately 75 million tons of CO2 equivalent, as much as the carbon footprint of all of Colombia. The electricity used just for Bitcoin is the same as the entire usage of Malaysia. A single Bitcoin transaction could power a U.S. household for 59 days. There are attempts to try to transition Bitcoin to a proof-of-stake concept, which would randomly assign a transaction to a given miner. Others would just simply have to verify the transaction. This might dramatically reduce energy usage.
Fee prices: In Q2 2021, there were $497 million in fees for stablecoins, yet the amount of transfers was also growing. There is an attempt through the so-called Ethereum 2.0 technology to reduce these fees, but there is an inherent problem in the process of Bitcoin and Ethereum mining and transfers, which is the same technology that creates new tokens. As Ethereum or Bitcoin get more expensive, transactions also get more expensive.
Government crackdowns: A constant threat to digital assets is what happens if a good portion of the network is taken down either for operational risk or for reasons relating to a government crackdown. By looking at the hash rate (processing power), there was a 25% reduction in capacity on the Bitcoin network after China cracked down on mining. Capacity has begun to slowly rebuild through relocation, but this is a serious threat.
Time: A key thing about digital asset trading on markets such as Coinbase: it is truly a 24/7 market. Those considering entering this space should understand that this will require a trading desk that’s staffed 24/7.
High-frequency trading: Recent estimates suggest high-frequency trading activity in ranges similar to what we’re seeing in the United States equity market, somewhere in the neighborhood of about 30% to 40%. Exchanges in this case offer collocation, meaning the ability to trade at high frequency, and customers are certainly taking advantage of it. There have been numerous flash crashes in the exchange-traded space in which liquidity has been broken down, meaning the exchange is no longer available to trade, or bid-ask spread has widened to the point where it’s not feasible to trade. These markets are still struggling with first-order questions relating to the availability to trade.
An interesting thing here from my own research is that we’re seeing high-frequency trading in stablecoins. What that indicates is that traders are using stablecoins as ways to momentarily withdraw their assets from the risky exposures, but still have them available for immediate trading, should a new opportunity exist.
Prices: Should you start to trade on any of these digital asset platforms, the primary risk is that you’re not necessarily always seeing the best prices. In the time we studied the market, Coinbase was the most liquid. That remains true, but Binance would probably have to be in here as well for most assets. Certain exchanges are not always at the best price at the same time. Anyone trading actively in this particular market would need to build a consolidated book. Some private offerings are now enabling that. Our research found that Kraken offers a better price than Coinbase.
These are some of the risks when trading in digital assets, but a key thing to keep in mind is that the digital asset network, despite claims to the contrary, is not mystical. It’s extremely transparent. This is indeed something that can be to your advantage.
Dr. Bruce Mizrach has been a Professor of Economics at Rutgers University since 1995. Mizrach has held appointments at Boston College, the Wharton School, the Federal Reserve Bank of New York, and the Stern School of Business at New York University. Dr. Mizrach is the founder and Editor of Studies in Nonlinear Dynamics and Econometrics, which is devoted to using nonlinear analysis to understand economic and financial markets.
This financial industry article is adapted from the GLG Webcast “Risks & Trends in Digital Assets.” If you would like access to events like this or would like to speak with financial industry experts like Bruce Mizrach or any of our approximately 1 million industry experts, contact us.