The ever-increasing risks that financial institutions face include market risk, credit risk, and operational risk. As a result, there’s a race to explore the benefits of Block chain technology for its capabilities in improving risk management and operational efficiencies. For example, the distributed ledger technology could allow asset managers to gain a holistic view of trading activity, positions, and mark-to-market reporting.
In order to understand the risks surrounding crypto asset investment, it’s important to first understand the components within any crypto asset fund.
What Are The Components Of A Crypto Asset Fund?
Cryptocurrencies are digital assets that trade off their own Block chain platform. Bitcoin is the most popular for retail investors. However, financial institutions have taken an interest in the Block chain ledger of other currencies such as etheruem for its smart contract technology. Investment interest in these cryptos and the subsequent market risk is largely determined by the safety, validity, and the practical applications of the Block chain technology behind them.
Altcoins are alternatives to Bitcoin in so much that they were originally a modification of Bitcoin’s open-sourced technology. Just as you might come to a fork in the road when driving your car, many altcoins are the digital equivalent of a fork. However, some altcoins operate off their own Block chain platforms like Ethereum (smart contracts) and Ripple (payment platform).
Tokens are an asset class created from an existing Block chain and represent a share of a particular asset. In the financial markets, asset securitization is when a marketable security is created from a group of assets. Tokens are the securitization of an asset on top of an existing Block chain. Tokens represent a fraction of ownership similar to shares in a stock and are issued to raise funds for a development of a project through initial coin offerings (ICOs).
One of the chief concerns of cryptocurrencies is that they’re unknown commodities. There are no financial statements, earnings reports, or financial ratios to study to determine their fair value. Some cryptos are majority-owned by private trusts like Ripple, despite their currency trading publicly following its ICO or initial coin offering last year.
While stocks can be analyzed based on fundamental analysis and risk factors determined, crypto assets have no such fundamentals or risk factors. And with those unknowns comes uncertainty. And with uncertainty comes volatility.
Large swings in the market value of crypto assets can occur and make them at the present moment a highly volatile investment. The volatility of crypto asset funds is largely determined by the price action of the underlying assets.
All of these assets would likely be included in any crypto asset fund given their large market caps. Bitcoin rose by 200%, Ether to 340%, while Ripple gained 1200% near the end of 2017. Like Bitcoin, all three have fallen from their highs.
Any crypto asset fund that included these currencies would have seen unprecedented gains and losses within a few months time. Very few asset classes, if any, have a volatility factor of 20% or more on a frequent basis as in the case of cryptos.
With crypto assets, there’s widespread agreement that regulations need to be created, and enforcement actions need to be increased to protect investors, asset managers, and financial institutions. The regulations should include measures to prevent fraud, money laundering, and funding of terrorist activity.
If fraud and money laundering exist, it’s difficult for fund managers to assign a fair value on the underlying assets and put their reputation and their institution’s reputation at risk by investing in them.
An initial public offering is the issue of public shares of a company to fund business operations and expansion. An initial coin offering is the sale of a digital coin or token to fund development of a project. Just like an IPO, an ICO is used to raise funds from investors.
However, there are distinct differences between the two offerings.
● An IPO has regulatory approval and oversight. An ICO does not.
● An IPO has a private financial history of the firm and performance. An ICO does not.
● An IPO is for long-term issuance. An ICO is typically issued for short-term funding.
● An IPO has exclusivity while an ICO allows public access.
The lack of regulatory approval and oversight is a differentiating factor with ICOs. And with asset securitization on the rise, a major concern is that companies may offer an ICO to bypass the regulatory requirements currently in place for an IPO.
There is no governing institution or exchange presiding over crypto assets. Ethereum is not controlled by the Fed or the European Central Bank whereby financial intervention or controls could be implemented if the market becomes out of balance as with traditional currencies.
The difficulty remains in classifying crypto assets. Are they currencies? Central banks don’t believe so. This explains the mounting pressure from global central banks to ban cryptocurrencies and assets trading on their country’s exchanges.
The broad scope of central bank powers includes managing money supply by expanding supply to boost growth or reducing supply to reduce inflation and temper growth. Central banks also control the value of their currency’s exchange rate, manage reserves for their banking system, and lend to their domestic institutions. Since cryptocurrencies are not attached to any individual central bank, they fall outside the controls of central banks.
Without central bank governance and the lack of regulatory controls in place, volatility and illiquidity are likely to continue with crypto assets.
Originally published at medium.com