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Digital Assets & Risk Management

Digital Assets & Risk Management

Cyber Security and Hacking

Yes, I’m afraid this time it is different.

With the cyclical digital asset boom and bust cycle now a few churns in, a world once made up of libertarians and other “separatists” has attracted the very antithesis of these players, traditional financial companies. 

And these are not fringe or small players, they are the really big guys, the household names that everyone recognizes. 

As these newer, but very substantial, entrants begin to multiply their products and services in the digital asset space, I’ve been very interested to see how they are thinking about the risk management around these various offerings.

Risk management is something I’m very familiar with, having been the CRO for one of the largest brokerage firms and clearing firms in the US. 

As I consider the multitudes of questions that we were asked to answer, uncover, or weigh in on, for all types of asset classes and products, my interest lies with how digital assets are being considered.  This is not only from an accounting perspective, there are no shortage of agencies, accounting practice organizations, and lawyers willing to offer their perspective. 

But from the perspective of developing and distributing products and services, as well as the management of the in-house portfolios, that will be utilized (potentially) by both institutional and retail clients.

From research produced by me and colleagues, as well as many others, we recognize the fact that digital assets behave very differently than most other asset types. 

Bitcoin ETFs: Measuring the Performance of This New Market Niche by Alessio Brini, Jimmie Lenz :: SSRN

With this being the case, utilizing the same methodologies and procedures to assess risk on say an equity for a digital asset would be fraught with issues.  In addition to considering new assessments, there is the issue of understanding how these may positively or negatively correlate (if they do) with other assets held by clients or a firm. 

These “assets” go far beyond the traditional assets, e.g., equities, fixed income, etc. to include assets like personnel resources, computational run time, settlement, and a myriad of not so sexy functions that most people only see when they fail. 

For example, most brokerage firms operate on computer systems that nobody touts as “state of the art,” to add significant amounts of computational processing time would be significant, besides all of the work to front end systems.

The ability to understand and assess risk is paramount to any financial firm and must occur prior to the ubiquitous “pricing of risk”. 

This understanding is important to all sides of the equation, from the development of a product to the assessment of who should be able to purchase the product, how much, and under what terms. 

During my tenure at this very large retail-oriented firm with millions of clients, thousands of financial advisors and over a hundred clearing firms, what seemed to be very simple questions, often had dozens of features that had to be accounted for. 

And keep in mind these products were almost always based on very well-known assets with decades of accurate detailed data, ever try pulling data on even the most actively traded cryptocurrency? 

This is not to say that the task is impossible, or insurmountable, it is to say that the task is at hand and needs to be considered now.  Developing the measures needed to understand how various digital assets need to be accounted for in products already being offered is a quite pressing need, in particular given some of the limiting factors mentioned.

To address the question many readers will have, “are these really that different?” Consider this, can you unequivocally tell me if digital assets have a time value?  If not, then this very basic premise used in pricing almost any asset is clearly moot.  If yes, then it must have a risk-free rate of return, what exactly would that be. 

Certainly, there are no sovereign debt associated with digital assets that we normally look to when referencing a risk free rate.  While this may seem academic, it is anything but, as this is the basis on which much of the risk controls and measures rely on.  Even basic pricing of assets and derivatives need these types of inputs, so if these aren’t available or are not pertinent new methods must be developed and tested.

The digital asset space itself is quite nascent, so it isn’t surprising that sophisticated methods and techniques for assessing various risk factors have yet to be developed. However, the ball is starting to roll more quickly and the next generation of risk controls that include this emerging asset class need to be a primary concern for those in industry, as well as those teaching the next generation in universities around the globe.

Digital Assets & Risk Management

Written by

Jimmie Lenz

Lenz
Duke Professor & Executive Director of Duke’s Master of Engineering in FinTech Dr. Jimmie Lenz