Cryptocurrency Brings New Meaning to Managing Risk

A Brief Look at Speculative Securities

When a security is deemed “speculative,” there is an inherent risk that it may lose interest or principal or both — and many investors rightly tend to shy away from high-risk securities. But, the outcome of any speculative investment is hard to anticipate and may just as easily lead to gain as it does to loss.

For example, high-yield bonds, also called junk bonds, are among the riskiest assets because the companies that issue them generally have very low credit ratings, so these securities have more potential of defaulting than the better-rated corporate-bond issuers. In the late-1980s — the heyday of junk bonds — these debt instruments were called “speculative-grade” or “below-investment-grade” bonds. In addition to their low credit ratings, many issuers of high-yield bonds were in various stages of bankruptcy and it was unclear which companies would make it and which would not. If you invested in a firm that successfully emerged from bankruptcy, you might have made a fortune. However, that would have been hard to do and many investors ended up losing their capital. The uncertainty of investing in a junk bond, even with the use of traditional investment analytical tools — like company history, financials, performance metrics, and market trends — is what made them speculative.

The Evolving Risks of Crypto

The cryptocurrency market is speculative, too, and the returns there can also be quite high, as evidenced by bitcoin’s astronomical ascent from $10,000 to $20,000 USD in less than two weeks in December 2017. And, like the junk-bond issuers of the ‘80s, no one really knows which digital assets will come out on top in the long run. But cryptocurrency trading risks are very different from the ways in which high-yield bonds are risky. Still, crypto risk management is important.

With crypto, so much of the asset class is new and evolving at breakneck speed. We cannot even decide what cryptocurrency is: the IRS views crypto as property and taxes it as capital gains and the SEC believes it’s a security that should be subject to the SEC’s regulations. So, when the very essence of a thing is in question from a regulatory perspective, then it’s easy to default to calling it “risky.” Accordingly, it makes sense to approach cryptocurrency with a degree of caution, as well as excitement.

Speculative Risk-Taking Is a Conscious Choice

Investing is as much an art as a science, and even professional investors are not immune to surprises in the market. One thing investing should not be, however, is a gamble. It’s important to do your due diligence, educate yourself about the assets that interest you, and familiarize yourself with known risks and the crypto exchanges on which you can trade.

Here are some risk factors to consider regarding investing in crypto and creating a crypto risk management process:

• Market volatility: A digital asset’s price can run the gamut of extreme highs and lows in a single day. Moreover, this volatility doesn’t seem to follow a pattern. In this environment, it’s wise to watch the market carefully when investing. It’s also important to have a plan. Decide how much you want to spend on crypto based on your budget, and plan it out ahead of time.

• Market regulation: Depending on who you talk to, the fact that the crypto market is not regulated by any one entity may or may not be an investment risk factor. Some believe that the regulation itself makes crypto risky, while others feel that the advent of more regulations could stifle innovation in the sector. Some risks that could arise because of evolving regulation include consumer protection, the absence of a clear legal venue for adjudicating disputes, and a general lack of clarity about precisely what investors and exchanges can and cannot do. But aside from those who don’t want any controls on crypto at all, most market participants believe that, as with any industry, cryptocurrency needs some standardized regulatory controls.

Perhaps the more salient issue with respect to building an effective crypto risk-management strategy is about not imposing traditional financial language on a new asset class. While crypto can arguably still be characterized as speculative, there is growing consensus that the underlying technology, networks, and crypto assets themselves do indeed have value. How to properly define and quantify that value is a work in progress that will ultimately determine investor’s perception of the risk within the asset class.