The Black Swan Risk In Cryptocurrency Markets

As most investors have already discovered, there are several risks associated with investing in cryptocurrencies. But one that is not often discussed is the black swan risk, says Matthew Hougan, vice president of research and development at Bitwise, a San Francisco-based cryptocurrency asset management company. 

A black swan risk refers to the possibility of the occurrence of an unexpected event. The term was first popularized by Nassim Nicholas Taleb, an economist and professor at NYU. According to him, a black swan risk has three attributes: rarity, extreme impact, and retrospective predictability. (See also: Black Swan Risks And Investment.) 

A black swan event can take on several forms within the cryptocurrency industry. As an example, Hougan cited a magnification of regulatory risk due to a majority of cryptocurrency trading occurring on exchanges within specific countries. A clampdown on cryptocurrency trading or on certain exchanges by governments in such countries could crash the virtual currency’s prices. 

Ethereum faced such a situation until recently. Chinese exchanges accounted for more than 90% of trading volumes in ether, its cryptocurrency, until the end of 2016. The Chinese government’s crackdown on exchanges at the start of 2017 helped disperse their trading to other exchanges, notably to ones in Japan and South Korea.

Cardano is a similar case in point. It is traded almost exclusively on South Korean exchanges. A single exchange - Upbit - accounted for almost 70% of overall trading volumes in the cryptocurrency, as of 22:15 UTC this past Sunday. 

An exchange glitch or a crackdown on cryptocurrency exchanges by the South Korean government could crash its price. There is already a precedent for such an occurrence. Cardano’s price crashed by 30% after South Korea’s Justice Minister Park Sang Ki said the government was preparing a bill to ban crypto trading through exchanges. (See also: Bitcoin Price Crashes On Fears Of South Korea Cryptocurrency Ban.) 

Impact on Institutional Markets

According to Hougan, the black swan risk is part of a “large and exogenous” regulatory risk that has already produced results within the cryptocurrency ecosystem. For example, cryptocurrency exchanges have adopted self-regulation to prevent hacks and ensure minimum safeguards for customers while governments and regulatory agencies around the world understand and assess the impact of cryptocurrencies on financial markets. 

But it is the impact of cryptocurrencies on institutional markets that interests Hougan, a veteran of the ETF industry.

Several firms have already filed applications with the SEC to start bitcoin ETFs. But the agency has pushed back and expressed concerns. (See also: SEC Blocks Bitcoin ETFs Again.) Hougan (pictured) has a measured take on the matter and says the agency’s concerns “resonated” with him.

According to him, bitcoin ETFs based on futures contracts could crash cryptocurrency prices. As an example, he refers to inverse volatility ETFs which recorded their steepest drop recently. That event had a domino effect on stock markets. (See also: The Market Is Crashing. Please Explain What All Of These Words Mean.) 

The possibility of a similar occurrence in cryptocurrency markets is high, especially given the low liquidity and trading volumes. If they gain sufficient traction and liquidity, bitcoin ETFs and ETNs could "overwhelm" spot markets, says Hougan.

The other problem with bitcoin ETFs is the absence of physical custody for coins. Several exchanges have attacked that problem and begun offering custody services at premium prices to institutional clients. “The ETF is a beautiful vehicle and investors are well-served by it but the SEC has taken a sound and steady approach,” Hougan says. 

Meanwhile, the brief at his new job has kept him busy. “Outside of the cryptocurrency community, the level of understanding starts and stops with bitcoin,” he says, adding that it is important for investors, whether institutional or otherwise, to broaden their understanding beyond bitcoin.

According to him, the cryptocurrency space needs significant academic style research. “It's sort of true that anyone can launch an equity ETF, but it’s not true that anyone can launch crypto ETFs,” Hougan said. He says institutional investors are still “grappling” with the positioning for cryptocurrencies in a long- term portfolio.

Matthew Hougan is also aggressively testing out different approaches to product structuring to make accessing cryptocurrency markets as easy as possible for swathes of the investment community. “How the markets are sliced and diced is still up in the air,” he says.

Investing in cryptocurrencies and other Initial Coin Offerings ("ICOs") is highly risky and speculative, and this article is not a recommendation by Investopedia or the writer to invest in cryptocurrencies or other ICOs. Since each individual's situation is unique, a qualified professional should always be consulted before making any financial decisions. Investopedia makes no representations or warranties as to the accuracy or timeliness of the information contained herein. As of the date this article was written, the author owns small amounts of bitcoin.

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