Markets
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 talked about is the black Swan risk, says Matthew Hougan, vice president of research and development at Bit by bita cryptocurrency asset management firm based in San Francisco.
A black swan risk refers to the possibility of an unexpected event occurring. 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 Investments)
A black swan event can take many forms within the cryptocurrency industry. For example, Hougan cited an amplification of regulatory risk due to the majority of cryptocurrency trading occurring on exchanges within specific countries. A crackdown on cryptocurrency trading or certain exchanges by governments in those countries could send cryptocurrency prices plummeting.
Ethereum has faced a similar situation until recently. Chinese exchanges accounted for over 90% of trading volumes in its cryptocurrency ether by the end of 2016. The Chinese government’s crackdown on exchanges in early 2017 helped disperse their trading to other exchanges, particularly those in Japan and South Korea.
Cardano is a similar case. It is traded almost exclusively on South Korean exchanges. A single exchange, Upbit, accounted for nearly 70% of the total trading volume in the cryptocurrency as of 22:15 UTC last Sunday.
A technical glitch or a crackdown on cryptocurrency exchanges by the South Korean government could send its price plummeting. There is already a precedent for such an event. Cardano’s price plunged 30% after South Korean Justice Minister Park Sang Ki said the government was preparing a bill to ban cryptocurrency trading on exchanges. (See also: Bitcoin Price Crashes on Fears of Cryptocurrency Ban in South Korea)
Impact on institutional markets
According to Hougan, the black swan risk is part of a “broad 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 protections for customers, while governments and regulatory agencies around the world understand and evaluate the impact of cryptocurrencies on financial markets.
But it’s the impact of cryptocurrencies on institutional markets that interests Hougan, a veteran of the ETF industry.
Several companies have already filed applications with the SEC to launch bitcoin ETFs. But the agency has reacted and expressed concerns. (See also: SEC Blocks Bitcoin ETFs Again.) Hougan (pictured) takes a measured approach to the issue and says the agency’s concerns “resonated” with him.
According to him, bitcoin ETFs based on futures contracts could cause cryptocurrency prices to collapse. As an example, he points to inverse volatility ETFs that have seen their steepest decline recently. That event has had a domino effect on stock markets. (See also: The market is crashing. Please explain what all these words mean)
The possibility of a similar event in cryptocurrency markets is high, especially given the low liquidity and low trading volumes. If they gain enough traction and liquidity, bitcoin ETFs and ETNs could “overwhelm” spot markets, Hougan says.
The other problem with bitcoin ETFs is the lack of physical custody for the coins. Several exchanges have attacked this problem and have started offering custodial services at premium prices for institutional clients. “The ETF is a wonderful vehicle and investors are well served by it, but the SEC has taken a robust and consistent approach,” Hougan says.
In the meantime, briefings for his new job have kept him busy. “Outside of the cryptocurrency community, the level of understanding starts and ends with bitcoin,” he says, adding that it’s important for investors, institutional or otherwise, to broaden their understanding beyond bitcoin.
He says the cryptocurrency space needs significant academic-style research. “It’s kind of true that anyone can launch a stock ETF, but it’s not true that anyone can launch a cryptocurrency ETF,” Hougan said. He says institutional investors are still “struggling” with how to place cryptocurrencies in a long-term portfolio.
Matthew Hougan is also aggressively testing different approaches to product structuring to make access to cryptocurrency markets as easy as possible for segments of the investment community. “How markets are sliced and diced is still uncertain,” 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 author to invest in cryptocurrencies or other ICOs. Since each individual’s situation is unique, you should always consult with a qualified professional before making any financial decisions. Investopedia makes no representations or warranties as to the accuracy or timeliness of the information contained herein. The author holds small amounts of bitcoin as of the date this article was written.