If crypto assets are shaking up finance, how do you stabilize risk?

For the past few years, cryptocurrencies have been transforming the financial landscape like no other asset before. Back in 2009, Bitcoin debuted as the cryptocurrency breaking away from monetary systems. Its initial value was virtually negligible, but by 2021 Bitcoin’s market capitalization had skyrocketed to over a trillion dollars. The remarkable expansion that we are witnessing not only indicates the growing acceptance of digital currencies but also reflects the high standing among investors.

Bitcoin’s success has paved the way for other cryptocurrencies that bring unique functionalities and applications. A notable case is Ethereum, which came into existence in 2015 and was the first crypto currency to introduce smart contracts, agreements that automate complex transactions without any intermediaries. As of 2021, Ethereum’s market capitalization exceeded USD 400 billion, solidifying it as a key player in the world of cryptocurrencies.

And Bitcoin and Ethereum are not the only players on the scene. The crypto market has experienced rapid expansion, with thousands of tokens and coins entering the scene. Binance Coin (BNB), which is affiliated to the Binance exchange, has emerged as a key player in the decentralized finance (DeFi) ecosystem. Its market capitalization exceeded $60 billion by 2021. Indeed, the surge in cryptocurrencies has attracted investors and institutional players alike. Companies like Tesla and Square have made investments in Bitcoin, with Tesla allocating a USD 1.5 billion to the cryptocurrency early in 2021. Moreover, traditional financial institutions have started incorporating cryptocurrencies into their offerings, while major banks are exploring the potential of technology and digital assets.

The impact of this crypto revolution extends beyond finance. It has sparked a discourse about the very nature of money, the central banks’ role, and the future of the global commerce. Governments are starting to question the regulatory implications arising from this shift and acknowledge the importance of establishing frameworks that balance innovation and risk with consumer protection.

As we mentioned earlier, digital assets come with a set of risks which need to be identified and evaluated. One effective approach is using the Crypto Risk Assessment Matrix (C-RAM) model. This advanced tool has been carefully designed to provide assessments of risks associated with cryptocurrencies. It operates through a three-step process that applies on both national and international levels.

Firstly, the decision tree stage focuses on determining the macro criticality of crypto assets within an economy. It examines how crypto assets are being utilized within a given country. This assessment distinguishes between assets used as legal tender and those held as private assets.

For example, let’s imagine a situation where a country has adopted a specific cryptocurrency for daily transactions, even recognizing it as an official form of payment. This is the case for El Salvador and the Central African Republic, which declared bitcoin as official currency in 2021 and 2022, respectively. This indicates a high degree of macro criticality, meaning that the crypto asset plays a substantial role in these countries’ financial activities.

On other the hand, in a different country, individuals or businesses might use digitals assets for specific purposes but they may not hold the same level of significance on a larger scale. In this case these assets may not function as legal tender but rather serve as instruments for private or specialized transactions. Understanding this distinction is crucial when assessing how crypto assets are integrated into and impact the economy of a nation.

The second step is country risk mapping. This phase involves conducting a quantitative assessment of the risks associated with cryptocurrencies within a specific economy. A risk matrix enables thorough analysis of various aspects of risk across these seven distinct vulnerability groups:

The third and final step of C-RAM focuses on assessing the risks related to crypto assets on a global level. This step is crucial as it has implications for both the stability of economies and the broader global financial system.

Let’s imagine a scenario where a particular type of cryptocurrency gains widespread acceptance and is adopted by countries. This widespread adoption could potentially intensify market volatility and systemic risks, impacting not only economies but the global financial ecosystem.

For example, if a cryptocurrency becomes commonly used for border transactions it could influence exchange rates and potentially affect the stability of national currencies. Extensive adoption could potentially influence trade balances, capital flows and monetary policies across different countries.

Once risks related to assets have been assessed and identified, it is important to establish strong measures for risk mitigation. This is where smart contracts come into play. A game-changing solution, smart contracts revolutionize the way transactions are conducted by harnessing technology to automate and enforce agreements eliminating the need for intermediaries. These self-executing contracts provide a transparent framework that ensures transactions occur when predetermined conditions are met.

Finally, when it comes to regulatory risk, smart contracts can be designed to facilitate automated compliance with regulatory requirements. For instance, in a token sale, the contract can confirm the identities of participants and conduct verifications to ensure adherence to relevant laws. By utilizing these features smart contracts greatly improve risk management within the asset industry.

Smart contracts also generate a lot of on-chain data throughout the entire lifespan of a blockchain. Using tools to analyze and interpret this data can be a powerful enable of risk management in areas such as compliance and fraud prevention. It means organizations and financial institutions can benefit from the speed, accuracy and convenience of smart contracts while confidently navigating the changing landscape of digital assets with foresight and trust.

Summary

While crypto assets have completely transformed the financial landscape through decentralization, we must also acknowledge the potential risks that come with this shift. Our proposed C-RAM framework provides a way of assessing risks on both a global and country-specific level. An effective way to mitigate risks is by implementing smart contracts, which automate agreements and reduce counterparty risks. Using data-driven analysis tools can take risk management to a new level through insights into on-chain data.

Acknowledgements

We kindly thank Vadym Sheiko and Alexandre Caye for their valuable contribution to this article.