Last week, at the at the Blockchain Money Conference in London, First Global Credit’s CEO and capital markets veteran, Gavin Smith gave a talk highlighting the risks to bitcoin companies and arguing for companies to take a more pragmatic view of risk.
Smith began: “In the conventional capital markets we have many metrics used to measure risk. They are not great; they are not fool-proof, but they are a decent framework that [start to] measure where the risk comes from. In the cryptocurrency world, we don’t yet have that.”
Speaking to an audience of investors, entrepreneurs, and experts including Jon Matonis, Michael Parsons and Roger Ver, the talk comes after reports of online bitcoin wallets being hacked and exchanges being compromised. In order to provide assurance and generate confidence users need to be able to trade in cryptocurrencies safely. Smith discussed methods that First Global Credit takes to reduce risk.
Smith explained: “First we actively grade bitcoin exchanges based on a weighted set of criteria including whether the exchange is domiciled in a respected jurisdiction, the transparency of their management structure and finally the longevity of the exchange. Once we have identified acceptable counterparties we spread assets across multiple exchanges. We need to be in a situation where we keep operating and continue to provide our customers with service even if one of our counterparties fail. So we don’t risk more than 15% of reserves on any one bitcoin exchange. We further control risk by minimising the time that we have funds out of our control. We do this by continuously moving funds out of exchanges when not actively being used to trade.”
Following on from this, Smith pointed out the logical fallacies of exchanges for decentralised cryptocurrencies, remarking: “One of the benefits of bitcoin is that it should cut away middlemen from financial settlements, but bitcoin exchanges have failed to follow the vision themselves by acting like centralised authorities. I believe the real challenge over the next 2 years – for companies who operate in the cryptocurrency capital markets – is to move beyond this model of us holding client funds and being ourselves, a point of risk for the customer assets.”
Highlighting current and up-coming developments which are taking steps to combat counterparty risk, Smith added: “We’ve already seen some attempts to deal with this problem, but thus far these have failed because they do not cover the security of funds over the full trade lifecycle. They protect funds when they are initially placed on the exchange, but as soon as funds are committed to an active trade they are subject to the same risks as they are on a conventional bitcoin exchange because they are pooled with other trades. So while protecting inactive funds provides a partial solution, this benefit is counteracted as soon as you open a position and start trading. This is not a particularly useful innovation for funds lodged with First Global because we are actively moving dormant money out of the control of the exchange anyway. So a solution that only protects funds when there is no active trade does not really add value.”
Pointing out another option, Smith noted: “The second area is using smart contracts to replicate trading. Again, this is a move in the right direction but the problem with the practical use of smart contracts at the moment is lack of liquidity. There is a real challenge of creating a solution that provides good liquidity and real security through the full lifecycle of a trade including point of settlement. To my mind that is where the real benefit and the future lies; If we can create a solution that achieves this we have not only provided value in the cryptocurrency capital markets, we’ve created something that actually leapfrogs existing mainstream capital market risk.”
In conclusion, Smith stated: “All counterparty risk management strategies in existing capital markets are based on allowing banks to transact business securely. Allow bank A to trade with bank B in a way that keeps them from having counterparty risk. Nobody considers the last step in the cycle, the piece that covers the transfer of funds to the end customer. That customer is still expected to assume all the counterparty risk of working with a bank or broker or other institution. If we can create an environment that allows customer A to trade with customer B without any added counterparty risk from working with an institution in the middle, that’s where I think the public blockchain can add real value to the whole finance industry and our market will pull ahead of conventional markets in what we can offer our customers. So in the next two years not only will counterparty risk become actively managed in the cryptocurrency space, I can imagine ways blockchain tech can be adapted for mainstream markets counterparty risk management as well.