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The Crypto Conundrum: What Are We Insuring?

byLowers & Associates | March 14, 2019

With the surge of cryptocurrencies, mainstream investors are looking at them as alternative vehicles for transactions and the storage of value. Despite their relative volatility, they have advantages in permitting transactions of any size on-demand, growing worldwide acceptance, anonymity of stakeholders, and independence from traditional financial institutions.

The security of the blockchain is inherent in its technology. Each step forward in time, when a new block is added to the chain with the guarantees of either the power of work (POW) or power of stake (POS), the transparency and permanence of transactions is theoretically immutable, as long as the private encryption keys are secure.

Every unit of cryptocurrency is exposed to investment risk, just like any other commodity that is traded in a market. Investors may seek hedges in the market against loss, but this kind of loss is not insurable in the ordinary sense.

So, the general answer to the question “what are we insuring?” is against the loss of value due to institutional failure or theft. But in the case of cryptocurrency, how is the value determined?

The institutional structure of cryptocurrencies is a wild west of new businesses emerging to manage the flow and storage of value. The most prominent type of business in this ecosystem is the exchange, where the market value of crypto can be traded for a traditional fiat currency. You can sell your Bitcoin for U.S. dollars, products or services, or almost any other currency.

Unfortunately, the exchanges have proven to be insecure. Billions of dollars’ worth of cryptocurrency have been stolen by hackers who break into the online system. In an odd feature of the blockchain, it has been possible to see which accounts received the stolen money, but without the encryption keys it cannot be recovered.

Shifting the risk offline.

A response to the risk of storage of value on a crypto exchange (in a “hot wallet” online) is to move the currency to a “cold wallet” that is offline. In other words, you download the value onto private keys.

Therefore, the insurable event is when either the encryption key or the currency value, or both, are stored offline. Whenever this happens, you are no longer in the purely digital world of the blockchain, and the risk of loss through theft arises.

Insurers will want to replace the fiat currency system’s security rules with procedures and processes that duplicate their functions. For instance, they will want to replace ‘Know Your Customer’ regulations with procedures that identify the owners of the currency and/or encryption keys. They will also want to see custodial procedures that safeguard the offline items with security commensurate to the value.

There is some irony in the fact that the blockchain, which was devised to do away with all the cumbersome regulations of fiat currencies, maintain anonymity, and offer a high level of confidence, is now evolving toward systemic guarantees much like fiat currencies already have.  There is a cost for having secure transactions and storage.

For much more information about cryptocurrency storage and transportation, see our new white paper, Custodial Crypto Transportation and Storage: Understanding the Risks.

ABOUT THE AUTHOR

Lowers & Associates
Lowers & Associates provides comprehensive enterprise risk management solutions to organizations operating in high-risk, highly-regulated environments and organizations that value risk mitigation.
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