My Top 3 Crypto Risks for Companies
Today I'm focusing on existential-crisis level risks all companies operating in crypto face. This is an intersection of Technology, Finance, Risk, Investments, and Crypto itself.
TL;DR: 3 pervasive risks, and 3 proposed disclosures, as identified by yours truly.
Hello Curious One!
When talking about Blockchain Risks, the two prevalent ones that are talked about are Cyber Risks and Talent Risks. Those risks are inherent, but what about Crypto unique risks?
In my attempt to answering “What are the blockchain risks” beyond the usual suspects, I’ve been able to identify 3 pervasive issues that a company operating in the blockchain space simply can’t control.
Today’s piece is a continuation of last week’s piece around Crypto Financial Reporting, which I’m going to admit - I completely underestimated the things that could be said and realized last minute that what I had written should be cut up into 3 digestible pieces.
As always, you’ll find TL;DR: and graphics at the beginning of each section.
Good reading!
P.S. Thanks Sophie for bringing up the idea of Blockchain Risks for Enterprise Clients.
In Case You Missed It
Sections You Can Skim To
My Top 3 Crypto Risks for Companies
Digital Asset Valuation Risk
Blockchain Platform Risk
DeFi Protocol Risk
My Top 3 Crypto Risks for Companies
TL;DR: That’s right, we’re going there - and it’s based off 3 Crypto Risks.
In last week’s piece, I introduced 3 crypto specific scenarios. Don’t worry! I recap them here.
Based on my experience with all things Crypto, those scenarios constitute the 3 biggest uncontrollable risks for any company operating in Crypto, to the point that they impact not only operations, but existentiality of the company.
Those risks are:
Digital Asset Valuation Risk and (The Overall Market Risk)
Blockchain Platform Risk (Technology Risk)
DeFi Protocol Risk (…Hedge Fund Risk?)
I’m not even going to mention cybersecurity because that is so expected. But also that’s part of Blockchain Platform Risk.
Based on these risks, here are My 3 Proposals for Crypto Financial Reporting.
Digital Asset Valuation Risk
The risk(s) arising from Crypto to Fiat price volatile price fluctuations.
TL;DR: How does a company respond if Crypto loses 80% of its fiat value?
A Solid, Liquid, and Gas
At any given time, the value of Crypto will change. Crypto itself can also take on different financial forms as well. Crypto is a very fluid and volatile asset (very risky, can change value within the same minute).
Right now, your company can’t do anything to impact the USD Price. An investor in your company needs to be reminded of that that, and also needs to be informed on what you are doing around that.
As a company, how do you control the valuation of your digital asset? The short, and longer answer, is you can’t. It’s a kin to saying a company can influence the value of the US Dollar. You basically can’t.
So instead, the next line of question is what are the company’s responses to crypto valuation drops.
Here’s What I Propose:
If we’re going to operate under the conditions of extremely high uncertainty and volatility all the time, I would want this:
#1 - Disclosure around Crypto Financial Statements, with a Table showing how different Crypto Values can impact the overall presentation of the consolidated financial statements of the Company.
Today your company is worth $1b because $800m of it is because Bitcoin is at $60k. Tomorrow it can be worth $400m because 80% of your assets are in Bitcoin, and I’d like to know what Management will do in black swan events like this, which are becoming increasingly common these days.
What are the Crypto Inflow and Outflow, in an Income Statement like manner. What do the Company financials look like if Crypto were 80% its original value, and is the Company at major risk in that scenario? What about 60% original value? 25% original value? Essentially, what’s the exposure, how do you track it, and how do you intend to respond to events?
Blockchain Platform Risk
The risk(s) arising from the technology platform dependency
TL;DR: How does a company respond if it is reliant on a technology type’s ecosystem and governance?
A Persistent Risk
While not as volatile as the Digital Asset Valuation, a persistent risk a company will face operating in crypto is the platform risk associated for each blockchain they are working with. Platform risks arise from a dependency on an ecosystem or technology type.
As an example, 100% of the Solana Blockchain Ecosystem development is outside the control of your Company - unless you co-develop with the blockchain ecosystem developers themselves.
What about the the platform risk of using Ethereum, given that it has great sub-technologies such as non-fungible tokens and smart contracts?
High transaction fees (known as gas, or gwei) which can result in failed transactional operations, and loss fees. This is pretty important since 6.66% of Coinbase expenses, or $560m, were incurred from platform fees.
Fundamental Ecosystem Changes - The developers of Ethereum can introduce major updates in the form of new features, as well as fundamentally change major logic provided that the rest of the ecosystem follows. Right now ETH 2.0 Merge is around the corner (September 2022 release). Without getting technical, just imagine the chaos we suffer of these kinds of switches happen:
Switching a nation’s language from Manchester British English to American Bayou English
Switching from Imperial Units to Metric Units
Switching from iPhone to Android
As a company, what are your platform risks? What if certain features you clearly depend upon (such as specific data fields) are one day pulled? What if the network goes down?
Here’s What I Propose:
#2 - Disclosure on Platform Risk(s), but much like a legal disclosures, I expect the Company to asses the impact, relevancy, and likelihood of ecosystem changes on their business. Bonus points if you tell me what key ecosystem features are relied on.
If your company operates exclusively on Ethereum, or its primary business is from Ethereum, I expect you to talk about the ETH Merge 2.0, but much like how I would expect you to talk about ETH Classic Fork back when that happened.
You may also refer to your strategies around supporting the overall ecosystem development - but at that point I expect to find a tweet from Vitalik indicating how useful your company is in the space.
DeFi Protocol Risk
The risk(s) arising from immense crypto-wealth concentration that is uncontained.
TL;DR: I enjoy DeFi Protocols because of their existence, and I think they are an existential threat to everyone else.
The Existential Crisis-Triggering Risk
Contrarian take: DeFi Protocols will be the thing that kills Crypto over, and over, and over. If DeFi comes to Bitcoin, Bitcoin can’t be adopted. That’s how much of a existential-level threat I think Ungoverned DeFi Protocols are.
If you aren’t familiar, DeFi Protocols hoard attract a lot of the crypto assets at exponential rates with very little due-diligence on the customers, and gimmicky at best deposit security. With a technology-backed promise to give users who “Bank” with them a specific interest yield, it’s hard for users to not do business with it. I’ve written about how it works here.
Here are two DeFi Protocols I’m referring to that inspired my thoughts:
TerraUSD, a stablecoin by Luna, crashed as a result of Anchor Protocol, a DeFi Savings Protocol. Anchor held $14b of the $18b of TerraUSD in existence. TerraUSD’s crash also crashed the overall Cryptomarket. You can read my write up here.
Solana, a cryptocurrency by Solana Labs, almost crashed because of Solend, a Solana DeFi Protocol. Solend has 2% all Solana in global distribution, and came within metaphorical inches from taking down Solana and impacting the price negatively, and severely. You can read my write up here.
DeFi Protocols pose a unique danger to everyone else on the blockchain and related blockchains (if you can detect the related blockchains) in that:
They can cause a platform risk by sheer volume of activity they sustain or are tied to
They can cause a devaluation simply because the amount of tokens held on the protocol is a “market moving amount”.
They can do both at the same time
Here’s What I Propose:
#3 - Disclosure on DeFi Protocols - provide comfort that the the Company’s maintains a robust awareness and risk profile of DeFi Protocols, and is actively detecting (or paying for a service) to detect crypto-asset concentrations, charting what could go wrong, and having appropriate responses in place.
It’s basically like geopolitical instability or travel advisory warnings, but now its Crypto.
Imagine you are a country and you maintain your own currency.
Now imagine if I have my own country, and 25% of all your currency flows to me, and we’ve done this dance long enough that we’re at the point that my country can impact the value of your currency simply by selling your currency off, or swapping it out for something else.
We can alternate this imagination and say your company relies on the currency of Country A, but Country B keeps [use your choice of expletive here] with Country A, leading to value destabilization.
Worst yet, Country B isn’t aware it’s messing with Country A. It’s one of Country B’s best and brightest citizens that are trolling Country A.
I don’t even know how this gets tackled besides the strength of Bitcoin Marxist saying no to Bitcoin changes thereby creating Bitcoin and Bitcoin Cash, except this issue goes beyond the boundaries of 1 blockchain given the growing inter connectedness of blockchains (like geographic globalization, but in technology)
Summary of Risks and Proposed Disclosures
TL;DR: I made a list for you.
Digital Asset Valuation Risk
The risk(s) arising from Crypto to Fiat price volatile price fluctuations.
#1 - Disclosure around Crypto Financial Statements, with a table showing how different Crypto Values can impact the overall presentation of the consolidated financial statements of the Company.
Blockchain Platform Risk
The risk(s) arising from the technology platform dependency
#2 - Disclosure on Platform Risk(s), but much like a legal disclosures, I expect the Company to asses the impact, relevancy, and likelihood of ecosystem changes on their business. Bonus points if you tell me what key ecosystem features are relied on.
DeFi Protocol Risk
The risk(s) arising from immense crypto-wealth concentration that is uncontained.
#3 - Disclosure on DeFi Protocols - provide comfort that the the Company’s maintains a robust awareness and risk profile of DeFi Protocols, and is actively detecting to detect crypto-asset concentrations, charting what could go wrong, and having appropriate responses in place.
Closing Thoughts and Open Remarks
This piece is a convergence of multiple backgrounds across Technology Risk Management, Financial Assurance, Crypto, and Investments.
I’d love to hear what you think of this piece, and I want to push the boundaries of how companies are engaging the space.
Great article-Thanks for sharing!
Since I last posted this, here's what I would add:
1. Commentary on lack of accounting and risk management tools over crypto
2. Commentary on actively invested crypto assets, and where they are, and what the pull out % is.