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Cryptocurrencies 2018 special report

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22 CRYPTOCURRENCIES M anaging risk in fi nan- cial markets is a well-es- tablished discipline. Whether investing in equities, bonds or currencies, widely accepted practices protect market practitioners when they are buying, selling or intermediating. Risks are typically aligned into diff erent cate- gories, including market risk, credit risk and operational risk, and com- plex formulae are used to determine how much capital should be kept in reserve to absorb losses. When investing in cryptocurren- cies, however, many of these tra- ditional assumptions fall fl at. The product is still new and relatively untested, volatility is unpredictable and, with a small, albeit growing, investor base, the market is much less liquid, making it tougher to unwind positions. This doesn't mean investors should avoid cryptocurren- cies altogether, but it does necessi- tate a diff erent approach to risk. "Volatility and unpredictable liquidity are a reality of this mar- ket. Sadly, with weak governance, Cryptocurrencies are prone to high volatility and low liquidity, making risk tough to manage, but the rewards can be high "Mark-to-market considerations are clearly a large issue for institutional investors. Volatility in these curren- cies is a given and thus the danger of stop losses triggered in a wild ride is ever present," says Mr Longmore. "Consider also know-your-customer and anti-money laundering require- ments. Being what they are, cryptos present enormous diffi culties. An individual investor might not have too many concerns, but an institu- tional investor runs considerable risks from both a reputational view- point and from possible sanctions." While volatility has eased since the end of last year, the epic move in bitcoin has increased risk appe- tite both for existing and newer participants, with the realisation that even just a modest exposure to cryptocurrencies could turn out to be lucrative. Even if only investing a small proportion of the portfolio in cryp- tocurrencies, however, investors should be mindful of the risks they face. Every practitioner will have an opinion on what the biggest risk may be, but few would contest that the illiquidity of crypto assets is one of the toughest risks to manage. It is a reality in any emerging asset class that until participa- tion becomes mainstream and widespread, liquidity is likely to be unpredictable. This means that while it may be easy to take on a position and buy into a currency, it can be much harder to unwind, particularly at times when the fraud is also a real possibility. This is compounded with new currencies proliferating at an extraordinary pace, as the barriers to entry for an initial coin off ering are very low," says Richard Longmore, managing director of capital markets consul- tancy Finoesis and formerly a senior manager in fi xed income, currencies and commodities at UBS. The risks may be diff erent and tougher to manage, but as in any fi nancial market, participants need to balance risk with reward. Following a huge spike in the value of bitcoin at the end of 2017 – it rose from $7,000 to almost $20,000 – some investors have already realised huge gains. The attractive rewards are luring new participants into the market every day, including banks, asset managers and hedge funds. As these institutions move in, it represents a landmark shift for this emerging asset class, which had pre- viously been largely the domain of individual day traders who had lit- tle to lose from dabbling in bitcoin. For institutions, the risks can be much greater, not least because they are typically managing money on behalf of others. Show caution when seeking high rewards RISK katjen/Shutterstock JOEL CLARK The most prudent approach for new investors might be to hold just a very small proportion of their portfolio in cryptocurrencies

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