At its peak in January 2018, the combined market capitalisation of cryptocurrency hit $830bn. While that figure has since declined to just over $113bn, many businesses and individuals have accrued fortunes into the hundreds of millions. The rapid escalation of cryptocurrency’s market capitalisation and popularity left regulators playing catch-up. In the UK, the Financial Conduct Authority (FCA) has yet to classify cryptocurrency as either a virtual currency or a commodity.
Such lack of clarity leaves businesses in limbo when attempting to understand the risks involved in dealing with the cryptocurrency market, which has since evolved into numerous exchanges, derivative markets, futures markets, and funds and trusts.
Market liquidity and volatility
Bitcoin, at the time of writing the largest cryptocurrency by market capitalisation, has an ownership structure in which relatively few users own a majority of the currency. According to the “bitcoin rich list”, 58% of traders own more than a quarter of all bitcoin in circulation. These ‘whales’ are able to affect the market through the movement of large amounts of cryptocurrency. In 2018 a whale made 50 transactions between 23 August and 30 August involving 50,500 bitcoins ($2bn), which resulted in a 15% drop in asset price.
A report from Chainalysis identified that there are four groups of whales: traders, early adopters, “lost” wallets with no transaction history, and criminal wallets. Chainalysis researchers noted that bitcoin whales might continue to be a “mysterious” fixture for the cryptocurrency community; they have “less of an impact on market prices than many people believe.”
Exchanges constitute another risk, as many are not registered or regulated, and experience frequent service disruptions or hacking attempts. Japanese exchange Mt. Gox was hacked twice, in 2011 and 2014, leading to the irrecoverable loss of $350m. In 2015, criminals exploited a vulnerability in the multisignature wallet architecture of Bitfinex to make off with $72 million.
These types of losses are making potential users of cryptocurrencies question the security of such exchanges, and exchanges are starting to make a PR play on their security and risk transfer methods in order to pacify their customers. Insurance is beginning to play a major part in this, with various Exchanges now flocking to the London Insurance markets to find cover.
Mark Robinson, technology practice leader at Finch Insurance Brokers, specialises in insurance products for cryptocurrency exchanges and custodians and has seen a spike in the number of businesses looking to transfer their risk via Insurance.
“Over the course of the last nine months there has been a marked increase in the amount of crypto companies we are speaking to about their risk exposures,” he says. “A lot of the time, companies aren’t aware that cover is available, and discussing what can be provided is a real eye opener for them. Usually, it is a case of ‘our competitors are advertising that they have insurance cover’, so they want to investigate what can be obtained from the insurance market, as trust is key in the crypto sector.
“The press are quick to jump all over stories of ‘lost’ private keys and wallet hacks, and rightly so. This is helping educate crypto investors that there are risks in piling money into a currency which is not secured by a major bank, and therefore doesn’t carry the same levels of protection as fiat currency does.”
Insurance cover for loss, theft or damage of private keys, whether internal or external, is available from the London Insurance markets, but Mark is quick to highlight that, although cover is available, it is not straight forward to obtain:
“What we are finding is that Insurers are still in the very early days of writing cover for Crypto related businesses. This is ‘new space’ for them so it will take time to get them comfortable. One of the major issues faced is the lack of historical claims history available. Underwriters don’t have a reference point as to how claims are likely to come about and what they are likely to be settled at. This poses questions over rates and actual cover.
“Insurance syndicates will only work with brokers who they believe understand the sector and have the ability to present the risk exposures clearly because this enables them to source appropriate cover with attractive terms.
“The path is now well trodden for us, and underwriters trust that we understand the sector and the risk exposures involved. It makes both our and the underwriters’ jobs much easier if we can demonstrate what is needed in simple terms, cutting out any ambiguity.”
Cryptocurrency markets rapidly react to news, good or bad. In November 2017, following the news that the largest US exchange, Coinbase, had added 100,000 users in one day, the price of bitcoin rose to a then-all time high of $7,454. Similarly, bitcoin and other cryptocurrency are susceptible to flash crashes, while many trading platforms don’t have circuit breakers or failsafe options to prevent major price swings.
Distributed ledger technology (DLT) is the technology which underpins cryptocurrency. In its basic form, a blockchain is maintained by miners, who compete to solve logical puzzles using computing power for a reward. Mining is also the only way to release new cryptocurrency into circulation, essentially making the mining community the mint for crypto. Being a miner can also give an individual “voting” power when changes are planned for the protocol.
The existence of powerful mining pools – where groups of miners work cooperatively and share block rewards – has been called a threat to the stability of a cryptocurrency market. There are around 20 major pools globally, with a majority of them located in China. This overt control of a market, often larger than 50% of hash power, means that certain pools could dictate the future of the market and effectively hold it to ransom. These 51% attacks have been successfully used against smaller cryptocurrencies, including litecoin cash, bitcoin gold, verge, and ethereum classic.
51% attacks aren’t the only issue to arise from mining pools, says Robinson. “The increasing cost of power versus the drop in value of cryptocurrencies has meant that it is now uneconomical to mine coins such as Bitcoin as the cost of power output required now outweighs the reward of mining. Due to this, we have seen an increase in ‘cryptojacking’ attacks, whereby mining pools hack into the servers of large companies and utilise their server space and power overnight to mine for them. Insurers have been quick to understand this threat, and are now offering cover for such an eventuality.”