Cryptocurrencies risks in operational due diligence investigations

Posted by Andrew Borowiec on Jul 5, 2018 7:00:00 AM


With a global value of over $700 billion* and an average return on ICOs of 1,320%**, it is no surprise that the world of cryptocurrencies represents an almost irresistible draw to investors. But for every story of incredible returns, there are a similar raft of reports on the shadier side of this dynamic new marketplace. Here we take a look at how due diligence investigations must evolve to include cryptocurrencies if operational due diligence professionals are to protect their organizations from unnecessary risk.

Why cryptocurrencies pose a financial risk

Returns vary wildly: While the headline figures can be outstanding in terms of returns, especially on ICOs, they’re not an investment silver bullet. For example, 7 out of the 10 top crypto-assets recorded a negative return in February 2018***

Exchanges aren’t secure: According to a recent report, more than two-thirds of 25 major crypto exchanges and wallets in Europe and North America fall short when they scrutinize new customers. 68% of the exchanges let their users trade crypto and fiat with no formal identification or know-your-customer checks.****

Regulator and government warnings: Consumer warnings and advice to banks encouraging additional scrutiny issued from the UK’s FCA and a presidential executive order in the US are both indicators of the significant risks posed by cryptocurrencies.

Why cryptocurrencies pose a reputational risk

Anonymity attracts criminal activity: The relative anonymity for users of cryptocurrencies, combined with recent scaling up of money laundering legislation and regulation for conventional currencies has created the perfect combination of environmental factors for criminal activity to be financed through the new cryptocurrencies. If your firm is found to have significant involvement with a cryptocurrency that is subsequently proven to have been used to finance serious or organised crime, the potential reputational damage to your firm is huge.

Lack of security invites hacking: In addition to the threat of “real world crime” finances tainting the reputation of cryptocurrencies, their lack of proper security and identity verification for their users also make them a great target for hackers. Aside from the threat of data theft and the risk that poses to your reputation by association, major hacks can cause the value of a cryptoasset to plummet, affecting the returns you produce.

First steps to include cryptocurrencies in operational due diligence

Exposure: An obvious way to de-risk your cryptoasset investments is to ensure that they are smaller part of your broader investment portfolio. Similarly, making sure that your firm is not a headline investor in any one ICO negates the potential for negative press if something goes wrong.

Expertise: Ensuring that your hedge fund manager has sufficient experience and expertise in managing investments that leverage cryptocurrencies is another basic step that will offer you a degree of risk reduction and protection. There are over 50 hedge funds that deal specifically with cryptocurrencies, as well as several that have large, established divisions that provide this level of knowledge.

Security: Evaluate the security measures surrounding the cryptoassets and exchanges your investments will be leveraging, looking for evidence that measures are in place to prevent hacking, investment fraud and other cybercrimes.

Identity: As with security, making sure that users of the cryptoassets and exchanges involved in your investments are correctly and thoroughly identified by the operators of those entities means that you reduce the associated risks of anonymity outlined above.


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Tags: Due Diligence, Operational Risk, Due Diligence for Cryptocurrencies, Cryptocurrency

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