How Insurance Can Strengthen the Crypto Industry
Investing in digital assets comes with a number of risks, from cyber-security threats to market volatility. However, with proper risk management, these potential risks can be mitigated.
by Eric Nemeth, investment associate at Sino Global Capital
Summary
The nature of venture capital and investing in any startup or founder comes with inherent risks. As a relatively new technology, there are unique risks associated with investing in digital assets that may include risks such as specifically targeted cyber-security threats, susceptibility to fluctuations in sentiment and resultant market volatility, and inadequate methods to verify and separate legitimate projects from fraudulent ones.
While in 2022, several high-profile bankruptcies played a part in the downward pressures on most asset classes in global crypto markets, the emerging risks specific to this new technology remain the same, though their perception has been scrutinized by forward-looking policy makers. Digital assets and blockchain technology are becoming integral parts of the global economy. Cryptocurrency is increasingly being adopted and embraced, making it likely that it will eventually become accepted on a global scale.
While these new technologies bring with them some inherent risks, sound risk management strategies can effectively reduce the impact of these threats. This should include working to develop clear taxonomies, establishing a smart regulatory framework that allows for innovation, partnering with reliable insurance companies, and conducting thorough research to weigh the potential pros and cons of the technology.
Regulation
The crypto industry is a relatively new and rapidly evolving sector that requires a robust regulatory framework to function properly. The primary aim of any healthy regulatory framework is to protect investors– by promoting guidelines for activity, an infrastructure of trust is established between stakeholders and participants. Companies can operate having a clear set of effective rules, regulations, and guidelines, and go about the business of developing innovative technologies and products while providing a safe and secure environment to mitigate the natural risks associated with daring to create new things.
The recent failures of centralized entities underscore the need for a legal environment that pushes digital assets and blockchain technology further into the regulatory perimeter. The Chamber of Digital Commerce recently released its policy goals for 2023 highlighting legislative proposals that build a foundation to move the industry forward and provide regulatory certainty.
Regulatory Agencies
At last week’s hearing before the Senate Committee on Agriculture, which oversees the CFTC, Chairman Rostin Behnam testified that the existing regulatory framework was successful in ensuring that LedgerX's assets were segregated and secure from the rest of the FTX bankruptcy. However, without proper authorization from Congress, the CFTC was unable to enforce compliance with the rest of the FTX organization due to the limits of its regulatory authority. These issues arise because crypto assets have not been classified under a regulatory agency and broadly lack a taxonomy to provide a common understanding of the technology.
The Financial Stability Oversight Council recently released a report which discussed the potential risks to financial stability. It identified regulatory gaps in the absence of regulatory frameworks for spot markets dealing in cryptocurrency assets and the participants and platforms associated with these markets.
DeFi or CeFi
As much as the crypto industry believes code is law, this liminal space between DeFi and CeFi presents a gray area for regulations where they can only enforce so much without proper language for digital assets and the applicable regulatory frameworks. Not only is this a gray area for regulations, but also for crypto as the current technical advances in crypto do not extend well into the ‘real world.’ Given that ‘picks and shovels’ are the onboarding layer into crypto from traditional markets, much of these businesses will have to be rebuilt. However, the void is unlikely to be filled without an overhaul of the business models of centralized exchanges and brokerages.
Insurance
Forthcoming regulations may require insurance to protect consumers, ensure the stability of the financial system, and prevent the spillover of risks associated with crypto assets.
Traditional Finance
In the financial services industry, regulators provide certain types of insurance requirements, such as deposit insurance and credit default insurance.
The establishment of the FDIC, for example, was brought forth by the need to protect depositors from losses and to maintain public confidence in the banking system. Given that market collapses adversely impact depositors, the US government establishes banking regulations to curb future companies from adopting the same business models or undertaking an excessive amount of risk.
Insurance in Crypto
Enterprises developing crypto products and crypto-native companies may need insurance coverage for losses resulting from the theft of private keys or the failure of tech execution and operations, such as slashing of a non-performing validator. It is natural to assume that companies will seek out crypto-specific insurance policies that provide professional liability insurance that protect against claims related to the management of the specific crypto products and services the company offers.
However, to offer these insurance policies, incumbent insurance companies are not well equipped to underwrite against new risks because:
1. The new risks are difficult to assess and predict without more data points to analyze or expertise to properly assess the potential risks and determine how to price them.
2. These new risks will require new types of insurance coverage that the current insurance companies do not offer.
Given these reasons, the insurance companies will likely have start-up insurance companies develop expertise and proven methodology as specie underwriters before acquiring them or developing their business line. Traditional insurance companies will face difficulties building out their own business line given the level of expertise required and limited pool of qualified candidates, especially considering the brain drain from traditional finance.
These startups will take the form of crypto carriers and specie managing general agencies, which are specialized insurance companies that have expertise in underwriting insurance policies for crypto-related risks. By offering insurance coverage, these companies can help enterprises, institutions, and crypto-native firms mitigate the risks associated with offering crypto products to their clients.
Additionally, the presence of crypto carriers and specie managing general agencies in the market can signal to financial institutions that the industry is becoming more mature and regulated, increasing their comfort level for building and offering crypto products.
To reach this mature stage, proper risk management practices must be standardized across the industry, so insurance companies can be more confident in insuring against the inherent risks with this technology.
Conclusion
Even though this has been a challenging year, the industry has learned hard lessons that will be formative to the next cycles' robust development. We will look back on all of the failures as an inflection point for better understanding the risks associated with this technology and identifying ways to mitigate them. From the confluence of impending regulatory clarity and heightened awareness of risk management, the insurance industry will flourish, resulting in a new level of adoption for crypto.