Is Blockchain Risky Business?

Cryptocurrencies, underpinned by blockchain technology, are quickly becoming mainstream. The global cryptocurrency market recently soared to $3 trillion, a fivefold increase since November 2020, when it stood at $578 billion.

Financial services firms see the opportunity to help businesses in the blockchain industry get started, but what are the risks that are holding them back from participating in this vibrant industry?

Banks, tax accounting firms and insurance companies are no strangers to managing risk. But those who decide to be at the leading edge of this technology need to be able to understand businesses in the blockchain industry and their level of risk exposure. These financial services companies should not let a lack of understanding prevent them from supporting early adopters of the digital transformation wave.

Lack of Understanding on How Blockchain Businesses Work

Some firms are hesitant to get involved with blockchain and crypto businesses because they do not understand them or how to assess the risks. Because of this, companies in the sector can struggle to get the very same services that startups in other verticals receive relatively easily – like a business bank account or general liability insurance.

Banks may refuse to open business accounts for blockchain companies, accountants decline to audit them, and insurance providers are hesitant to underwrite policies for them.

Looking at insurers specifically, it is easy to see how far they are from their traditional areas of expertise when it comes to a blockchain business. They have little experience distinguishing between good and bad actors within the industry or discerning the quite nuanced differences between different types of blockchain businesses — whether they are crypto custodians or lending platforms or exchanges. The blockchain industry is branded as "highly risky" in broad strokes, while in reality, different businesses carry varying levels of risk .

Lack of proper insurance coverage hinders the blockchain industry from growing in a sound way and prevents companies from creating safeguards for customers’ funds in case of fraud, scams, exploits, market gyrations or even black swan events.

Insurers also rely on historical data to determine premiums, but this type of data is elusive in the crypto sector. In addition, once a business is onboarded, insurers don’t have the ability to monitor shifts in crypto customers' risk profiles, which is especially important considering how quickly the crypto industry changes.

In order to create effective insurance policies, insurers need to understand the risks attached to blockchain and crypto, and a comprehensive way to perform due diligence when onboarding such businesses. They may feel ill-equipped to do this but all they need to overcome their hesitancy is the right tools specific to the blockchain industry.

Reputational Risk

Underscoring reluctance to offer financial services, is the reputational hit that the blockchain industry receives from widely circulated media stories covering the exploitation of this new technology.

It’s true that the growth of the crypto industry has garnered the interest of bad actors. But contrary to the popular media narrative, less than 1% of Bitcoin activity is illicit. This is a much smaller number than illicit activity associated with fiat currency, which is estimated between 2% and 5% of global GDP ($1.6 to $6 trillion). While 1% may still be significant, when put in this perspective, bitcoin is apparently less risky than fiat currency.

Reports of hacks have not helped crypto’s reputation, however. According to industry reports, as of November 2021, a total of 169 blockchain hacking incidents have taken place with close to $7 billion in funds lost. These attacks highlight the crypto industry’s inability to store and protect the digital assets of the users.

In addition to hacking, the surge in growth has led to occasional black swan events, like government clampdowns on digital asset trading. Previous clampdowns, like the one in South Korea, caused the prices of crypto assets to plummet and left users with liquidated positions and penalty fees due to lack of collateral.

Despite these risks, it would be a missed opportunity for financial services firms to avoid doing business with the industry. By blacklisting the entire crypto industry, the financial services sector is missing a major opportunity to future-proof their businesses.

Dissecting the Anatomy of Crypto Risk

From an insurer's standpoint, even though the risks may seem daunting, they can be mitigated and even turned into opportunities. Firms can start by focusing on the nuances around the specific type of business and whether it is in compliance or in the process of becoming compliant. High level insights like these will give them the confidence needed to make better decisions and to develop robust insurance products for blockchain businesses.

Blockchain businesses have unique risk profiles. In crypto transactions, the focus is on the amount of risk that originates between the target wallet addresses and those which can be linked to illicit and suspicious activities.

On-chain data, such as whether a business is associating with addresses tied to sanctioned entities, can provide detailed insights. But it would be even better to understand whether the risks are direct or indirect and how closely linked illicit activities are to the business.

Off-chain Intelligence

Off-chain intelligence, like knowing who the main players are or whether a business is compliant, is just as important. Factors like law enforcement actions, acquiring licenses in key markets or the introduction of new technology all contribute to a company's risk exposure. Insurers should have the ability to be alerted to such changes so they can adjust their policies.

Financial services firms need a way to analyze both on-chain data and off-chain intelligence to know the businesses they are dealing with. The ability to detect or prevent illicit transactions before they happen is also important for mitigating risk. Firms that can do this will be able to help blockchain businesses get started and position themselves for success as the technology evolves and the industry grows.

When financial services companies use the right tools, they will be able to make better decisions and have increased confidence in their risk assessments. They will answer for themselves the key question: how risky is a blockchain business?

Mriganka Pattnaik is the CEO Merkle Science, a predictive cryptocurrency risk and intelligence platform that helps crypto companies, financial institutions, and government entities prevent illegal activities involving cryptocurrencies.