Business Risk and Cryptocurrencies

One of the questions people ask about our blockchain project is “Why are you building your small company using blockchain? Isn’t it risky?” That got me thinking about different dimensions of business risk and the behaviors we have adopted to address these risks.

Platform risk:

The ERC20 standard interface has been around for just 20 months and is the basis for more than 100 currencies, including 81% of the top 100 value asset tokens (i.e., not currencies, like bitcoin). That is an amazingly rapid penetration for a new technology, showing the power of this standard in enabling distributed applications (“dapps”). There are a few usage areas that still need to be addressed, such as transferring tokens to a token’s contract, and there are likely some scale efficiencies that will need to be addressed as the smart contract databases grow over time. All standards evolve over time, and eventually someone will come up with a scheme that works better, faster, or more efficiently. There are challenges associated with blockchain overhead compared with traditional centralized databases, but these issues are well recognized and are being addressed by many development teams.

Asset market risk:

One of the interesting characteristics of tokens is that they nearly all become traded commodities on one or more public exchanges within a week or two after an Initial Coin Offering (ICO). The market for most tokens fluctuates with the main cryptocurrencies, Bitcoin and Ethereum, which make up 2/3 of the total capitalization of all cryptocurrencies. The Bitcoin, Ethereum, and Litecoin volatility indices tend to fluctuate between 4–8%, or 3–7X the price volatility of gold (1.2%). As a comparison, most major fiat currencies have volatility indices of 0.5–1%. Since most tokens are traded much less frequently than bitcoin, the volatility index for tokens will be even higher. Financial planners usually recommend that a high net worth individual might place between 1–5% of assets in more volatile investments, but I have never met a corporate investment manager who ever recommended holding company liquid assets in anything riskier than money market funds. Corporate venture funds are treated differently, but they too are limited to a tiny fraction of overall assets. My answer here is to limit the amount of bitcoin or Ether retained by the company to just the volume needed to deal with suppliers and customers that engage with those currencies, about 1–2 weeks of “coin flow.” That way, no hedge is necessary against the inherent volatility of cryptocurrencies.

Black hat risk:

Cryptocurrency ICOs are a magnet for hackers and thieves. There are dozens of examples of token offerings that have been hijacked, with some agent replacing the official ICO website with one that appears genuine but with a token address that points somewhere else, defrauding the investors. Other cases involve theft from a company’s wallet during the sale period, draining funds from the newly funded project. It is now common for the principals of new companies to change all of their passwords to protect identities, because personal identity is often a weak point in a small company’s security profile. All you can do is to be extraordinarily diligent and aware.

Development schedule risk:

There is nothing fundamentally different about software development on the blockchain versus any other platform architecture. New innovation development is always extremely risky, with many false paths that need exploring until the chief architect is satisfied that the plan of record can be accomplished. Yes, there is a dearth of skilled developers, and we face manpower shortages on almost all of our development projects, but almost all highly innovative small companies are in the same boat. All a good leader can do is to set a vision that attracts and retains the top talent and make sure the culture celebrates and rewards creative advances and getting the job done.

Market risk:

To date, it seems that half of the blockchain projects address fintech applications, competing with traditional financial clearinghouses with a distributed peer-to-peer model by using cryptographic trust factors instead of relying on the reputation of the central entity in today’s typical corporate business model. The other half include a large number of projects that aim to use this distributed marketplace model to serve a huge range of potential marketplaces, including the Internet of Things (IOTA), patient electronic health records (Patientory), personal genome data (Encrypgen), and cloud storage (Sia and Storj). It is easy to see the direct financial advantages associated with a fintech transaction on the blockchain, with visibly faster transaction turnaround times and lower fees associated with the transaction. Very few of the non-financial applications have achieved traction with real customers, but as mentioned above, this industry is less than two years old, and it takes time to find and close sales with the early adopter segments.

Regulatory risk:

In late July, the US Securities and Exchange Commission issued a ruling that suggested they would take an active role in evaluating larger ICOs, over $1 million, since many appeared to have characteristics of private securities. This has forced several projects to delay their offerings and scramble to ensure they comply with US law, and it has forced many projects to stay away from US investors; almost one third of all current ICOs listed by Smith & Crown do not allow US residents to invest. This is a challenge for blockchain companies, but has made very little impact on the pace of new token offerings.

All of these challenges are things that we in the blockchain industry have accepted as part of the cost of doing business in this exciting industry. There is so much potential to disrupt today’s accepted industry value chains, applying a new decentralized business model against traditional “winner take all” centralized profit pools. We see the opportunity to dramatically expand hundreds of markets and change today’s accepted business rules. This is Schumpeterian activity at its greatest, and I am excited to play a part in making it all happen.

Photo by Tony Webster on Unsplash