Liquidity risk and management in Bitcoin

In finance, liquidity risk is the risk that a given security or asset cannot be traded quickly enough in the market to prevent a loss (or make the required profit). 

This of course begs the question how liquid do you need to be? Surely the answer is at least partially tied to the volatility of the asset in question and what your individual exposure to the potential loss might be.

When it comes to Bitcoin, at least more so than with physical assets, the more liquid you are the more at risk you are in that liquidity also means that the corresponding wallet keys are easily accessible.  And the more accessible the corresponding keys are the more at risk they are.

One can manage these risks a number of ways the most simple being not keeping “all your eggs in one basket” by keeping only the funds that must be readily available “online” and then using schemes like P2SH and Shamir Secret Sharing to manage the associated keys.

The Bitcoin ecosystem has clearly embraced these things as concepts, at least in the abstract in that “cold wallet” and “hot wallet” are synonymous concepts in the ecosystem. With that said the strategies you use to mitigate risk when you hold $10,000 USD should be different than when you hold $100,000 USD and this is not something individuals have had to take responsibility for historically.

One of the most fundamental changes Bitcoin represents today is that you, the principal are now also principally responsible for keeping your funds safe. Despite this we are still faced with the problem people struggle to understand the risks they are exposed to on the digital realm.

This is why in Bitcoin’s short history we find case after case of individuals putting their assets in the hands of under funded practically anonymous entrepreneurs with no real experience in finance or computer security.

The recent influx of capitol into the Bitcoin ecosystem has the potential to change this but it will also change the nature of Bitcoin at least in-part. The technology has been painted as the Libertarian’s dream and in many respects it might be but for broad acceptance it needs to embrace some level of regulation if it’s to see adoption outside that niche.

Liquidity risk management is a great example; How much of their assets should an exchange keep online? How quickly do they need to settle transactions? Should they be required to have 100% of the funds associated with their internal ledgers? Should they keep their assets and liabilities private or make them public? Should they be mandated to have security and fraud-analytics in place so they can detect abuse and market manipulation? Should they be required to carry insurance to protect consumers from negligence?

It is my belief that requirements like the above would strengthen the Bitcoin ecosystem and make it a more viable means for the less technical and the financial ecosystem to adopt Bitcoin.


Leave a Reply

Your email address will not be published. Required fields are marked *