Coining it…or just Untethered?

The Awbury Team’s members have been around long enough to have observed, lived through and survived multiple financial bubbles, crazes and crashes. However, we have looked on at the current frenzy surrounding the rise in the value of bitcoin (lower case, as opposed to the upper case Bitcoin payment system) with bemusement, which we shall use as a proxy for analogous “crypto-currencies”.

While the company behind the South Sea Bubble was a fraud, one could at least plant tulip bulbs and console one’s self with the beauty of the flower after that mania ended (Fun fact: in 1637, the Dutch East India Company was worth USD 7.9TN in today’s terms). In the case of bitcoin, it seems that what was once considered a curiosity and subsidiary component on a blockchain-based system has become the focus of the most extreme rise in “value” in recorded history. Having started life with what, in hindsight, is probably the most expensive pizza purchase in history in May 2010, and reaching a price of USD 1 in April 2011, bitcoin was supposedly quoted at a price of over USD 19,000- in early December. To say that the price is volatile is a serious understatement, as it becomes increasingly difficult to discern what, if anything, is “real” about it.

This begs the questions of what exactly bitcoin is; what purpose it serves; and what impact it is having or will have on the financial system, including (re)insurance. Classically, a currency is a medium of exchange, (one hopes!) a store of value and a unit of account. How does bitcoin measure up?

Frankly, as bitcoins are simply entries in a Bitcoin blockchain ledger and there is no-one who guarantees that a bitcoin has any particular value, such value depends entirely on supply and demand. Given that bitcoin is designed in such a way that there are only ever supposed to be 21 million of them in existence, and that creating new ones (up to the limit) costs increasing amounts of both computing power and (literally) energy, one can see how, as the desire to own a seemingly scarce item increase, demand can lead to the sort of frenzy seen in the past few weeks.

In theory, one can transact using bitcoin, assuming that the other party has both the desire and ability to accept them. However, the frictional cost of doing so keeps rising, and the time required to complete and validate a transaction also continues to increase, leading to the risk of “double-spending” of the same bitcoin. So, as a medium of exchange, bitcoin is far from optimal; and, of course, the volatility in its price also militates against that use. While, theoretically, bitcoin could be used as a unit of account for book-keeping purposes (and after all, Bitcoin is supposed to be a distributed ledger), that purpose seems to have become obscured by the frenzy surrounding whether or not bitcoin can be considered a store of value.

Of course, the “bitcoin billionaires” (yes, they now exist) would argue that it most certainly does. However, in reality, one can only realize that value in the real world by converting it into a more conventional and widely accepted currency, such as the US Dollar. Couple this with the thinness of the market; the fact that it would appear that holdings are quite concentrated; and the continuing reluctance of major banks to become involved in trading and clearing bitcoin transactions (in particular the newly-minted CME and CBOE futures markets), and one begins to wonder when and how bitcoin will become anything more than a speculators’ plaything and one more opportunity for the less salubrious fringes of illegal businesses to try to shield their profits from discovery and confiscation.

So, why, one might ask, should (re)insurers care about all this?

Well, consider the current obsession for growing revenues from cyber-risk coverages. Crypto-currencies are supposed to be free from the risk of “hacking” or misappropriation because of the underlying technology. Yet there are already numerous reported instances (and probably many more unreported) of bitcoins and their analogues “disappearing”, being misappropriated or simply stolen. If a (re)insurer had written a cyber-risk or even a standard theft and fraud coverage for a client who owned bitcoin, quantifying and pricing that risk might prove rather challenging, as might defining exactly what had been lost. Or consider covering risks relating to the default of a clearing broker or exchange involved with bitcoins. In theory, initial and variation margins should cover all but the most extreme loss scenarios; but, given the lack of reliable data and the brief history of the “asset”, what exactly is an “extreme loss scenario”.

At Awbury, we aim to maintain an understanding of complex risks and the opportunities they may bring, so we shall, of course, continue to monitor the evolution of the blockchain and crypto-currencies, while remaining a healthy skepticism about whether there is, as yet, sufficient data and market understanding to qualify and quantify the true nature and level of the underlying risks.

However, if you have a blockchain or crypto-currency risk that needs a solution, give us a call


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