Risk Management: The Survival Strategy of Digital Currency Trading Platforms

Risk, as a borrowed term, originates from the Italian "RISQUE", meaning objective danger in nature. In today's society, risk is no longer merely fate; it has increasingly become a choice, depending on our degree of freedom.

Financial historian Peter Burns pointed out in his classic work on Risk Management that the rise and fall of enterprises, the fluctuations of the stock market, wars, and economic depressions seem to always occur when people are caught off guard, but in reality, they are all cyclical.

As a digital currency trading exchange providing liquidity in the market, risk management is one of its core elements. These platforms not only undertake various functions such as asset custody, trade matching, clearing, and information dissemination, but also integrate characteristics of institutions like brokerages and funds, essentially becoming a comprehensive financial center.

Through interviews with frontline risk control leaders from multiple trading platforms, the industry generally believes that there is a lack of risk management in the blockchain sector. This situation has led to industry tragedies such as the collapse of FCoin and exchanges being hacked. How to improve risk management has become an important issue that the entire industry needs to continuously focus on.

Diversity of Risks

The biggest and hardest risk faced by the crypto market is the systemic risk brought by policies. Changes in regulatory policies directly affect the volatility of the entire market.

What market participants can control is non-systematic risk, including:

• Technical Risk: Involves system security and stability
• Business Risk: Caused by improper decision-making
• Liquidity Risk: Assets cannot be traded in a timely manner at a reasonable price.
• Trust Risk: Unable to timely execute withdrawal, transfer, and other operations
• Moral Hazard: Damaging investor interests to maximize one's own benefits.

The risk management department plays an important role in the exchange, needing to closely monitor various risk indicators such as liquidity, arbitrage activities, account anomalies, etc., and maintain close contact with other departments.

However, during the rapid development phase of the industry, risk management will undoubtedly impose certain constraints on the speed of development. Currently, many small and medium-sized trading platforms still lack awareness of risk management, with significant deficiencies existing at the physical, system, and governance levels.

There is no doubt that if the blockchain industry is to enter the mainstream, the trading platform, as the core of the industry, must properly address the issue of "Risk Management".

Asset Security: The Core Objective of Risk Management

According to the data, the total value of stolen assets on digital currency platforms reached 283 million USD in 2019. Despite major security incidents being years in the past, the phenomenon of digital currency "vanishing into thin air" still occurs from time to time, and the security of digital assets remains a focal point of concern in the industry.

To this end, some trading platforms have taken the following measures:

• Establish a strict financial audit and real-time monitoring alarm system
• Enhance security by separating hot and cold wallets and using hardware wallets.
• Establish a prior compensation mechanism for users
• Establish a user protection fund

At the same time, some platforms also focus on real-time and batch reconciliation, conducting real-time tracking, assessment, and tracing of blockchain addresses, and appointing professional customer service and risk management experts to analyze users' asset risks, enhancing user education related to risk management.

Custodial storage is regarded as an important method for ensuring asset security and is a key link in the transition from traditional finance to the blockchain industry. For small and medium-sized enterprises with limited technical capabilities, introducing third-party custodial services or purchasing relevant insurance can effectively enhance the security level of digital asset storage.

In addition to external measures, the moral risk of the platform itself is also a key focus that needs attention. Industry insiders suggest that platforms can choose to be as open and transparent as possible, inviting peers to jointly supervise to reduce the possibility of client assets being misappropriated.

Compliance Risk Management: Eliminate Uncertainty

In the face of many uncertainties, digital currency platforms actively embracing regulation and compliant operations have become necessary conditions to reduce policy and legal risks. Currently, leading digital currency platforms in the industry have established compliance risk management systems that cover pre-event, in-event, and post-event stages.

Some platforms' practices include:

• Establish a standardized KYC/AML anti-money laundering system, formulate strict account opening principles and pre-review standards.
• Obtain relevant licenses and accept supervision from regulatory agencies.
• Diversify compliance risks through distributed operations, such as applying for licenses in multiple countries and regions, and opening fiat trading channels.
• Collaborate with compliance companies such as AML/KYC and related consulting firms globally.
• Establish a dedicated compliance department responsible for compliance review of internal product lines and business lines, providing Risk Management guidelines.
• The legal internal control department provides professional legal guidance to avoid legal risks.

Technical Risk Management: The Guardian of Platform Security

For trading platforms, technical security issues are the most common risk management problems, and even leading platforms find it difficult to completely avoid them. For example, several well-known exchanges have suffered DDoS attacks during the same period, leading to temporary outages and other issues.

To build a strong technical defense, different platforms have adopted various measures:

• Achieve quantitative monitoring of market risks across various businesses and automatic strategy hedging.
• Establish a cybersecurity, compliance system, privacy data protection, and technology risk management system as required by the licensed institutions.
• Hire a globally leading external company for IT audit consulting
• Launch a big data risk control security system based on the blockchain industry to achieve multi-dimensional real-time risk monitoring.
• Build a comprehensive risk management system, based on data analysis to construct real-time data calculations, and employ online machine learning models for intelligent detection.

Internal Risk Management: An Important Aspect That Cannot Be Ignored

According to statistics, nearly 2/3 of cybersecurity issues are caused by negligence or dereliction of duty by internal employees. Therefore, internal security in blockchain enterprises is more important than external security, as most security incidents are often related to collusion between internal and external parties or long-term infiltration by hackers.

Each platform generally emphasizes the following points in internal control:

• Standardization of the process
• Clear division of responsibilities
• Strict Permission Management
• Regular audits

Some platforms have also adopted unique practices:

• Implement sufficient isolation of systems and permissions, and enforce minimal management of information permissions.
• Establish a Risk Management Committee system and a security incident handling framework
• Conduct irregular risk management related training for employees
• Conduct internal "phishing enforcement", such as sending simulated phishing emails, and establish a warning mechanism for staff who are lax in Risk Management.
• Implement a "Zero Trust Model", verifying and trusting every step of the operation.

Learn from Traditional Financial Experience

The risk management requirements in the digital currency market may be higher than those in traditional financial markets. On one hand, the volatility of the digital currency market far exceeds that of most traditional financial assets; on the other hand, the integration of information flow and fund flow in blockchain payments offers greater anonymity, making it very difficult to recover funds once they are transferred out.

Therefore, risk management in the blockchain industry can draw on experiences from traditional finance and the internet sectors:

• Learn about the relatively mature credit system in the traditional finance sector
• Drawing on the methods used in the internet industry to convert user behavior into credit records using big data.
• Explore how to effectively extract on-chain information and convert it into risk management decision indicators
• Consider separating trading from assets, with different entities responsible for asset settlement, clearing, and custody.

In addition, digital currency platforms need to increase their risk management investment. Research shows that the security teams of digital currency exchanges account for an average of 13% of the total staff, and spend an average of 17% of the budget to ensure the secure operation of the exchanges. Considering the profitability and growth potential of these platforms, it is clear that more funds need to be invested, more high-level risk management talent needs to be recruited, and a more advanced and comprehensive risk management system needs to be established.

As an industry insider said, "Investment in risk management can be seen as an opportunity cost. The stricter the risk control, the more resources need to be invested, and the more business opportunities may be lost as a result, but it also reduces the risk of loss of existing assets. Companies that value corporate reputation and long-term interests will naturally place greater emphasis on the safety of customer assets."