Let’s face it, with the recent events we can agree that we live in a world of uncertainty. However, this shouldn’t come as a surprise to us. After all, economy-wide changes have been a phenomenon that we have experienced throughout history. This might not be a comforting thought. After all, this means our investments are up against another set of risks. But don’t let yourself become crippled with fear. Instead, take the time to learn about the different risks at play and how you can strategize against them. There are two main types of risk we will consider. However, our focus will be on systematic risks that affect all markets, even the market for cryptocurrency. That’s why we put together a complete guide of everything that you need to know about systematic risk in crypto markets. 

Don’t worry if investing is new to you, we’ll start with the basics. When building a portfolio, an investor must consider the total risk of their investments. This is a combination of both unsystematic and systematic risks. Let’s start with the more common of the two, the unsystematic risks.

Unsystematic Risk

Unsystematic risk is any risk that is a company or industry-specific. We also refer to this type of risk as a specific risk, diversifiable risk, idiosyncratic risk, or residual risk. Errors and bad assumptions a business makes are among the most common forms of this risk. For example, in the absence of Covid-19, an organization might assume the majority of consumers will want to stay online. As a result, they believe the majority of grocery sales will be made through an online portal. Based on this assumption, the store may decide to close down its retail stores. Imagine that their assumption is incorrect and people actually preferred shopping in-store. Therefore, the grocery chain will be undertaking this risk. The decision will not affect any other business.

This means if you are an investor, you don’t have to take on all of this risk. By investing in different companies, you will reduce the risk of losing all your money in one bad decision. Some of these might include bonds, real estate, stocks, and other cheap equities. This is only one type of unsystematic risk. Another is liquidity risk. This is a form of risk that involves new competitors operating in your niche or changes in the behavior of your consumers. Financial risk is also unsystematic. This is because depending on how much debt a firm decides to take on will be different from one business to the next. 

Let’s go back to the cryptomarket. Here an example of unsystematic risk is if you held all of your money in a currency like bitcoin. This currency is known to be volatile since it is held by a few powerful players. Therefore, your investment will drop drastically if one of them decides to sell.

Systematic Risk Defined

To define systematic risk, we first need to consider that this term goes by many names. Some of these include market risk, non-diversifiable risk, and volatility risk. At first glance, these names might not mean a lot to you. However, an easy way to remember these terms are as any risk that is leftover after investors diversify the rest of the risk away. Therefore, anything and everything faces this type of risk since it is not in their control. There is no way to eliminate all of this risk, no matter how diversified your portfolio is. We can’t attribute this risk to any individual investment. This means when we are considering systemic risk it would affect the entire cryptocurrency market, not just a single coin.

In other words, systematic risk is any major failure of a financial system. When a crisis occurs, providers of capital including investors, depositors, or capital markets lose trust in the consumers. This happens in a market system so we can’t avoid it. This also means when investors lose trust in fiat money they turn to alternative assets like cryptocurrencies, precious metals, or bonds. 

It is important to remember that systematic risk is dependent on context. A risk that appears to affect everyone might actually leave some industries unscathed. For example, throughout the Coronavirus pandemic, we have noticed that several big tech companies performing very well. Some, like Amazon, even faced a small percentage of growth. For these ones the impact was minimal. In other examples, it is important to consider what seems systematic to one country or the technology industry at large might only affect the area in which you are closely related. From the perspective of another area, the risk may not be systemic at all.

Examples of Systematic Risk

Systematic risk is more prominent than you think. Consider the one we are experiencing right now. The presence of the novel Coronavirus has impacted just about every industry across the board leaving only a handful of big players untouched. Other examples include changes to laws, tax reforms, increases in interest rates, purchase power risk, natural disasters, political instability, changes to foreign policy, and exchange rate changes. The failure of banks should also be considered since a country’s economy is largely dependent on the health of the banking system. In general, this leads to economic recessions. Recessions are also considered a non-diversifiable or systematic risk. 

Another example of systematic risk is the financial crisis of 2007. Although the events leading up to it started in the mortgage market. It slowly spread to all credit and financial markets. The final result was an economy-wide recession. 

This can apply to the crypto market in a few ways. First, the market itself could be the systematic risk that undermines fiat currencies. Alternatively, the market itself might face its own systematic risks.

Where Crypto Comes In

It is important to note that the bitcoin network is designed to be decentralized. However, the web and the exchanges that offer cryptocurrency-related services are not. This means any risks that affect these networks can affect cryptocurrency. Therefore, cryptocurrency, like anything else, is still subject to systematic risk. Additionally, the less enticing the cryptocurrency market is for investors the less systematic risk that can spill over into traditional markets. With hacks, security scandals, and increased government regulations weakness the spillover power of this market.

Cryptomarkets Are A Systematic Risk

The alternative viewpoint is that the widespread use of virtual currencies might be the systematic risk that traditional assets should watch out for. This is because, unlike traditional assets, cryptocurrencies function as a separate risk source. According to one study, the total system-wide risk of cryptocurrencies operates opposite to that of traditional assets. This means in periods when risk in traditional markets is low, it is high in the crypto economy.

Why might this be the case? This is likely true to a couple of key fundamentals that cryptocurrency hopes to operate on. First, virtual currencies come to infinite supply. This is similar to assets that are precious metals like gold. Therefore, there is less opportunity for governments to inflate or deflate the prices as they can with fiat money. The second reason is that cryptocurrencies offer peer-to-peer transactions with no intermediary. However, they can still offer security through the blockchain. A new economy like crypto has the potential to undermine traditional asset classes altogether. 

In general, many believe cryptocurrency was designed to “threaten the financial system.” This is evident through the creation of a trust, which will undermine the dominance of institutions like central banks. If this occurs and people begin to lose trust in traditional markets they will look at new markets like crypto for investment.

Hedge Against Legacy Financial System

As Chris King says, “buying bitcoin is a non-expiring hedge against the legacy financial system.” Consider that cryptocurrency is almost an industry of its own. Since it is still considered new, many of the risks we had previously mentioned might not affect cryptocurrency. Since the nature of blockchain is that it is decentralized, one could suggest that political instability, interest rates, and the health of the banking system wouldn’t have a direct impact on the industry. Additionally, countries have continued to debate how the asset class should be taxed. Therefore, systematic risks are different for traditional assets than they are for crypto. However, many of the risks faced in traditional markets will continue to become apparent as crypto becomes more mainstream in usage. 

Another major systematic risk that must be considered is that of hacking. While hacking is common in traditional assets, it should be noted that hacking the blockchain can result in much greater returns at perceivably less risk. As the industry continues to grow and more money is invested, hackers become more and more of a risk. Although hacking has happened on many occasions, the fewer people feel secure they less confidence they will have. With less confidence means the crypto economy at large could lose value. This is because there is no intrinsic value in cryptocurrency and therefore, without belief, a cryptocurrency is worth something it won’t be worth anything at all. This is because the majority of crypto assets and crypto companies are either under-insured or uninsurable at all. 

Crypto is Resilient

Nassim Taleb who used the term anti-fragility to describe the Lindy effect and how some systems can benefit from shocks in the system. This means in the presence of all the systematic risks identified, crypto markets that succeed will be able to greatly increase their total lifespan. Although we also mentioned that the trust of the public could spurn a systematic risk of sorts, crypto markets have survived speculation from some of the most influential financial and political leaders today. 

How to Mitigate Against Systematic Risk

We’d agree systemic crises don’t happen often. However, when they do they often enforce big changes in the economy as a whole. It is at these times that traditional investments fare badly, and many lose their life savings. While a systemic risk won’t happen overnight, the gradual build makes it difficult to pinpoint the exact moment it will occur. With research, it is possible to improve judgment for when things might just be taking a downturn. Your research should help you to understand the nature of vulnerability in economies and markets. This can be done using a domestic systemic risk indicator which is a weighted average of early warning indicators. Some of these indicators include property prices being overvalued, changes in credit to GDP ratios, imbalances in the amount a certain country brings in from exports and spends on imports, media opinions, and debt burden in the private sector.

Additionally, it is important to remember things can only “stay good for so long”. This means in environments with low-interest rates and the accumulation of large amounts of debt, it is only a matter of time before things take a turn.

Therefore, in times of financial uncertainty, the cryptocurrency market may introduce additional unsystematic risks to traditional asset classes. While unsystematic risks are common, they can trigger larger systematic risks.

Diversify Your Portfolio With Crypto

Since systematic risks affect so many markets, the benefits of diversification can be quickly lost. This is because in global events, the majority of industries will be affected. However, studies like the one mentioned above present interesting finds. If these findings are correct, a combination of different categories of assets might help to limit some of the systematic risks. Many investors argue that cryptocurrency is uncorrelated to market factors making them less susceptible to systematic risk such as inflation. This can be done by purchasing small amounts of a cryptocurrency like bitcoin every day like you would any other investment portfolio.

Investing in a new market like cryptocurrencies can be scary. That’s why using a platform like HedgeTrade can be a great place to start. Using this platform, you will be able to access the predictions of experts in the industry. This will help to inform your decisions and create a balanced portfolio, ready to face any risks that come your way. To sign up, visit app.hedgetrade.com/signup!