Opening discussion on banking sector risk exposures and vulnerabilities from virtual currencies: An operational risk perspective

We develop the first basic Operational Risk perspective on key risk management issues associated with the development of new forms of electronic currency in the real economy. In particular, we focus on understanding the development of new risks types and the evolution of current risk types as new components of financial institutions arise to cater for an increasing demand for electronic money, micropayment systems, Virtual money and cryptographic (Crypto) currencies. In particular, this paper proposes a framework of risk identification and assessment applied to Virtual and Crypto currencies from a banking regulation perspective. In doing so, it addresses the topical issues of understanding important key Operational Risk vulnerabilities and exposure risk drivers under the framework of the Basel II/III banking regulation, specifically associated with Virtual and Crypto currencies. This is critical to consider should such alternative currencies continue to grow in utilisation to the point that they enter into the banking sector, through commercial banks and financial institutions who are beginning to contemplate their recognition in terms of deposits, transactions and exchangeability for fiat currencies. We highlight how some of the features of Virtual and Crypto currencies are important drivers of Operational Risk, posing both management and regulatory challenges that must start to be considered and addressed both by regulators, central banks and security exchanges. In this paper we focus purely on the Operational Risk perspective of banks operating in an environment where such ‘electronic’ Virtual currencies are available. Some aspects of this discussion are directly relevant now, whilst others can be understood as discussions to raise awareness of issues in Operational Risk that will arise as Virtual currency start to interact more widely in the real economy. We propose a structure of risk analysis starting with the exposures and vulnerabilities of virtual and crypto currencies as the drivers of operational risk for these new means of exchange. Then by using risk drivers, our approach allows us to highlight the sources of possible adverse consequences, when using or generating virtual and crypto currencies. These are then mapped into the risks associated to the Basel categories, providing an easier view of regulatory response, and better mitigation techniques. In addition, this will help identify and address the root causes of the Operational Risks associated with virtual and crypto currencies, rather than just presenting their symptoms.