Note: This post should not be considered professional investment advice. If you want to invest in digital assets like cryptocurrency, assess your own personal and financial situation, risk tolerance and consult a financial professional.
Cryptocurrencies have become a significant topic of interest for investors. As with any overly hyped topic, there are polarising opinions and lots of noise, making it difficult for investors to get a clear picture of the risks involved. The truth is, cryptocurrencies are in their infancy and have several significant risks that demand an investor’s attention. Over time, these risks will increase and decrease, and new risks will emerge. If you’re considering whether to add cryptocurrency to your traditional portfolio, here are a few critical risks to examine.
Price volatility & manipulation
Cryptocurrencies have been on a wild ride. Epic booms, busts, wild swings, and scams have amazed and baffled investors who have witnessed unexplainable and unprecedented gains and losses over the last decade.
For example, here’s a coinmetrics chart on the volatility of daily returns (14-day average) comparing BTC (Red) to S&P 500 (Teal). Volatility swings in Bitcoin (BTC) and other crypto assets makes it hard for investors (especially retail investors) to build confidence and secure gains.
Volatility in crypto prices is common and generally stems from three main sources; sentiment, speculation and market manipulation. It’s the unregulated and anonymous nature of digital asset markets combined with the susceptibility of cryptocurrencies and other crypto assets to sentiment, emotion, and publicity that make prices volatile.
Crypto exchanges, media owners, and powerful investors can manipulate prices. This manipulation seems to be widespread – albeit not widely proven yet. The most used manipulation strategies include wash trading, dark pool trading, pump and dumps, and shilling.
Lack of regulations
A lack of regulatory frameworks means there is a high degree of uncertainty like price volatility and manipulation. Investors and entrepreneurs are also concerned about the possibility of future restrictions which may have a significant impact on the value of cryptocurrencies or completely ban them altogether.
For the large part, crypto regulations are complex, disorganised and haphazard. One area of particular concern for investors is tax treatment. A lack of regulation or what some term as regulatory greyness means some investors are scared off investing because they don’t have a clear understanding of what tax obligations need consideration or what actions must be taken and what records need to be kept.
The good news is that regulators are catching up. Authorities in many jurisdictions are taking steps, producing research papers, standards and introducing new regulations. One of the first countries to begin building a robust regulatory framework is Switzerland. The country has proposed an idea for minimising rules while still keeping companies in line with legislation through ‘sandboxes’ allowing startups to experiment and innovate within controlled conditions. Britain and Singapore have been exploring their blockchain and crypto regulatory environment as well, providing platforms which enable companies to experiment under relaxed regulation and licensing requirements. In the US, the New York Attorney General’s Office recently launched the most comprehensive study on exchanges.
Thanks to a market downturn, the entire digital asset market is worth less than McDonald’s. But even before the 2018 slump, the crypto market relative to other markets like currency, gold, stock markets was vastly smaller.
Market adoption remains low for a host of reasons from regulatory concerns and technology shortfalls to market volatility, public misunderstandings and the fact that cryptocurrencies and the underlying blockchain technology that powers them are still emerging and in their infancy. This means there’s a chance that this new asset class, impeded by many different factors, regulations being one of them, will never be broadly adopted, leading to a complete loss of value. There is a clear need for more regulations, technology improvements and institutionalisation to help drive trust and scale.
Security, custody & consumer rights
Storing cryptocurrencies and other crypto assets can be risky business. There have been significant incidents of theft on personal wallets but also on exchanges. Hacking remains a constant threat if cryptocurrencies are not correctly stored and protected. To make things worse, assets that get lost or stolen cannot be recovered, and mistaken transactions cannot be reversed. Also, unlike traditional investing through a bank or brokerage, cryptos don’t have official safeguards or insurances. Rebates on lost investments depend on the whim of the organisation you’re dealing with.
The good news. Custody solutions which give financial institutions the ability to hold cryptocurrencies on behalf of trading clients are beginning to emerge. This is expected to catalyse the entry of institutional capital into the industry and in-turn provide a trusted stamp of approval for retail investors as well.
Coinbase has announced its custody product upon completion of their first successful deposit. The multinational investment bank, Citigroup, has announced that it will offer crypto custody solutions to institutional investors. Citigroup launched a product called Digital Asset Receipt, intended for institutional investors to securely invest in cryptocurrencies in a regulated and secure manner. There is also Fidelity, which has announced a new and separate company called Fidelity Digital Asset Services. The Wall Street incumbent will handle custody for major cryptocurrencies such as bitcoin and execute trades for investors such as hedge funds and family offices.
Exiting the market
The crypto market’s off-ramps are a real problem for many investors. Many exchanges only allow withdrawals in USD, some also allow EUR, GBP, and JPY, but the choice is minimal, and exchanges frequently require high minimum withdrawals when withdrawing to fiat. Lots of exchanges that support fiat withdrawals also only accept a few leading cryptocurrencies and to withdraw fiat money, investors need to go through a tedious verification process that can take months.
Some exchanges have also been accused of withholding funds for unclear reasons, and many banks are still very wary of accepting money from the sale of cryptocurrency. All this exposes investors to exchange rates, fees, and risks associated with dealing with opaque exchanges. The situation is improving, but it’s far from ideal.
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Anthony is the head of content and research at Intrepid Ventures.
Also published on Medium.