What Are the Risks of Investing in Cryptocurrencies?

In every investment, there are risks that one has to take. The higher the risk, the bigger the profits tend to be. Cryptocurrencies are no different. The volatility of cryptocurrencies is what creates the potential for high gains, which in turn motivates people to invest in this emerging market in the first place. However, investors should always act responsibly to mitigate risks and understand that we really could lose all of our money if we’re not careful. This is particularly true of the particularly volatile crypto market. Bitcoin, the leading cryptocurrency, has shown a growth rate over the course of 2017 higher than any other commodity before it. No wonder everyone wants to get on board, and no wonder it’s called digital gold. What goes up may not necessarily go down, but there is certainly no guarantee it will stay up. Here are some things to think about before investing in cryptocurrencies.

Factors in the High Volatility of Cryptocurrencies

Cryptocurrencies are prone to immense volatility. Their price swings limit their usability as a currency, which means, at this stage, people tend to look at them more like investments than as currency. Some see them as a long-term store for value, others see them as a short-term speculative asset to flip. Investor decisions are driven by word of mouth, public announcements, news and most importantly, knowledge of the viability of the technology and features each cryptocurrency is based on (as defined by their websites and white papers).

After peaking at almost $20k on Dec 17, 2017, Bitcoin faced a major plunge down to $10,775 in one day, before climbing back to $14,400 the next day. Some analysts believe that the price drop, which occurred shortly after Bitcoin Cash (a cryptocurrency created by a hard fork on Bitcoin) became available for trading at the reputable exchange Coinbase, is not coincidental. Others blame the drop on the rumor spread on chatrooms and forums claiming cryptocurrency transactions would be a taxable event from the beginning of 2018. Speculators swarmed to sell their coins when the prices began falling and Coinbase halted operations for two hours. The announcement on their website claimed it was due to “high traffic,” but evidence of insider trading is under investigation.

It is said that 40% of all the available Bitcoins are held by 1000 people. It would be possible for them to manipulate the market by over-inflating the market value before they perform a massive sell-off, in order to create fear and uncertainty to ordinary investors about the rapid downfall.

Investors should be aware that the value of their coins could also be affected when buying or selling, due to the unpredictable time required for completing a transaction on the Blockchain. As all Blockchain transactions come in the form of a block entry, high traffic can cause a queue. The transaction completion time can range from a few minutes to a few days. Additionally, paying in Bitcoin can be problematic, as price fluctuations could dramatically affect its value from the initial payment until the refund request.

On the other hand, Bitcoin’s price volatility has created fortunes for many people, like the Winklevoss twins, who purchased 120,000 Bitcoins in 2012 to become the first Bitcoin billionaires in 2017. As Tyler Winklevoss put it, “We are very comfortable in very high-risk environments with absolutely no guarantee of success” (New York Times 12/2017).

Vulnerability to Hackers, Fraud and Legal Issues in Cryptocurrencies

The digital form of Cryptocurrencies, together with the lack of intermediaries (banks) or regulators (government), make Cryptocurrencies a tempting target for hackers or fraudsters. Individuals should be extra prudent about securing their private keys and be careful when confirming a transaction. Moreover, investors who store their assets at an exchange are not necessarily legally protected in case of losses by hack attacks. (MT. GOX, for instance, is a large exchange that suspended operations in 2014 after 850,000 Bitcoins were stolen).

Fraudsters may seize the opportunity of the lack of oversight to form Ponzi schemes, by promoting fast and guaranteed returns. Investors should be warned that when investing in cryptocurrencies, guarantees are not possible and if something seems too good to be true, it should be avoided. Furthermore, executing payments with cryptocurrencies should be conducted with additional attention, as there is a lack of legal protection in case of a scam (e.g. phishing).

Anonymity in cryptocurrency transactions has also been proven to be a tool for money transfers linked to illegal activities like drugs and child pornography. Peer-to-peer transactions may expose legit investors to unknowing participation in fraudulent events.

The decentralized nature of cryptocurrencies, together with their anonymity and differing regulatory status from country to country, raises issues that are yet to be addressed. For example, while capital gains from cryptocurrencies are considered taxable in the USA, there are plenty of loopholes for tax evasion as no such tax regulations exist in many other countries. In the same way, money laundering from illegal activities could occur, by cashing out the funds that were previously sent to an account at a country without relevant regulations.

Lastly, as laws and regulations are currently being adapted to cryptocurrencies, investors should be aware that the setting could change in the near future. Keep track of the new developments as banks and governments begin to get involved.

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