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The Dark Side of the Coin: Risks of Investing in Cryptocurrencies

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May 11, 2018 – Comments (0)

Bitcoin has had a great run. And that run has resulted in a deluge of other cryptocurrencies, used not only for financial transactions, but for entrepreneurs who issue them as a means of garnering investment capital. What once was a joke on Wall Street now has venture capitalists and fund managers sitting up and taking notice. And there is a certain democratization in all of this. As economist Jesus Fernandez-Vilaverde at VoxEu states:

“Today, any person with internet access can use a bewildering array of cryptocurrencies as means of exchange. Everyone has heard about Bitcoin, whose market capitalisation (the price per unit times the circulating supply), as of 6 July 2017, exceeds $42 billion. This is only slightly below the market capitalisation of Ford Motor Company. Six other cryptocurrencies (Ethereum, Ripple, Litecoin, Ethereum Classic, NEM, and Dash) have market caps of more than $1 billion, and another 37 have market caps between $100 and $999.99 million. Cryptocurrencies still represent a trivial fraction of all payments in the world economy, but these shares may perhaps increase exponentially over the next few years. Cryptocurrencies may even become widespread in emerging economies with dysfunctional government monies.”

The Cusp of a New Financial Market?

It appears at first that we are on the cusp of an entirely new financial market – private money - currencies that are not regulated by any government and whose value in fiat currency is based upon what users are willing to pay. Rather like a traditional stock, with the exception that financial transactions also occur to purchase products and services, and those transactions are completely encrypted, available only to those who hold password keys

The blockchain technology upon which cryptocurrencies are built, moreover, provides a certain layer of protection against fraud and theft, albeit not 100%, but certainly more than traditional banking systems have afforded. It’s difficult to commit identity theft, for example, if a hacker has no access to the identity of holders of cryptocurrencies. These benefits, of course, make crypto a haven for illicit activity of other sorts – drug and illegal weapons sales, for example.

Still, there’s lots of hype around cryptocurrencies, with some saying they will overtake fiat currency as a preferred means of financial transactions.

But the verdict is still out. While big names such as Tim Draper extol the huge potential of crypto and the possibility to become the preferred tender for financial transactions, a recent survey of top European economists resulted in 75% stating that they did not see cryptocurrencies as a risk to traditional banking and overall systemic financial stability.

The “best case scenario” is probably that fiat and crypto currencies will settle into some type of co-existence, at least in countries where both governments and fiat currencies are stable.

As an Investment

Crypto is a dizzying market. Every week new currency ICO’s are launched. But, according to Christopher Catalini (professor at MIT’s Sloan School of Management), in a recent interview with Kiplinger, most will not be around 10 years from now. This makes investment in them risky business indeed. Anyone who is considering such an investment should be fully informed of the risks involved.

Rush to Invest Without Deep Analysis

Cryptocurrencies are complex and totally reliant on the technical abilities of their founders. Consider the research and deliberation that venture capitalists undergo before ever investing in a startup of any kind. While an existing crypto or an ICO may look like the “next shiny thing” on the surface, there are underlying supports that must be in place and some gatherable data about the prospects of its success. Many ICO’s are the result of entrepreneurs’ attempts to raise capital for their startups. In this case, any investor should act diligently to research the prospects of that startup.

Risk of Fraud

There is a never-ending flood of ICO’s. in fact, as of January, 2018, there are near 3600 cryptocurrencies out there. Obviously, they are only worth was someone is willing to pay for them, and most are currently worth nothing. And, like every wave of new and risky investment opportunities, there is ample evidence that some are fraudulent or Ponzi schemes. ames Scott, CEO of a bockchain-based company Essay Supply, states "Investing in cryptocurrencies is a medium risk, whereas buying tokens is a waste of time in 90% of cases. ICO reviews can't cope with the enormous amount of frauds. Facebook, Twitter and Google have a strict policy towards them. Have we not so many scammers, ICO could be a great opportunity for the attraction of the investors. Right now, it remains a shaky investment".

One hedge against this risk is the rise of crypto index funds, most recently Chance River and Belpointe Crypto Index. The concept is the same as other index funds – acquire a diversity of currencies, based upon their own research, usually their trading volume, market capitalization, and quality of block chain technology. J. Some may fail, some will realize mediocre performance, and some will be clear “winners,” and the hope is that, over time, investors will realize profits from those that do survive and perform. This may be a less risky path for novice investors who are unwilling or unable to conduct their own research.

Volatility

Anyone who has watched Bitcoin understands the volatility of cryptos. It has dropped up to 80% of its value on several occasions. And, according to Ari Paul, CIO of the cryptocurrency hedge fund, Block Tower Capital, this is perhaps the greatest risk to investor dollars. But he points to valid and serious other risks as well:

Hacking/Theft

While blockchain technology is highly secure, storing of password keys is not. Once a personal key is stolen, a holder can easily and quickly be wiped out, and because those transactions have been entered into blocks and verified, there is nothing the true owner can do. Unlike bank accounts, there is no person “connected” to a coin, no FDIC insurance for protection, and no institution that will assist in recovery. The only “proof” of ownership is through a private key. Whoever hold the key holds the coin.

The method for coin storage is known as a wallet. There are online “wallets,” such as those offered by Coinbase, a Bitcoin brokerage that handles transactions and storage. Are they subject to hacking? Possibly.

The most secure method of storage, according to Paul, is to have your own physical control through a hardware wallet – a small piece of hardware similar to a USB stick – on which your private key is stored. Not having that key in your own computer or in anyone’s cloud service is just smarter.

Regulatory Risk

At this point, cryptocurrencies exist outside of government control or regulation, and this is a big part of the attraction to own them and to use them for purchases, sales, and other transactions.

But because these currencies are global in nature, there is a risk that governments may step in with regulatory restrictions and attempts to impose taxation. Just how this can be done is not exactly spelled out yet, but consider this: A U.S. citizen who owns an amount of Bitcoin could be negatively impacted by government intervention in a country across the world.

The biggest incentive for government intervention, according to Hermitage Capital CEO Bill Browder, is the ease with which criminal activity can occur without detection. Governments can bypass sanctions; criminals can conduct illegal transactions of any type. This, according to Browder, will force regulation, and the attraction of cryptos will decline significantly.

In Sum

Cryptocurrencies represent a new market. On the one hand, they are commodities that are traded like gold, based upon what a buyer is willing to pay. On the other hand, they are currencies used for financial transactions, in many of the same ways that fiat currencies are used. Further, this is a market that has experienced rapid growth, and that certainly contributes to instability and volatility. Consider, too, that no one has a crystal ball to predict the future of this market. Investors should be cautious, do their homework, understand the risks, and certainly never invest more than they can afford to lose.

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