Risks of Investing in Cryptocurrencies

All financial markets carry some risk with them. This is the price that must be paid in return for potentially earning a return on your investments. Conversely, one can also say that the return earned on an investment is the reward for taking a risk.

Different markets have different risk profiles. Bond markets are generally the safest, especially because nobody expects an entire country to default on their debt, and the risk of a Fortune 500 company defaulting on a bond issue is also fairly low. Municipalities, smaller companies, and many other types of entities can also issue bonds, although such bonds might be deemed to be more risky. Stock markets are usually even more risky than, with Blue Chip companies being less risky than mid-caps, and penny stocks being high risk. ETF's, Forex, and Derivatives markets all have varying risk profiles. In the end, however, there is no question that Cryptoasset markets may be more volatile and more risky than all other types of financial markets.

There are different reasons why investing in crypto is risky. Some of these factors relate to the market as a whole, and others relate to specific projects. Let's examine some of the potential issues.

Issues that are Internal to Projects

At the most basic level, a cryptoasset project needs to be assessed on a number of levels: Technology, vision, team, financial structure, marketing, and a dozen other factors described in more detail on our Evaluating a Project page.

A chain is only as strong as its weakest link. Something that goes wrong with any number of aspects of a project can derail that project, and with it, your investment. A project not designed properly for scaling can be strangled as usage ramps up. A mistake in the coding can be discovered years into the project, and exploited by malicious actors. Project milestones can be missed when coding challenges prove to be greater than expected. Key developers can lose interest and move on to more exciting projects. Marketing campaigns can backfire.

Any of the above reasons, and many more, can derail a project internally. When that happens, the trading price can suffer and the market value of your portfolio will diminish, sometimes for extended period of time (or even permanently). There are literally thousands of blockchain projects that have been started over the past few years and which are now defunct, with assets no longer trading on public exchanges. To keep things in perspective, check out the "dead coins" website.

Competition With Similar Projects

In any market, the "First Mover" usually has a very strong advantage over other competitors. Imagine how hard it would be now for a new social media platform to dethrone Facebook, or for a new search engine to dethrone Google. Even if the first mover has technology that is inferior to new entrants, their "first mover advantage" is usually enough for the entrenched entity to remain dominant.

Critical mass of users is also important. Some systems are designed to work best when large numbers of people are using them. Think about social venues - a crowd attracts a crowd. People want to go where their friends are. If a technology is not widespread in implementation, its usage will not be widespread either. ExampleCoin could be the most innovative new cryptocurrency on the planet, but if no merchants or service providers accept it, it may never gain traction.

When evaluating a project, technical superiority does not guarantee success. Will the project that you're investing in be able to survive in a crowded and competitive space? History shows us many examples of good technologies that were crowded out by inferior products. Just do some research into Betamax vs VHS as a prime example of a good product that was eventually buried by a competitor.

Market Dominance of Bitcoin

For many years, Bitcoin essentially moved the entire cryptocurrency market space. When Bitcoin went up, the entire market went up. When Bitcoin went down, the entire market went down. Eventually, with a strong rise in the number of alternative cryptoasset projects in 2016 and 2017, the market began to partially decouple from Bitcoin. It was possible to see some periods where investment seemed to flow in a wave between Bitcoin and all other currencies. Sometimes, Bitcoin gained strength (and market share) as alternative projects went down, and at other times, the alternative cryptos seemed to gain strength while Bitcoin went down. However, even today (Summer 2019), Bitcoin still accounts for more than fifty percent of the global market capitalization of all cryptocurrencies combined.

Another phenomena that started to happen with increasing frequency in 2017 and 2018 was the gradual introduction of more "pairing couples" on cryptoasset exchanges. For years, essentially the only way to buy most alternative cryptos was to purchase them with Bitcoin. However, especially in 2017, some exchanges began to offer trading of alternative small-cap cryptos against other coins (especially ETH, Tether, and LTC), or directly against fiat currencies (especially the USD and EUR). This phenomenon further decoupled the price of Bitcoin from the rest of the crypto marketplace. This overall trend may continue in coming years, as more trading options become available and Bitcoin's dominance is further eroded. Note that this doesn't necessarily mean that Bitcoin will drop in fiat price; it just means that Bitcoin's share of the overall crypto markets may decline in percentage terms. Of course, if you're investing, it's always important to consider the performance of your assets in percentage terms rather than just in absolute terms.

Despite the gradual decoupling of Bitcoin from alternative cryptoassets, all future Bitcoin corrections will almost undoubtedly have a negative effect upon the rest of the market. And Bitcoin is no stranger to corrections! In 2017 alone, Bitcoin went through seven separate notable corrections. Looking at a broader time frame, Bitcoin was at an all-time high of around $1200 USD in late 2013, but then dropped precipitiously to around $200 two years later. Obviously, it eventually recovered and surpassed the previous 2013 highs, but it took years. Are you willing and financially able to stomach a drop of 80% of your portfolio value for a period of a few years? Remember, the markets can remain irrational for longer than you can remain solvent.

Regulation of Cryptoassets

At the present time, most governments around the world have almost no idea of how to deal with cryptoassets. This uncertainty remains a common theme whether you're talking about ruling governments, central banks, member banking networks (consumer banking), taxation authorities, or accounting firms.

With respect to national governments, a few countries have actively embraced cryptocurrencies and passed legislation to confirm that investors need not fear government intervention. Japan officially recognizes Bitcoin and digital currencies as a "means of payment that is not a legal currency." Other countries have gone in the opposite direction and have stated that cryptocurrencies are illegal. In Algeria, "The purchase, sale, use and holding of so-called virtual currency is prohibited." To be clear, the status of cryptocurrencies is "legal" in most countries, but don't confuse this with "legal tender." More detailed information about the legal status of cryptocurrencies in various countries can be found in this Wikipedia article.

In the late summer of 2017, rumours swirled about China banning cryptocurrencies, and the entire cryptoasset markets took an immediate hit, deep into correction territory. The Chinese government subsequently banned citizens from participating in ICO's. That was a wise long-term move, in order to protect citizens from scams. If another major nation such as the United States were to take the same blanket approach to all ICO's, the overall crypto markets would probably crash, and it could take a long time for them to recover. Of course, nobody knows what the risk of this sort of event could be. In fact, there was already a fairly significant crack-down on ICO's in the United States in 2018, and the effects were negative for overall market sentiment.

The proliferation of cryptocurrencies has certainly attracted the attention of central and member banks around the world. It is certainly quite possible that central banks could start creating and issuing their own nationalized cryptocurrencies, with the full support of political powers. Such a move could be embraced by many mainstream consumers, especially if such a currency could be used safely and conveniently within the existing banking systems. Nationalized cryptocurrencies could theoretically draw capital away from existing decentralized global cryptoasset markets.

Regulations about the conversion of fiat to crypto (and vice versa) could have a major negative impact upon the ability of users/investors to embrace crypto in today's fiat-based society. If governments shut down fiat gateway exchanges, or banking systems freeze the ability to transfer fiat to and from known cryptoasset trading entities, that would significantly slow the adoption of cryptocurrencies. Gateway exchanges are the weakest link in the system, and an anti-cryptoasset campaign would almost certainly attempt to target this weakness.

Tax laws, depending on the way they are written, can either encourage or discourage trading or investing in cryptocurrencies. In some countries, every single transaction (including crypto-to-crypto) is treated as a taxable event. In a system where direct fiat equivalents and capital/income gains and losses must be determined for every transaction, and then any applicable foreign exchange rates established simultaneously, it is very difficult for an individual to properly account for trading gains/losses and to maintain compliance within the tax system. Criticizing the relevant taxation authorities for this problem is probably a waste of energy. One solution would be the development of accessible and affordable tax preparation software packages that could factor all necessary data into their calculations, including transactions on foreign exchanges, and therefore facilitate the submission of tax-compliant returns.

If a major global exchange such as Binance or Coinbase wanted to help encourage the global adoption of cryptocurrencies, perhaps they could help sponsor the development of such software. In the meantime, tax treatment is a risk in many countries. As tax authorities continue to gain an understanding of cryptoasset markets, and make decisions about how tax treatments will apply to transactions, there is the potential that future clarifications of taxation regulations in some countries will not be friendly to cryptoasset investors.

If you'd like to read an interesting article on CoinDesk, written by a US lawyer who sues cryptoasset exchanges, click here.

Global Economic Factors

Global economic developments can affect your cryptocurrency portfolio. What happens to your portfolio when your national fiat currency gains or loses strength again the US dollar? What happens when the US dollar gains/weakens against all other fiat currencies?

What happens when global geopolitical events affect financial markets? If stock markets go up/down, does this affect cryptoasset markets? What about a major stock market correction like "Black Monday?" In general, the second half of 2017 saw a general "small" outflow from traditional markets into cryptoasset markets, but the transfer of funds turned out to be a significant infusion of capital (due to the much smaller size of the crypto markets in comparison to traditional markets). The same trend may happen again during all future upcycles in the crypto markets. Would financial strengthening of traditional markets slow this transfer of capital? What about bond and forex and derivatives markets, would the same apply?

Do trading prices of various commodity markets have an effect on cryptoassets? In particular, think about the effects of changes in the prices of oil, gold, and silver. Although the relationship between these commodities and crypto is much more tenuous, every action in the global financial system has ripple effects upon all other systems.

If there was another global economic recession similar to the Great Recession of 2008, how would cryptoasset markets react? Would there be a "flight to safety" which would result into money flowing into the cryptoasset markets? Or would margin calls in the traditional markets need to be covered, leading to some crypto investors rapidly selling off crypto assets to meet those stock market margin calls?

How do central bank interest rates, national inflation rates, and national/global GDP rates affect the cryptoasset markets? As cryptoasset markets mature and stabilize over the upcoming ten to twenty years, diminishing volatility will be beneficial to investors. However, at the same time, stronger cryptoasset markets will probably also become more subject to effects based upon the vagaries of external global economic factors.

Black Swan Events

A "black swan" is an event or occurrence, geopolitical or natural, that deviates beyond what is normally expected of a situation. Black swan events are extremely difficult to predict. Black swan events are infrequent, but often have far-reaching or even global implications. Some geopolitical examples of black swan events have been the tearing down of the Berlin Wall, the fall of Soviet communism, or the Arab Spring uprisings. Some natural examples of black swan events would be the 2004 Indian Ocean tsunami, the 2010 Icelandic volcanic ash clouds that disrupted global air travel, or Hurricane Katrina's effect upon the United States in 2005.

It is sometimes possible to predict potential black swan events, although it is not possible to accurately determine the likelihood that such events could actually happen, or exactly when they might occur. We can think of many possible examples of potential natural black swan events. Major earthquakes in western North America could cause part of California or Vancouver to slide into the ocean. A full collapse of ice shelves in Antarctica could raise global sea levels by several feet and displace billions of humans. A major volcanic eruption could disrupt or prevent regional or global air travel for more than a year. A massive solar flare could knock out half of Earth's satellites and electronic systems. A meteor impact could rival the effects of a global nuclear war. Those are just some possible (but hopefully unlikely) examples.

We can also think of several possible examples of potential geopolitical black swan events. There could be a nuclear exchange between the US and a rogue North Korean regime. The assassination of a major world leader could plunge a country into full-scale civil war. A revelation that life exists on other planets, coupled with communications from an intelligent extra-terrestrial species, would completely change our world.

Black swan events do not necessarily have to have a negative impact on humanity, even though it seems that way based on our possible examples so far. One beneficial potential black swan event would be the discovery of a cheap cold fusion process that would essential give the gift of extremely cheap electricity to all of mankind. This would also disrupt global economic systems, although in a different way than most geopolitical or natural disasters.

Although the number of assorted black swan events that happen in any person's lifetime is quite low, these events invariably have major global repercussions. They would affect global economic systems and financial flows, and could therefore affect your investments. A volcano spewing ash in Iceland probably doesn't seem like it would have an effect upon your crypto portfolio, but what if your main investment was in a blockchain asset used in the global aviation networks, and global air travel was restricted for several months or longer?

Lateral Thinking

The aim of lateral thinking is to solve problems by using indirect and creative approaches, typically through viewing problems in a new and unusual light. In other words, "think outside the box." Here's an article that you should read that "thinks outside the box" with respect to cryptocurrencies:

https://hackernoon.com/what-will-bitcoin-look-like-in-twenty-years-7e75481a798c