Crypto Investment: Smart Move Or Risky Gamble?

Cryptocurrencies are digital assets that people use for investment and to buy goods and services. They are incredibly volatile and not for all investors. The most popular cryptocurrency, Bitcoin, is highly volatile, and its value can fluctuate thousands of dollars in a single month. Other cryptocurrencies, such as Ethereum, Solana, Cardano, and Dogecoin, have also experienced significant price swings.

While some people have made large sums of money investing in crypto, it is primarily based on speculation, akin to gambling. Crypto is not a safe investment due to its volatility, unproven rate of return, and the ease with which theft and fraud can occur. Additionally, crypto is not considered a good long-term investment because of its volatility and the fact that it does not generate cash flow.

However, blockchain technology, which underpins cryptocurrencies, shows promise, and investors can bet on this technology by investing in companies that are rapidly adopting it.

Crypto's volatility

Cryptos Volatility

Volatility is a measure of how much the price of an asset has moved up or down over a period of time. Generally, the more volatile an asset is, the riskier it is considered to be as an investment. The more volatile an asset is, the more potential it has to offer higher returns or higher losses over shorter periods of time compared to less volatile assets.

Crypto is widely considered to be a volatile asset class, with the potential for significant upward and downward movements over shorter time periods. For example, at its peak in November 2021, the crypto market was worth upwards of $2.9 trillion. By mid-2022, hit by rising inflation and an aggressive rate-hiking cycle, the entire market was worth less than $900 billion. Then, in June 2024, cryptocurrencies collectively were worth more than $2.5 trillion.

Bitcoin, the first cryptocurrency and the largest by market capitalization, is not immune to volatility. For instance, after languishing below $17,000 at the beginning of 2023, less than two years later, Bitcoin now trades for upwards of $69,000.

Other cryptocurrencies, such as Ethereum, Solana, and Cardano, have also experienced significant volatility.

Factors that can increase volatility include news coverage, earnings reports, and unusually high or very low spikes in trading volume.

The crypto market is still a relatively new asset class, and as it matures, many of the factors that drive volatility are expected to subside.

Unproven rate of return

Cryptocurrency is a nascent asset class with origins only dating back to 2009. It is a decentralised, digital medium of exchange, secured through cryptography. Bitcoin, the first cryptocurrency, remains the largest by market capitalisation.

The value of a cryptocurrency is not determined by any macroeconomic metric, such as GDP, interest rates, or inflation; neither is it rooted in any material goods. Instead, it is based on supply and demand. This means that the rate of return on investment in cryptocurrency is unproven and unpredictable.

The extreme volatility of the crypto market is both what makes crypto assets desirable to investors for their high returns and also what prompts them to display risk-averse behaviour due to the innate unpredictability.

The price of cryptocurrencies can be influenced by several factors, including trading volume, information demand, stock market returns, and exchange rates. However, the relationship between these factors and cryptocurrency prices is complex and non-linear, making it difficult to predict how the market will behave.

For example, according to a Bitwise Asset Management report, the difference in returns between the top- and bottom-performing coins in December 2017 was 784.9%, with an average price difference of 300.1% over the entire year. Ripple’s cryptocurrency XRP provided the maximum returns to investors in nine out of the 12 months tracked, yet its returns of 373% in May 2017 quickly slid to -36.1% by July.

The inherent volatility of the crypto market means that it is impossible to rely on price signals as a clear buy signal to traders. The wide dispersion of returns among cryptos is due to the market’s understanding of crypto assets surpassing that of the average investor, as well as the inherent volatility of cryptocurrencies compared to stocks or bonds.

Therefore, while cryptocurrency can provide high returns, the rate of return on investment is unpredictable and subject to significant fluctuations.

Fraud and theft

The decentralised and unregulated nature of cryptocurrency makes it an attractive target for fraudsters and thieves. Crypto fraud and theft can take many forms, and it is a growing problem. In 2022, crypto thefts hit an all-time high of $20.6 billion, with about $3.8 billion stolen, more than in any other year.

Scams and Impersonation

Scammers often impersonate well-known companies, such as Amazon, Microsoft, FedEx, or your bank, and contact you via text, email, or social media. They will claim there is fraud on your account or that your money is at risk and instruct you to buy crypto and send it to them. They may also impersonate government agencies, law enforcement, or utility companies and demand payment in crypto to resolve a legal problem or outstanding bill.

Scammers also create fake initial coin offerings (ICOs) with phony team member bios and copied technical whitepapers. They may promise low-risk investments with guaranteed high returns or demand payment in crypto in advance for a product or service.

Hacking and Manipulation

Criminals can hack investors' crypto wallets and steal their currency. They can also set up fake wallets, phony crypto exchanges, and manipulate decentralised finance (DeFi) protocols to steal customers' money.

A growing trend in DeFi hacks is oracle manipulation, where an attacker compromises the mechanisms by which a decentralised protocol gets a price for traded assets, creating favourable conditions for fast and super-profitable trades. In 2022, DeFi protocols lost $386.2 million in 41 separate oracle manipulation attacks.

Blackmail

Scammers may send emails or letters threatening to release embarrassing or compromising information or media unless a payment is made in cryptocurrency.

Money Laundering

Crypto can be used for money laundering due to its anonymous and decentralised nature. Criminals can send extorted money to centralised crypto exchanges, which remain the major receivers of criminal funds, or use DeFi platforms for money laundering, especially when the DeFi protocols themselves are victims of hacks.

Ransomware

Ransomware hackers often target crypto infrastructure. They extort money from their victims and then send it to centralised crypto exchanges.

Pump and Dump Schemes

Owners of a stock or cryptocurrency try to drive the price up by making false claims to create demand. When the price reaches an artificial peak, they sell off their holdings for massive profits. This is common during the ICO stage of a cryptocurrency or whenever false claims can be used to generate hype.

Ponzi Schemes

Crypto investments can be used as a vehicle for traditional Ponzi schemes, where new adopters are necessary to give artificial returns to early adopters. The inherent complexity of crypto and the fact that it is widely misunderstood make it a perfect cover for such schemes.

Regulatory uncertainty

Cryptocurrencies are designed to be free from government control and manipulation. However, as they have grown in popularity, governments and regulators are pushing back with restrictions to maintain control over the industry. This pushback creates a restrictive climate towards crypto, especially for "privacy coins," which promote privacy as their key value proposition. The regulatory scrutiny of privacy coins has led to several exchanges delisting certain tokens to avoid regulatory issues.

Impact of Regulatory Uncertainty on the Crypto Industry

The regulatory uncertainty around cryptocurrencies has led to a cautious approach from some market participants. For example, Ken Griffin, the founder of Citadel Securities, one of the world's biggest market-making firms, stated that his company does not trade cryptocurrencies due to the regulatory uncertainties surrounding them. Griffin expressed concern about taking on regulatory risk in the absence of clear regulations. He also mentioned that thoughtful regulation around cryptocurrency would be beneficial, even if it made the market smaller and more competitive.

Global Regulatory Concerns

Regulators globally have expressed concerns about the rise in privately operated currencies, fearing a loss of control over their financial and monetary systems, increased systemic risks, and potential harm to investors. The Financial Action Task Force (FATF), a global AML agency, has increased transactional reporting requirements for virtual asset service providers (VASPs), which include centralized exchanges and other companies.

Regulatory Scrutiny of Privacy Coins

"Privacy coins" are a specific type of cryptocurrency designed to add a layer of privacy to transactions and hide information such as the identity of users, transaction amounts, and the amount of cryptocurrency held. Examples of privacy coins include Zcash, Monero, Findora, and Secret Network. While privacy coins offer enhanced privacy features, they have also attracted regulatory scrutiny and are even banned in some countries like South Korea and Japan.

Regulatory Impact on Crypto Investments

The regulatory uncertainty around privacy coins has had a significant impact on their investment performance. While some privacy coins have outperformed bitcoin during bull markets, they have also faced delisting from major exchanges due to regulatory concerns. This regulatory scrutiny has created a challenging environment for investors, who have to navigate an ever-changing landscape of rules and restrictions.

The Need for Thoughtful Regulation

Industry experts and investors advocate for thoughtful regulation that balances privacy and security concerns. Warren Anderson, VP of Product at Discreet Labs, the team behind the privacy coin Findora, highlights the importance of privacy as a basic human right. Tor Bair, Founder of the Secret Foundation, emphasizes that "privacy is fundamental to security and usability," and users deserve strong privacy protections.

Tax implications

Investing in cryptocurrencies has various tax implications, and the tax treatment of cryptocurrencies is still evolving. The Internal Revenue Service (IRS) treats cryptocurrencies as property for tax purposes, and any profits or income from cryptocurrency investments are generally taxable. Here are some key considerations regarding the tax implications of investing in cryptocurrencies:

Taxation of Capital Gains:

• If you sell or exchange cryptocurrency for a profit, you will owe capital gains tax on that profit. The tax rate depends on how long you held the cryptocurrency before selling it and your total income for the year.
• Cryptocurrencies held for less than a year before selling are subject to short-term capital gains tax, which is typically higher than the long-term rate.
• Cryptocurrencies held for more than a year may qualify for lower long-term capital gains tax rates.
• When calculating capital gains, it is important to consider the fair market value of the cryptocurrency in USD on the day you received and used it.

Cryptocurrency as Payment:

• If you use cryptocurrency to purchase goods or services, you may owe taxes on the increased value between the price you paid for the crypto and its value at the time of the transaction. This could result in paying sales tax and creating a taxable capital gain or loss event.
• If you accept cryptocurrency as payment for goods or services, you must report it as business income.

Mining and Staking:

• Cryptocurrency mining rewards are generally taxed as ordinary income, based on the value of the cryptocurrency at the time it was mined.
• Staking rewards, where you lock your cryptocurrency and earn interest, are also taxed as ordinary income.

Hard Forks and Airdrops:

Hard forks, which split a blockchain and create two cryptocurrencies, have ambiguous tax implications. While the IRS has confirmed that airdrops (receiving new cryptocurrency after a hard fork) are taxable, there is a lack of guidance on the tax treatment of promotional airdrops or those unrelated to hard forks.

Retirement Accounts:

• Investing in cryptocurrencies through a retirement account, such as a Transamerica 401(k) plan, can have tax implications. Any gains or losses are generally tax-deferred until you withdraw the funds.
• Withdrawing funds before the age of 59 and a half may result in early withdrawal penalties and taxes.
• It is important to consult with a tax professional or financial advisor to understand the specific tax implications and regulations regarding cryptocurrency investments in retirement accounts.

Record-Keeping and Reporting:

• It is crucial to maintain detailed records of your cryptocurrency transactions, including dates, fair market values, exchange information, and the purpose of holding the currency.
• The IRS has added questions about crypto activity on tax return forms, and it is important to accurately report your crypto transactions to comply with tax laws.
• While crypto exchanges are required to report income over a certain threshold, you are still responsible for reporting and paying taxes on smaller amounts.

Frequently asked questions