Cryptocurrency: A Risky Investment Gamble Or Worthwhile?

Cryptocurrency is a risky investment. It is highly volatile, with prices rising and falling quickly, and it is not suitable for risk-averse investors or those with limited funds. The market is also highly speculative, crowded, and prone to fraud and theft. There is a potential for financial loss, and the lack of regulation and consumer protection makes it difficult to recover funds in the event of an exchange bankruptcy. Additionally, the irreversible nature of transactions, tax complexities, and environmental impact are other factors to consider. However, cryptocurrency can provide direct exposure to the demand for digital currency and has the potential for high returns.

Historical volatility

Volatility is a natural part of market activity, referring to changes in the price of an asset. It can be healthy, with steady increases or decreases in price within a general range, or it can be extreme, with rapid price movements in either direction. Extreme volatility is often associated with market chaos, uncertainty, and loss.

Cryptocurrency is known for its extreme volatility. For example, in one day, Bitcoin's value dropped by 30%. In the first quarter of 2021, it appreciated by more than 70%, but on May 19, 2021, it dropped by 30% again before recovering some of its value. In 2016, the price of Bitcoin rose by 125%, and in 2017, it rose by over 2000%.

There are several reasons for the extreme volatility of cryptocurrencies:

• News developments and speculation: Media outlets, influencers, and industry figures can create investor concerns, leading to price fluctuations. For example, Elon Musk's tweets have significantly impacted Bitcoin's value, a phenomenon known as "The Musk Effect."
• Liquidity: Cryptocurrency markets have less liquidity than traditional financial markets due to a lack of institutional investors and large trading firms.
• Derivatives markets: Most cryptocurrencies, except for Bitcoin, lack established and widely adopted derivatives markets.
• Investor sentiment: Fear and greed are two primary drivers of cryptocurrency volatility. Investors fear missing out on big price movements, leading to panic buying or selling, which influences demand and prices.
• Supply and demand: As a limited asset, Bitcoin's market value is affected by the number of coins in circulation and how much people are willing to pay.
• Investor actions: Large investors, known as "whales," can significantly influence the market value of cryptocurrencies. If they were to suddenly sell their holdings, prices would plummet as other investors panicked.

While volatility is often associated with risk and negative outcomes, it is important to note that volatility is not inherently bad. Volatility creates opportunities for profit, and in the case of cryptocurrency, it can signal important information to founders and investors, increasing transparency in the system.

As the cryptocurrency market continues to grow and mature, it is likely that volatility will become more manageable, and it may even be viewed as a quality to be embraced rather than a reason to avoid investment.

Difficult to value

Why Cryptocurrency is Difficult to Value

There are several reasons why cryptocurrency is difficult to value. Firstly, it is a relatively new asset class with a limited history, making it challenging to compare to other, more established asset classes. Secondly, cryptocurrencies are decentralised and not backed by any central authority, government, or tangible assets, which can make it challenging to determine their underlying value. Thirdly, the value of cryptocurrency is highly volatile and subject to significant price swings due to its speculative nature and sensitivity to market sentiment. Finally, the lack of standard valuation methods, such as those used for stocks, commodities, or real estate, makes it challenging to assign a value to cryptocurrency.

Lack of Historical Data

Cryptocurrency is a relatively new asset class, with Bitcoin, the first cryptocurrency, being released in 2009. This limited history makes it challenging to compare to other, more established asset classes such as stocks, commodities, or real estate. For example, when valuing stocks, investors can look at a company's management, balance sheet, revenues, and long-term historical value. In contrast, cryptocurrency lacks this long-term historical data, making it more difficult to value.

Lack of Central Authority or Tangible Assets

Unlike traditional fiat currencies or commodities, cryptocurrencies are typically decentralised and not backed by any central authority or government. Fiat currencies, such as the US dollar, derive their value from the backing of a central government, which guarantees their value and widespread acceptance. In contrast, cryptocurrencies are not backed by any physical assets or government decrees, making it challenging to determine their underlying value.

Additionally, cryptocurrencies are not tied to any underlying tangible assets, such as gold or silver, which have intrinsic value as precious metals. This lack of tangible backing further contributes to the difficulty in valuing cryptocurrencies.

High Volatility and Speculative Nature

The value of cryptocurrency is highly volatile and subject to significant price swings. This volatility is driven by various factors, including media hype cycles, changes in market sentiment, and news events. For example, a negative tweet by Elon Musk about cryptocurrencies resulted in a loss of 30-40% of their valuation for many currencies. This high volatility makes it challenging to assign a stable value to cryptocurrencies.

The speculative nature of cryptocurrency investing also contributes to its volatile price movements. Investors often buy and sell based on short-term price fluctuations, hoping to make quick profits. This speculative behaviour can lead to rapid and significant price swings, making it difficult to establish a stable value.

Lack of Standard Valuation Methods

Unlike stocks, commodities, or real estate, there are no standard valuation methods widely accepted for cryptocurrencies. The value of a stock can be determined by analysing a company's financial statements, business model, and future growth prospects. Commodities can be valued based on their scarcity, industrial uses, and demand in various sectors. Real estate values are influenced by factors such as location, size, and market conditions. However, cryptocurrencies lack these tangible valuation metrics, making it challenging to assign a definitive value.

While supply and demand play a crucial role in determining cryptocurrency values, predicting demand over time is incredibly challenging. Demand can be influenced by various factors, including media coverage, regulatory changes, and the success of blockchain projects. The complex and dynamic nature of these factors makes it difficult to develop reliable valuation models for cryptocurrencies.

Bad for the environment

Cryptocurrency mining is an extremely energy-intensive process that threatens to undermine global efforts to reduce dependence on climate-warming fossil fuels. Bitcoin, the most widely mined cryptocurrency, uses vast amounts of energy. Estimates of its energy consumption range from 98 to 151 terawatt-hours (TWh) of electricity annually, which is more than some small countries and represents around 0.4% to 0.59% of global electricity use.

The energy-intensive nature of crypto mining is by design, as it requires large amounts of computational power to validate transactions and maintain the security of cryptocurrency blockchains. The process, known as proof of work, involves miners competing to solve complex cryptographic puzzles to earn rewards in the form of cryptocurrencies. This competitive process incentivizes miners to use more energy-efficient methods and hardware, but it also leads to a significant increase in energy consumption as the value of the block reward increases.

The high energy demands of cryptocurrency mining have led to concerns about its environmental impact, particularly its contribution to greenhouse gas emissions. It is estimated that Bitcoin mining produces millions of tons of carbon dioxide (CO2) annually, equivalent to the emissions of small countries. The energy used to mine Bitcoin is predominantly generated through fossil fuels, with studies showing that most mining occurs in countries heavily dependent on coal and crude oil, such as the United States, China, and Kazakhstan.

The environmental impact of cryptocurrency mining is further exacerbated by the short lifespan of specialized computer hardware used for mining, resulting in significant electronic waste. Additionally, the heat generated by mining machines has led to the use of water cooling, raising concerns about the contamination and temperature increase of water bodies.

While some argue that cryptocurrency mining could support the development of renewable energy sources by utilizing surplus electricity, others criticize this idea, stating that it may limit the availability of clean energy for the general population. The debate around the environmental impact of cryptocurrency mining has led to varying responses from regulators and policymakers, with some jurisdictions imposing restrictions or incentives to address these concerns.

Complicated taxes

The tax rules for cryptocurrency can be complicated and confusing. In the US, the Internal Revenue Service (IRS) treats cryptocurrencies as property for tax purposes. This means that if you sell or use your cryptocurrency in a transaction, and it is worth more than when you bought it, you will owe capital gains tax on the profit. If you have held the crypto for a year or less, you will pay short-term capital gains tax, which is taxed as regular income. If you have held it for longer than a year, you will pay long-term capital gains tax, which is usually lower than regular income tax.

If you receive cryptocurrency as payment for goods or services, it is taxed as business income. If you are paid in crypto for mining or staking activities, it is taxed as ordinary income.

Even small transactions can trigger tax implications. For example, if you buy a cup of coffee with Bitcoin and the price of Bitcoin has gone up since you acquired it, you will need to report the gain to the IRS. This is because cryptocurrencies do not have the same exemption from taxation that government-issued currencies have.

To accurately report your taxes, you will need to keep a record of each cryptocurrency transaction, including the amount you spent, how long you held it, how much you sold it for, and the fair market value of the crypto when it was used or sold.

Given the complexity of crypto taxes, it is recommended to consult an accountant familiar with cryptocurrency and current practices to ensure you are reporting your taxes correctly.

Susceptible to fraud and theft

Cryptocurrency is stored in a digital wallet, which can be online, on your computer, or on an external hard drive. If something happens to your wallet or your cryptocurrency funds, you may find that no one can step in to help you recover your funds.

There are many ways in which your cryptocurrency can be stolen or lost. For example, your online exchange platform could go out of business, you could send cryptocurrency to the wrong person, you could lose the password to your digital wallet, or your digital wallet could be stolen or compromised.

Cryptocurrency scams are also becoming increasingly common. Scammers are always finding new ways to steal your money using cryptocurrency. For example, a scammer may pose as a celebrity who can multiply any cryptocurrency you send them. Alternatively, they may pose as a love interest on a dating site or app, and offer to help you invest in crypto.

There are some steps you can take to avoid losing your cryptocurrency to theft or fraud. For example, you should only invest money that you can afford to lose, and you should always do your research before investing in a particular cryptocurrency.

Frequently asked questions