Cryptocurrency: Safe Investment Or Risky Business?

Investing in cryptocurrency is risky due to its volatility and the potential for scams and hacks. However, it can also be lucrative, with the potential for high returns.

Cryptocurrency is a digital currency that uses cryptography to secure transactions. It is not issued or regulated by a central authority, but by a decentralised system. The first cryptocurrency, Bitcoin, was founded in 2009 and remains the most well-known and commonly traded.

Cryptocurrency can be purchased through a broker or a cryptocurrency exchange. Before investing, it is important to research the thousands of options available, understand the risks, and only invest what you can afford to lose.

Volatility and risk

Cryptocurrency is a highly volatile asset class. The prices of cryptocurrencies, even the most established ones, are much more volatile than the prices of other assets like stocks. The prices of cryptocurrencies can change in seconds on nothing more than a rumour. This volatility can be great for sophisticated investors who can execute trades rapidly or who have a solid grasp of the market's fundamentals, but for new investors without these skills, it's a minefield.

Volatility is a game for high-powered Wall Street traders, and a new investor can easily get crushed by the volatility. Volatility shakes out traders, especially beginners, who get scared and sell, while other more experienced traders may step in and buy on the cheap. In short, volatility can help sophisticated traders "buy low and sell high" while inexperienced investors "buy high and sell low".

Cryptocurrency is also subject to far less regulatory protection than traditional financial products like stocks, bonds, and mutual funds. The regulatory environment is also constantly evolving, which is likely to contribute to continued volatility.

Cryptocurrency is also vulnerable to hacks. In 2018, hackers hit Coincheck for $534 million and BitGrail for $195 million, making them two of the biggest cryptocurrency hacks of that year. According to Chainalysis, more than $3.2 billion of cryptocurrency was stolen in 2021. Although many exchanges offer private insurance, if you lose your crypto in a hack, you may have no recourse for getting back your investment.

Cryptocurrency is also associated with a high level of fraud. Cryptocurrency fraud soared in 2022, and the lack of regulatory oversight of the industry left many thousands of investors out of pocket. One scam operation, BitClub Network, raised more than $700 million before its perpetrators were indicted in December 2019.

Given the high level of risk and volatility associated with cryptocurrency, it's important not to invest more money in crypto than you can afford to lose.

Diversification

• Invest in cryptos with various use cases: Every cryptocurrency coin has different use cases. For instance, Ripple makes money transfers easier in financial institutions like banks, while Ethereum serves as the foundation for DeFi protocols and smart contract technologies.
• Invest in different blockchains' cryptos: Blockchain is a technology that makes cryptocurrencies work. The most well-known blockchain is Ethereum, which enables the execution of contracts without the involvement of a third party. Cardano (ADA) is a competing blockchain that prioritises efficiency, scalability, and security.
• Invest in different sectors: Cryptocurrency opportunities uncover several industries. The banking industry has been the most accepting of cryptocurrency, with decentralised finance (DeFi) enabling users to perform digital transactions without a third party. Cryptocurrency use has also grown in the video game industry, with gamers selling virtual goods in a worldwide virtual marketplace.
• Diversify by market capitalisation: A high market cap cryptocurrency may be more stable and have better fundamentals. On the other hand, a cryptocurrency with a lower market cap may have significant growth potential.
• Diversify by geography: You can add blockchain initiatives from the US, Europe, and Asia based on your interests and risk appetite. For example, Portugal is regarded as a crypto powerhouse and a tax haven for cryptocurrency investors, while El Salvador was the first government to accept Bitcoin as a lawful currency.

Diversifying your cryptocurrency portfolio is essential as it allows you to profit from the market's general expansion. Additionally, investing in several cryptocurrency projects can help spread your risk if one or more perform poorly. It also improves the probability that your crypto investment will be profitable, and you can take advantage of many different currencies at the same time.

Security and storage

As with any other currency, keeping your cryptocurrency safe is a top priority. There are two main options for storing your cryptocurrency:

• Self-custody: You look after your crypto yourself, using a non-custodial crypto version of a safe.
• Custody: You trust a third party, such as a crypto bank, to look after your crypto for you.

The fundamental difference between these two options is that with self-custody, you control your private keys and therefore your funds. With custody, you trust a third party to look after your private keys, and they give you access to your funds.

Crypto Wallets

Crypto wallets are devices for storing, sending, and receiving cryptocurrency. There are several types of crypto wallets, including:

• Hot wallets: These are connected to the internet by default, making them convenient for transactions but less secure. Examples include mobile wallets and web wallets.
• Cold wallets: These are offline by default, making them more secure but less convenient for transactions. Examples include hardware wallets and paper wallets.
• Custodial wallets: These are managed by a third party, such as an exchange. The custodian stores your private keys for you and may provide insurance on your holdings.
• Non-custodial wallets: You use these wallets to store your keys yourself, with no one else involved. Examples include hardware wallets and paper wallets.

Security Precautions

• Back up your crypto wallet regularly, especially before any computer software updates.
• Keep your software up to date. This will help protect your wallet from hackers.
• Use multi-signature (multi-sig) approval for transactions, which requires transaction approval from several people, reducing the risk of theft.
• Use a seed phrase, a series of randomly generated words that act as a master password for your wallet. These are easier to memorise than a 64-character private key.
• Only keep the amount of crypto you plan to use in your hot wallet. Once you're done with your transaction, move the rest of your crypto back to cold storage.
• Use two-factor authentication to add an extra layer of security to your crypto investments.

Tax implications

Investing in cryptocurrencies like Bitcoin has tax implications, and the rules are still evolving. The Internal Revenue Service (IRS) treats cryptocurrencies as property for tax purposes, and any profits or income from your cryptocurrency is generally taxable. Here are the key tax implications to consider:

Capital Gains Tax

If you sell or exchange your cryptocurrency for a profit, you will likely owe capital gains tax. The tax rate depends on how long you held the cryptocurrency before the sale and your total income for the year. If you owned it for one year or less, the tax rate is typically higher, ranging from 10% to 37%. If you held it for more than a year, the long-term capital gains tax rates apply, which are usually lower, ranging from 0% to 20%.

Income Tax

If you receive cryptocurrency as payment for goods or services, or through mining or staking activities, it is generally taxed as ordinary income. The fair market value of the cryptocurrency at the time you received it is considered taxable income.

Tax-Deferred Investments

Investing in cryptocurrencies through a retirement account, such as a Transamerica 401k plan, can have different tax implications. Any gains or losses from cryptocurrency investments made through these plans are generally tax-deferred until you withdraw the funds. However, early withdrawal before the age of 59 and a half may result in penalties and taxes.

Hard Forks and Airdrops

Hard forks and airdrops can create ambiguous tax situations. A hard fork occurs when a blockchain splits, creating two cryptocurrencies. An airdrop is when units of cryptocurrency are distributed to certain investors, often after a hard fork. The IRS has stated that airdrops following a hard fork are taxable as ordinary income when you receive the new cryptocurrency. However, there is a lack of guidance on the tax treatment of promotional airdrops or those unrelated to hard forks.

Record-Keeping and Reporting

It is essential to maintain detailed records of your cryptocurrency transactions, including dates, fair market values, and purposes for holding the currency. The IRS has added questions about crypto activity on tax return forms, and cryptocurrency exchanges are required to issue 1099 forms to their clients. While there is dedicated crypto tax software to help with record-keeping, consulting a tax professional is advisable to ensure compliance with the evolving tax regulations.

Adoption and regulation

The adoption of cryptocurrencies is driven by a combination of extrinsic and intrinsic motivations. The launch of the Bitcoin system was embedded in idealistic notions of providing means to replace existing financial structures, and nurturing an alternative monetary and financial system that would enable greater anonymity, privacy, and autonomy. The decentralised nature of blockchain technology, which underpins cryptocurrencies, has the potential to be a powerful disruptive force.

Individuals and organisations may benefit from blockchain technology by increasing secure data exchange and making transactions simpler and easier. The use of blockchain technology has been found to be positively correlated with the level of financial inclusion and development in a country. The more financially included a population is, the greater the adoption of Bitcoin infrastructure.

The spread of Bitcoin infrastructure seems to be complementary to existing financial systems, as more Bitcoin infrastructure is adopted where bank rents and the share of the unbanked are highest. The greater the level of competition in banking markets, the greater the adoption of Bitcoin infrastructure.

The perceived usefulness of cryptocurrencies is the most influential factor in the intention to use them for electronic payments. People who perceive cryptocurrencies as easy to use and receive a positive social influence regarding their use are more likely to use them.

The adoption of cryptocurrencies is also driven by their usefulness in engaging in illicit trade. The greater the risk of narcotics-related money laundering in a country, the greater the adoption of Bitcoin infrastructure. The stronger the rule of law in a country, the greater the adoption of Bitcoin infrastructure.

The regulatory framework surrounding cryptocurrencies is still developing. The implementation of blockchain applications must navigate complex economic and political regulation, and no central bank policy is available. The default blockchain security is not enough to protect against security threats, and hackers are stealing money from blockchain platforms.

Regulation

The regulatory framework surrounding cryptocurrencies is still developing. The implementation of blockchain applications across the world must go through a lot of complex regulation in terms of economic and political factors, and no central bank policy is available.

The default blockchain security is not enough to protect against security threats, and hackers are stealing money from blockchain platforms.

The regulatory framework of digital currencies in Malaysia, for example, is a conceptual paper that aims to investigate the antecedents of individuals' behavioural intentions for adopting Bitcoin cryptocurrency.

The US' Bureau of International Narcotics and Law Enforcement Affairs performs an annual assessment of the risk of money laundering in 200 countries and jurisdictions. The bureau identifies “major money laundering countries” as those whose “financial institutions engage in transactions involving significant amounts of proceeds from international narcotics trafficking”.

The emergence of cryptocurrencies has often been viewed as driven by the opportunity for radical innovation and entrepreneurship in financial solutions as created through the spread of new Internet-based technology. However, recent studies have emphasized that in order to understand the historical growth and future prospect of fintech innovations, we must also understand the nature of the needs addressed by such innovations.

The development and spread of technology is, therefore, a prerequisite but not a sufficient factor for the spread of cryptocurrencies.

The adoption of cryptocurrencies is driven by a combination of factors, including the perceived usefulness of the technology, the level of financial inclusion and development in a country, the perceived failings of traditional financial systems, and the usefulness of cryptocurrencies in engaging in illicit trade.

The regulatory framework surrounding cryptocurrencies is still developing, and the default blockchain security is not enough to protect against security threats and hackers.

Frequently asked questions