Crypto Investment: Worth The Risk?

Investing in crypto is a hot topic in 2024. With thousands of coins to choose from, it can be a daunting prospect for investors. Crypto is a highly volatile asset, and investors need to understand the risks involved. It is not a wise investment for those seeking to grow their retirement portfolio or savings. However, for more speculative investors, it may be worth taking a chance on crypto.

Cryptocurrencies are digital or virtual currencies secured by cryptography, which makes them nearly impossible to counterfeit or double-spend. They are generally not issued by any central authority, which in theory, makes them immune to government interference or manipulation.

The advantages of cryptocurrencies include cheaper and faster money transfers, and decentralized systems that do not collapse at a single point of failure. They also offer protection against inflation and act as a hedge against it.

However, there are several disadvantages and risks associated with investing in crypto. These include price volatility, high energy consumption for mining activities, use in criminal activities, regulatory risks, and counterparty risks.

Despite the risks, crypto has delivered tremendous profits for some investors. Bitcoin, the original cryptocurrency, has seen a growth of 11,280% since May 2016. As of September 2024, it had a market capitalization of $1.1 trillion.

Ethereum, the leading altcoin, has also experienced tremendous growth. From April 2016 to September 2024, its price went from about $11 to around $2,343, increasing by 21,196%.

In conclusion, investing in crypto involves taking on a significant amount of risk. It is not suitable for all investors, but for those who understand and can manage the risks, it may present great opportunities.

Crypto's extreme volatility

Cryptos Extreme Volatility

Cryptocurrencies are incredibly volatile and not for all investors. Decide if they fit your risk tolerance before diving in. Extreme volatility is par for the course, so investors looking to insulate themselves from the potential total collapse of their holdings will want to go with more established names.

Volatility in financial markets refers to changes in the price of an asset. It can be healthy, with steady increases or decreases in price within a general range. It can also be extreme, with sudden price movements in either direction. Healthy volatility serves many purposes in a market, but it mainly creates opportunities for profit. Extreme volatility occurs when an asset’s price changes rapidly within a short time.

Most observers of the cryptocurrency market agree that crypto volatility is in a league of its own. There are no indices to measure crypto price volatility, but a glance at historical price charts reveals that price peaks and troughs occur at a quicker and more extreme pace in crypto prices compared to prices of assets in mainstream markets.

Cryptocurrencies are not regulated investment vehicles, so you may not be aware of the inner dynamics of your crypto or the developers working on it. The volatility of the cryptocurrency market creates opportunities for traders to make big profits relatively quickly. But volatility makes crypto trading extremely risky and challenging, even for experienced traders.

The crypto market is still dominated by Bitcoin and Ethereum. Their market capitalizations comprise about 70% of the $2.05 trillion global crypto market. Bitcoin has become the most popular and valuable cryptocurrency. It was created by an individual, or perhaps a group, operating under the pseudonym Satoshi Nakamoto. Ethereum was one of the first altcoins and the leading altcoin debuted in 2015 and ranks second to bitcoin in market capitalization.

Crypto's high energy consumption

Cryptos High Energy Consumption

Cryptocurrency mining is an energy-intensive process, and its high energy consumption has raised concerns about its environmental impact. The energy consumption of the Bitcoin network alone is estimated to be between 7–17 MJ, with energy usage for coin production second only to aluminium production. At its peak in 2021, the crypto market was worth over $2.9 trillion, but by mid-2022, it had lost more than half its value due to rising inflation and aggressive rate hikes.

Bitcoin mining relies on the "Proof of Work" (PoW) consensus mechanism, which requires significant energy input. The process involves solving complex mathematical problems to validate transactions and secure the ledger. As more Bitcoins are mined, the problems become more challenging, requiring even more energy.

The energy-intensive nature of Bitcoin mining has led to concerns about its sustainability and environmental impact. Some countries with cheap electricity have attracted crypto mining operations, but this often relies on non-renewable energy sources like coal and other fossil fuels, contributing to global warming.

To address these concerns, some mining organisations are adopting renewable energy sources, known as "green mining". Additionally, algorithms that direct miners to the most profitable cryptocurrencies are being utilised, a strategy called "smart mining".

While these approaches improve efficiency, they do not change the fundamental way miners function. Most mining organisations are slow to shift from the traditional model, showing inefficiencies in adapting and evolving.

A more radical solution is to move away from the energy-intensive PoW method to the less energy-intensive "Proof of Stake" (PoS) method. With PoS, those with higher coin numbers in a system are selected to forge blocks instead of mining them, as it is believed that their higher stake reduces the chances of them breaching the system.

However, PoS has its drawbacks. It may be more susceptible to hacks and attacks, and it could potentially return power to a few individuals, going against the decentralised nature of blockchain.

Despite these challenges, finding more sustainable ways to verify transactions and secure the network is crucial for the long-term viability of cryptocurrencies.

Crypto's use in criminal activities

While cryptocurrencies are becoming an increasingly popular tool for criminal activities, the notion that they are predominantly used for illicit purposes is largely a myth.

There are several reasons why criminals and terrorists opt to use cryptocurrencies. Firstly, the promise of anonymity is appealing as while transactions are recorded on the blockchain, the identities of those making them remain unknown. This enables criminals to trade drugs, weapons, explosives, and child pornography, seemingly without a trace. Secondly, cryptocurrencies are transferred directly between peers with no prior acquaintance, which is often exploited for one-off sales of drugs or digital data, as well as for terror funding across borders. Thirdly, trading with crypto is incredibly easy and only requires an internet connection and a wallet application. Cryptocurrencies are always available, and there is no need to validate the transaction with a central body or third party, nor are there usually any delays. Finally, cryptocurrencies are easy to store and transfer, both locally and internationally, with no risk of being seized, making them ideal for money laundering.

However, the very features that make cryptocurrencies attractive to criminals also pose significant challenges for law enforcement agencies. For instance, there is no link between a cryptocurrency address and the person behind it, and criminals can transfer funds globally with ease and speed. Nonetheless, blockchain technology is inherently transparent, and law enforcement agencies can track and investigate crypto transactions. Crypto exchanges are also increasingly sharing their expertise and resources with law enforcement to combat criminal activity. In 2022, the Binance Investigations team responded to over 47,000 law enforcement requests, with an average response time of three days, playing a vital role in dismantling criminal groups.

Although the use of cryptocurrency in criminal activities is increasing, it is important to note that crypto transactions related to criminal activities represent only a limited share of the criminal economy compared to cash. Furthermore, the constraints associated with the use of cryptocurrencies in criminal activities, such as volatile value fluctuations, contribute to the reluctance of criminals to use them for long-term investments.

Regulatory risks

One of the most critical regulatory risks facing crypto investors relates to taxation. In the US, the IRS has defined cryptocurrencies as property rather than currencies. This means that investors are subject to capital gains tax laws when reporting profits and expenses on their annual tax returns. The situation is further complicated by the fact that, as of August 2023, federal law does not consider a foreign cryptocurrency account to be a "reportable account". However, this could change at any time, and crypto investors would then be required to disclose their foreign accounts to the Financial Crimes Enforcement Network (FinCEN). Given the severe penalties for failing to file the required reports, it is recommended that crypto investors consult a tax professional familiar with cryptocurrency when filing their taxes.

Another regulatory risk to consider is the potential for increased government regulation of cryptocurrencies. Governments and regulatory bodies have pushed to track crypto transactions, strip encryption protections, and regulate major crypto exchanges, which could remove a core benefit of the technology that boosts its usage and price. In the US, the Securities and Exchange Commission (SEC) has been considering a range of new cryptocurrency regulations, including whether to classify certain assets as securities. Such a classification could make it prohibitively expensive or unlawful for investors to purchase crypto on the open market. It is also possible that regulatory changes could affect the value and costs of holding crypto assets or cause investors to dump them in a hurry when panic sets in.

The lack of a central authority backing the value of cryptocurrencies could also result in legal complications. Without a central authority, the value of digital currencies is entirely dependent on the value that other owners and investors ascribe to them. This could leave investors in a difficult position if complications with transactions or ownership arise. Additionally, the decentralised nature of crypto transactions means that there is no trusted financial institution involved in creating and settling deposits and debt claims, which can lead to legal confusion between parties.

In summary, regulatory risks are a significant consideration for anyone thinking of investing in cryptocurrencies. The lack of regulation and central authority in the crypto market means that investors are exposed to unique risks that are not present in more traditional investments. Changes in government regulation and taxation could have a significant impact on the value of crypto assets, and the lack of a central authority could lead to legal complications and confusion.

Crypto's potential as a hedge against inflation

However, critics argue that cryptocurrency's history is too short to determine if it can effectively protect against rising prices. The extreme volatility of the crypto market also makes it a risky investment. For example, the crypto market was worth less than $900 billion in mid-2022, down from over $2.9 trillion in November 2021, due to rising inflation and aggressive rate hikes.

Despite the debate, the rapid growth of Bitcoin and the perception of it being a hedge against inflation have attracted many investors. As a result, investors are turning their savings into stores of value investments like stocks, bonds, and crypto.

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