Cryptocurrency Investment: Worthwhile Or Risky Business?

Investing in cryptocurrency is a highly debated topic. Cryptocurrency has been described as a transformative technology that could revolutionise several industries. It is also a stable, censorship-resistant store of value since it cannot be printed or seized. However, it is a highly speculative investment with no guarantee of achieving mainstream usage. Cryptocurrency is also susceptible to thefts, scams, and other losses. As a result, investors need to carefully consider their financial situation, conduct due diligence, and assess their risk tolerance before investing in cryptocurrency.

Potential for high returns

Cryptocurrency can provide high returns, with some investors becoming "filthy rich" overnight. The incredible growth of Bitcoin and Ethereum has spurred the expansion of the cryptocurrency market, with new types of blockchain investment products emerging. Cryptocurrency has been described as a "transformational technology" that could revolutionise many industries, making it an attractive investment for those who believe in its future.

The limited supply of most cryptocurrencies, capped by mathematical algorithms, also makes them a stable store of value. Unlike fiat money, cryptocurrencies cannot be printed or seized, and their value cannot be diluted by inflation. This makes them attractive to those worried about hyperinflation or bank failures. Bitcoin, in particular, has been likened to "digital gold" due to its deflationary and censorship-resistant properties.

The blockchain space is often described as a transformative industry with the potential to disrupt the world in the same way the internet did in the 1990s. The emergence of new asset classes, such as stablecoins, and the development of more investment instruments, such as options and futures on Bitcoin and Ethereum, also contribute to the potential for high returns.

The high returns associated with cryptocurrency are largely due to its speculative nature. Studies show that exchange trades remain the most prevalent use for cryptocurrencies, accounting for far more economic activity than ordinary trades and purchases. However, this speculative behaviour can be a double-edged sword, as it may lead to market bubbles that end badly for investors.

Despite the potential for high returns, it is important to remember that investing in cryptocurrency carries significant risks. The market is highly volatile, and there is no guarantee that cryptocurrencies will achieve mainstream usage. Investors should carefully consider their financial situation, conduct thorough research, and consult with a financial advisor before investing.

Regulatory risks

The lack of central authority and the evolving regulatory landscape pose legal and financial risks to cryptocurrency owners. Cryptocurrencies are not issued or backed by central governments or monetary authorities, and their legal status varies across jurisdictions. For example, China has banned cryptocurrencies, while El Salvador has adopted Bitcoin as legal tender. The European Union has implemented the MiCA regulation, which establishes rules for companies providing financial services using cryptocurrencies.

The decentralised nature of cryptocurrencies also raises legal concerns. In the absence of a central authority, investors may face complications with transactions or ownership disputes, and the path of legal recourse is unclear. Additionally, the lack of regulation makes cryptocurrencies susceptible to fraud, money laundering, and other financial crimes.

From a tax perspective, the regulatory environment is also uncertain. In the US, the IRS treats cryptocurrencies as property, subjecting them to capital gains tax laws. However, the requirement to report cryptocurrency holdings as foreign assets remains unclear, and investors must navigate complex rules regarding wash sales and tax liabilities.

Overall, the evolving and uncertain regulatory landscape poses significant risks to cryptocurrency investors, and it is crucial to stay informed about the latest developments in this area.

Fraud and cybercrime

The decentralised nature of cryptocurrency, its perceived anonymity, and the difficulty of following a money trail in the blockchain make it a preferred method for cybercriminals to conduct their illicit activities and launder money.

The COVID-19 pandemic increased the use of virtual assets for both legitimate and illegitimate purposes. The lack of legislation on virtual assets and seizing them also contributes to a void that cybercriminals exploit.

Cryptocurrency exchanges are vulnerable to being hacked and are targets of other criminal activity. Security breaches have resulted in sizable losses for investors who have had their digital currencies stolen.

Cryptocurrency exchanges such as Coinbase make it fairly easy to buy and sell crypto assets such as Bitcoin and Ethereum, but many people don't like to keep their digital assets on exchanges due to the risks of allowing any company to control access to their assets. Storing cryptocurrency on a centralised exchange means you don't have full control over your assets. An exchange could freeze your assets based on a government request, or the exchange could go bankrupt and you'd have no way to recover your money.

Some cryptocurrency owners prefer offline "cold storage" options such as hardware wallets, but cold storage comes with its own set of challenges. The biggest is the risk of losing your private key. Without the key, it's impossible to access your cryptocurrency.

There are companies that help recover digital assets. They trace and monitor stolen funds and flag and blacklist addresses to intercept the proceeds of crime. They also assist in legal cases, from divorce cases to criminal proceedings, by providing expert support to parties and their lawyers, as well as expert testimony before the court.

Volatility

As a relatively new asset class, crypto is widely considered to be highly volatile. Crypto has the potential for significant upward and downward movements over shorter time periods. For example, in one day, Bitcoin’s value dropped by 30%.

The crypto market is still in its infancy and is experiencing growing pains. The market, investors, and speculators are still finding their feet during this early and high-growth phase. Crypto is also more challenging for investors to gain exposure to, and the relatively small size of the market means there is less liquidity and depth to accommodate larger traders.

The unique supply dynamics of many different digital assets also play a role in crypto volatility. The limited supply of certain assets can create conditions where sudden increased demand can put even greater upward pressure on prices, increasing volatility. Bitcoin, for example, has a supply cap of 21 million coins.

Crypto markets are also heavily influenced by investor sentiment. The immaturity of the crypto market means that positive or negative views can spread like a contagion. This is due to the psychology of the crypto investor, who is typically an individual/retail investor who is less informed and more impressionable than more seasoned traditional investors.

Positive or negative news coverage and earnings reports that are better or worse than expected can also increase volatility. Unusually high spikes in trading volume will usually correspond to volatility. Very low volume (as seen with so-called penny stocks) also usually corresponds with high volatility.

While crypto is a highly volatile asset class, there are cryptocurrencies specifically designed to have low volatility, called stablecoins. These have their prices pegged to a reserve asset like the U.S. dollar.

Diversification

• Invest in cryptos with various use cases: Every cryptocurrency coin has different use cases. For example, Ripple makes money transfers easier for financial institutions like banks, while Ethereum serves as the foundation for DeFi protocols and smart contract technologies.
• Invest in different blockchains: Ethereum is the most well-known blockchain, enabling the execution of contracts without third-party involvement. Cardano (ADA) is a competing blockchain that prioritises efficiency, scalability, and security. EOS (EOS) is particularly efficient at providing web services like cloud storage, dApps, and smart contracts.
• Invest in different sectors: The banking industry has been the most accepting of cryptocurrency, with 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, while a cryptocurrency with a lower market cap may have significant growth potential.
• Diversify by geography: You can invest in global cryptocurrency ventures, adding blockchain initiatives from the US, Europe, and Asia to your portfolio.
• Time diversification: This technique involves market timing and buying crypto assets at the appropriate time.
• Expand to more asset classes: Digital assets are part of different asset classes, giving investors more ways to spread their crypto portfolios. These include utility tokens, NFTs, stocks, bonds, and real estate.

It's important to note that while diversification can help reduce risk, it doesn't guarantee protection against losses. Conducting thorough research and staying informed about market trends is essential.

Frequently asked questions