*Note: this is part two in our series, “Investing in Cryptocurrency.” Our first post explored different ways to get involved in cryptocurrency.
Investing in cryptocurrency continues to be a hot topic. The market is now worth more than $3 trillion, quadrupling from its 2020 year-end value. Just in the last week, Ether, the second-largest cryptocurrency by market value under Bitcoin, hit a new all-time high of $4,700.
Its reach into the public sphere is becoming more prolific, as incoming NYC Mayor Eric Adams recently announced he will take his first three paychecks in Bitcoin – inspiring a community-led crypto project planning to create a dedicated city-based token.
As the market shows no sign of slowing down, more and more people are becoming interested in investing. As with any asset, however, there are always things to keep in mind – or be aware of – before choosing to invest. Below are some risks to investing in cryptocurrency.
1. Market Volatility & Manipulation
The cryptocurrency market is notoriously volatile; in January 2021, it lost nearly $170 million in a single day. While all markets can move in an unfavorable direction, the crypto market in particular has been prone to dramatic swings. For instance, Bitcoin has undergone multiple corrections in the last several years that have cut its value by half or more. Earlier this year, its price fell by 20 percent within 24 hours. Other coins can be even more volatile, such as memecoin, which has been known for its highly variable price fluctuations.
Part of the reason for the market’s volatility is that the value of cryptocurrencies are determined largely by supply and demand, as opposed to more traditional currencies which fluctuate based on the economy, central banking system, monetary policies, global trade, etc. In other words, because there is no regulation or governing authority, the value of a cryptocurrency can be subject to arbitrary whims. For instance, as has happened before, Tesla CEO Elon Musk could tweet something about a cryptocurrency that ends up sending its price soaring or crashing. This is largely why many financial experts have described cryptocurrencies as a “bubble.”
One thing to consider is the big picture of your investment. If you’re looking to invest short-term, market volatility can be a large concern. If, however, you approach it as a long-term investment, the volatility could turn into future opportunity.
2. Cyber Attacks, Hacks & Security Issues
Since Bitcoin’s inception in 2009, there have been multiple cases of cryptocurrency scams, hacking and theft. For instance, nearly $72 million worth of cryptocurrency got stolen from Bitinfex in Hong Kong in August 2016. As a result, prices dropped to 23 percent. A similar attack was carried out in September 2015 when BitPay lost about $1.8 million worth of bitcoins. And in Q1 of 2021 alone, cybercriminals stole more than $100 million; in this specific case, Ethereum DApps, blockchain wallets, and cryptocurrency exchanges were the criminals’ target of choice.
The first thing to be mindful of is the cryptocurrency itself. Given that there are nearly 8,000 cryptocurrencies in circulation, it can be difficult to determine which ones are legitimate. Educating yourself before making that choice is the best way to protect yourself. One way to do this is by reading user reviews on Reddit or highly-esteemed review sites, such as ExchangeRatings.com. You can also learn about the red flags to watch out for by visiting the U.S. Securities and Exchange Commission’s fake ICO (Initial Coin Offering) website.
Furthermore, as mentioned above, cryptocurrency exchanges – where you can buy, sell and trade the digital assets – are prime targets due to the vast amounts of cryptocurrency they hold. And since there are numerous exchanges out there, it is important to choose one that is credible, trustworthy and safe. While Blockchain (the technology behind cryptocurrencies) is highly secure, there are no guarantees of total security since hackers like to take advantage of vulnerabilities on trading platforms. Coinbase, Gemini, Kraken, and Robinhood are some of the most established, well known exchanges we recommend.
Similarly, digital wallets can be vulnerable too. While exchanges typically allow you to store your crypto there, a wallet can safeguard against potential hacks and freezes on an exchange. While they’re not foolproof, it is vitally important to choose one that is reputable. Ledger is considered one of the best, safest and most secure cryptocurrency hardware wallets, while MetaMask is the most popular software wallet. (Note that “hardware” wallets are more secure because they are not connected to the internet, thus making it impossible for hackers to access them. “Software” wallets, although more accessible and convenient, are connected to the internet and thus susceptible to hackers, malware or viruses).
3. Regulatory and Tax Issues
One of the greatest concerns with cryptocurrency – but also one of its greatest draws – is its decentralized nature. Given that cryptocurrencies aren’t backed by a central authority, governments aren’t able to regulate it like other commodities, such as the dollar or gold. While various governments around the world have attempted to bring digital currencies under regulatory control, they have largely remained unattached to any jurisdiction or institution. What this means is that there is no financial backing if a cryptocurrency fails. Indeed, if a cryptocurrency does fail, the investor loses everything. There are also legal implications to consider; investors who have been defrauded don’t have the same legal recourse as traditional fraud victims.
Furthermore, there is great uncertainty when it comes to taxing investments in cryptocurrency. While some countries view cryptocurrencies as assets, the IRS in the U.S. has defined cryptocurrencies as property. This means that investors in cryptocurrency need to pay capital gains taxes regardless of where they bought the digital asset.
All of this is further complicated by the fact that rules are continually changing. For instance, as Barron’s reports, the recent infrastructure package passed by Congress includes a variety of new tax-reporting requirements that could affect cryptocurrency investments. Accordingly, it is vitally important to solicit and follow the advice of tax professionals when it comes to reporting cryptocurrency profits and losses.
As with any investment, whether in the stock market, real estate, etc., investing in cryptocurrency comes with a certain amount of risk. While significantly more risky due to its unregulated nature and novelty, making a smart, educated investment in cryptocurrencies could yield significant returns. As mentioned in our last blog post on how to get involved in cryptocurrencies, the data indicates that the market is really only in its infancy. Consider this: in less than 10 years, Bitcoin has increased over 227,000% in value. In other words, if you had invested 22 dollars in Bitcoin in 2012, it would be worth one million dollars today.