The risks of cryptocurrencies laid bare

Cryptocurrencies are so new to the world of investment that debate still rages – as it does around foreign exchange – about whether we call them an asset class. But one thing was made perfectly clear at the end of 2017: they belong at the riskier end of the investment spectrum.

Institutional investors barely touch the digital currencies – yet. But some are predicting a flood of institutional funds in the coming months, that will drive fervent retail demand and further cryptocurrency issuance.

Investors pick a portfolio of assets that reflect a wide spectrum of risk: the riskier the asset, the higher the returns when it wins. But on the other side of the trade, the bigger the losses when it fails.

by Andrew Pritchard, managing director of Blockspace Once the public come in, they'll drive growth in the market to the point where it blows up again

Long-term investors currently consider the risks of cryptocurrencies too high. The volatility at the turn of 2018 saw bitcoin – the crypto figurehead – times its value twentyfold to nearly $20,000 between April and December. Four months later, it has more than halved this peak to stand at around $8,100.

Institutional investors

But what is going to tempt the institutional investors into cryptocurrency assets?

Andrew Pritchard, managing director of Blockspace and talking to Capital.com on behalf of The Easy Access Crypto Company's 10x Growth Account, believes a bubble is forming that could be all over in 18 months as institutional and retail investors pile into cryptos.

"Only a small percentage of the population have any exposure to the crypto market. There's not much money in there yet," he says.

The institutional players are on the sidelines, he believes, possibly even manipulating the market as they prepare to enter. At this point, he expects the market to take off again and – as the name of the account suggests – could drive asset growth by tenfold.

Crypto-bubble: phase one

As the market takes off, retail investors enter in droves. "We need to see bitcoin trading through $9,100 to see the bulls coming back into the market, which will coincide with an influx of retail investors," says Pritchard.

"But once the public come in, they'll drive growth in the market to the point where it blows up again. This will happen within the next 18 months, and then it'll go pop."

Timing the escape will be paramount to those investors who have bought and held, and the big risk is that they get this wrong. The price action seen in December bears out this concern.

Crypto-bubble: phase two

The second phase – after the bubble bursts – will see the clever traders make money by shorting the market, Pritchard suggests.

Shorting is where those who are trading on the physical markets sell stock borrowed from a broker or exchange at a high price, expecting the asset to fall in value, then buying the stock on the physical market at the lower price to give back to the lender.

Otherwise, on electronic CFD trading platforms, shorting is simply speculating on the price moving lower.

This is a big risk for long-term investors who haven't timed their exits correctly, or for those day traders chasing profits.

Crypto-bubble: phase three

Phase three will see the better crypto companies emerge as they were always intended – as payment companies and blockchain developers. Of the current crop, Pritchard believes Litecoin and Ripple will be among the major players. He adds a caveat that we've not yet seen the best cryptocurrencies. But bitcoin is not among them.

DeVere's Nigel Green similarly believes bitcoin will go the way of the also-rans.

Responding to recent comments by Twitter chief executive Jack Dorsey that bitcoin will become the global single currency, Green says: "I am confident that there will be many successful cryptocurrencies alongside Bitcoin.

"This is primarily because they all have different inherent characteristics, strengths and values and, therefore, they are useful in different ways for people and organisations."

Market domination and bubble theories aside. The events surrounding this highly controversial asset class this year have highlighted several major risks to trading cryptocurrencies, which we at Capital.com feel is our duty to share with our members.

And remember, that while greater risk can bring higher rewards, greater risk can also result in abject losses.

Risk: High volatility

While many traders consider some market volatility a reward, any asset that fluctuates up and down on a daily basis to the extent that the digital currencies have been since December is almost impossible to time perfectly.

And given the high level of volatility in the crypto market, technical analysis becomes impossible as trends fail to manifest in such a turbulent price environment.

"You can have wins, but you can't win all the time," says Pritchard.

Ben Sapper, chief executive of Australian crypto exchange Blockbid, says: “The key to successful investment is to stay put for the long run and not panic sell when the price rises.

“Once you’ve done extensive research, getting on board with an ICO early can reap rewards once the secondary market sees its benefit and the value of the token rises.”

Alexey Burdyko, chief executive at Play2Live, which recently completed a $30m token sale also advocates diligent research.

“There have been around 150 new launches already this year, so be completely aware and clued up on not only the success and price of the token to date, but also the company behind it.”

Don’t forget – if you’d bought just one bitcoin for $800 at the beginning of 2017, you’d still be sitting on a $7000 profit.

Risk: Low visibility

It's a difficult market for longer-term investors though, as those who would buy and hold assets are ever in thrall to the lack of transparency in the governance of exchanges and the execution of transactions.

"Financial regulatory bodies around the world are increasingly looking to regulate cryptocurrencies," says deVere's Green.

Again, it comes back to the market being too new and too turbulent to spot trends that could give longer-term investors a clue as to the direction of the market.

But this will change if, as both Pritchard and Green suspect, the market gets much bigger in the coming months.

Green says: "Regulation – which I now firmly believe is inevitable – will drive the market even higher. It will give investors more protection and more confidence. It adds a layer of certainty and legal assurance. We have seen how the market has grown in Japan since exchanges were regulated there."

Risk: Regulatory crackdown

When, in December, the price of cryptocurrencies began to plummet, it appeared that the response by several countries to the huge growth in unregulated exchanges was to blame.

Some investors feared that tough regulation would suck the juice out of a fresh, new market that they considered ripe for profits.

“It is important that governing bodies do not create too many barriers, as this could stifle growth to a new, efficient and accessible means of funding business concepts,” says Sapper.

However, it was the lack of regulation that led to weak governance –in turn, allowing hackers to steal $500m in digital currency from a "hot wallet" on the CoinCheck exchange in January. And it continues to be the lack of regulation that allows scammers to operate Ponzi schemes under the guise of initial coin offerings (ICOs).

"This incident, and subsequent action from the regulators, added to the ongoing pressures to introduce regulation into the cryptocurrency space was one of the major contributing factors to the fear, uncertainty and doubt that has seen a cryptocurrency crash and an ongoing bear market," says Alexander Larsen, president of Baldwin Global Risk Services.

Pritchard adds: "Some countries are becoming very proactive in their approach so as not to kill the market - Switzerland, Estonia, Gibraltar, are all working with the crypto exchanges to help protect investors.

"The ICO market really does need stricter regulation, however."

Risk: Funding criminality

If a cryptocurrency's image becomes smeared by news of criminals using it to rinse their dirty money or making payments for illegal activities, it becomes less attractive an investment.

But criminals have always used financial markets in efforts to legitimise their illegal activities. Black markets for international currencies also exist to help with laundering ill-gotten cash.

It remains a risk, however, that trading could be halted on your exchange for several hours, or days, leaving you unable to make transactions if domestic or international authorities suspect illegal activity on it.

Burdyko says: “As with most things that involve large sums of money, this has attracted a large number of scammers looking to take advantage of people’s generosity.”

Nigel Green suggests: "The best way to avoid falling prey to scams and other fraudulent activity is to seek professional, independent financial advice and to choose a crypto exchange that is properly run and backed by a major financial brand."

Ben Sapper agrees: “It is important to research the cryptocurrency before you buy. This is the best way to avoid a scam before proper regulations are brought in.”

Risk: Existential risk

Cryptocurrencies are not tangible assets: "They rely on supply, demand and hype," says Green.

If a company goes bust, bondholders and some equity investors might get something back once the administrators move in.

And while fiat currencies are not apt to collapse suddenly, even if they did, they are backed by central banks who would help smooth the market through periods of turbulence.

Even popular derivatives are backed by physical assets that vendors must purchase to back up their contract – not that this stopped the financial crisis from happening.

But cryptos are nothing more than a promise. They have no intrinsic value, nor are they backed by a central bank. The risk that they collapse, leaving investors with nothing, is a very real risk.

Green accepts this is a risk. He says: "The main risk would be putting too much of your wealth into this highly speculative market. It’s a cliché, but diversification – across sector, asset class and region – is the investor’s best weapon against risk and the best tool to take advantage of opportunities."

Pritchard says that part of the reason the bubble will burst is because so many "crapcoins" will do nothing "apart from be crap" and will unfortunately go to zero.

"Nothing will be left as they are not backed by tangible assets," he says. "This is why we need education, knowledge sharing and better quality people in the industry to give opinion and warn people that certain companies need to be avoided."

Risk: Dilution

Demand is high and competition is increasing. This is not necessarily good for investors as it encourages a glut of new issuances that could see the market become heavily diluted, meaning all cryptocurrencies lose value as a result.

"There are currently about 1500 cryptocurrencies in existence with more coming online in the next 12 months, so dilution is a risk, says Pritchard.

"But," he adds, "the amount of money about to come into this market will be more than enough to de-risk the problem of dilution."

Let's hope he's right.

The bottom line

Whether or not the massive influx of investors that many here have forecast materialise, cryptocurrency investment is currently a highly-speculative endeavour.

Because the market is in its infancy, the regulatory landscape has not yet fully developed and investors remain vulnerable to fraudsters.

Some self regulation is beginning to emerge. Larsen at Baldwin Global Risk Services points to the seven British cryptocurrency companies that have set up CryptoUK, a crypto trade association intended to improve industry standards and engage policy makers.

He says: "The industry is being proactive and responsible about protecting investors, preventing fraud, protecting against cyber-attacks and stamping out scams."

One thing everyone agrees on, however, is that long after the last cryptocurrency dies, or retires to a quiet life of backing global payments systems, blockchain – the technology that underpins many cryptos – will have developed a life of its own. It will be as important as the development of the internet.

"Blockchain is revolutionary and could very well change the world way beyond finance," says Green, pointing to its likely role in the future dissemination of data.

"Everything we do is online, and all that information is recorded – including values, goods and services, and timings, amongst a host of other data."

Pritchard suggests medical records and other forms of data storage will be transformed by this technology.

He adds: "Blockchain is incredible. It's going to fundamentally change the way we do business."

One final thought, then: the wise men of the gold-rush sold shovels and pickaxes instead of heading to the goldfields.

Buy blockchain.

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