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Since Bitcoin was invented in 2008, the world of digital currencies, or cryptocurrencies, has advanced significantly.
There are currently estimated to be more than 2000 different cryptocurrencies in the world and they are now being invested in heavily by financial institutions that once dismissed them. Accounting for billions of dollars of market cap, individuals are now also looking to cryptocurrencies as an investment option.
However, while cryptocurrencies certainly have their advantages over government-issued legal tender, the industry is still in its early years and is therefore volatile, resulting in specific risks. Here we will look at some of the risks specific to investing in cryptocurrencies.
Lacks derivatives markets
In a traditional financial market, investors are protected by derivatives such as options and futures contracts; however, cryptocurrencies do not have a derivatives market which makes them risky, particularly for business contracts that are lengthy. There is talk about creating a decentralized platform and this will help to stabilize the price of cryptocurrencies.
Cryptocurrencies can be particularly volatile. Bitcoin, for example, has peaked as high as US$5300, but it has also traded at as low as US$200. There is no real rule, except for volatility and no one really knows where it is going to go. However, economists are optimistic about the future of cryptocurrencies and point out that while they have had their ups and downs, the general trend is upwards.
While stocks and bonds are also volatile, they have been around for a lot longer than cryptocurrencies, making them better understood.
No intrinsic value
Cryptocurrencies have no intrinsic value, but rather, their value is derived from what the market is prepared to pay for it. As long as people trust a particular currency, it will continue to grow in value, but as soon as people lose faith, its value will drop until it can become worthless.
Unlike commodities, such as gold, oil or wheat, which have industrial uses, cryptocurrencies only have a virtual purpose which restricts its demand.
Stored cryptocurrencies can be lost
Cryptocurrencies are encrypted to keep them secure with the coin’s encryption code or private key becoming its only form of identity.
This means that whoever holds the coin with its encryption code, is its owner so that if it gets lost or stolen, there is no way to trace it or retrieve it. These encryption codes need to be stored very securely, adding another element of risk to this type of investment.
Vulnerability to hacking
This links in with the point about the encryption code that is unique to each coin. Your coins will be accessed via online coin exchanges and wallet services and a copy of the coin’s encryption code will be stored together with it. If these online coin exchanges are hacked, large volumes of coins could be transferred out of them in a short period of time and in fact, this happened both in 2014 and in 2016. To reduce the risks, these coins can be stored physically; however, while you will be reducing the risk of hacking, you will increase the risk of them being physically stolen.
Keeping track of cryptocurrencies
With the large number of unique cryptocurrencies in the world today, and with each one having its own unique features, it is almost impossible to keep track of them all. Particularly, it is almost impossible to keep on top of all the benefits and risks of each individual coin. In addition, the market cannot support such many unique coins.
This adds to the difficulty of being able to predict which coins will grow in popularity and which will eventually fall away. This means that in order to reduce your risk, you would need to diversify your holdings instead of focusing on one cryptocurrency.
Restriction by jurisdiction
Future regulations and restrictions is an unknown risk at present. This falls into the area of new technology and like with any other new technology, governments will analyze its risks and benefits and decide how to govern it, or whether to ban it outright.
There are risks due to its anonymity and this will likely lead to governments imposing regulations to try to avoid it being used in money laundering, which has already occurred. In April 2017, Japan became the first country to recognize Bitcoin as legal tender. Canada, on the other hand, has developed its own cryptocurrency, with the Royal Canadian Mint creating MintChip, a type of cryptocurrency that is contained on a smartcard and is backed by the Canadian dollar. It is still unclear how other countries will approach the issue.
Cryptocurrencies are becoming more popular options for investors as they continue to grow. However, there are a number of risks associated with investing in these digital currencies and it is important to understand them before you begin to invest.