Cryptocurrency! What is it? What are the Risks?

What is Cryptocurrency?

Most people have heard of cryptocurrency by now, but many still don’t understand what it is.  Cryptocurrency is simply a form of digital cash or currency, and serves purely as a digital medium of exchange, allowing users to transact directly with each other without needing banks or governmental regulations.  Many users invest in cryptocurrencies as speculative assets, hoping that the value of a particular cryptocurrency increases over time.

While many cryptocurrencies have dramatically increased in value since 2019, they are still very risky and unpredictable assets.  Their value can swing wildly based on a single tweet, responding more to community expectations than any underlying value.  

Should I invest in cryptocurrencies?

A general impression is growing that there are get-rich-quick opportunities in bitcoin and other cryptocurrencies. Much of this buzz is driven by industry insiders who need to attract more investors to make any profit and celebrity endorsers who have often been paid for their endorsements.  This buzz combined with the often-anonymous nature of cryptocurrency investments makes it easy for scammers to thrive.  

Cryptocurrencies pose unique risks since they are novel, opaque, and unregulated.  But beyond their risks, they might not have much of an upside.  Over the last few years, cryptocurrency returns have been increasingly correlated with stock market returns.  This means that you could risk losing all of your hard-earned money for a lower profit than if you had just invested in an index fund.  Consider this: as of right now, there are about 47.9 million digital wallets holding bitcoin.  24.6 million, or over half of the wallets, are worth less now than when they purchased bitcoin.  If you purchased $1,000 of bitcoin at its peak of roughly $65,000, your investment would now be worth about $246.  In fact, the total value of all cryptocurrencies is down over 70% from its peak just over one year ago.

Are other investments just as risky?

All investments are risky, but many other investments have important legal and regulatory protections.  For example, when you invest in the stock of a publicly traded company, the stock has an underlying value, and the investor has an interest in the future profits of the company, commonly paid out to investors as dividends.  If the company is sold, the investor is entitled to a share of the proceeds.  If the company goes bankrupt, there is still a chance that investors can recover a portion of their investment.  Even if the company commits fraud, investors have legal rights they can enforce. 

None of these protections are available to cryptocurrency investors.  Cryptocurrencies often do not have any underlying value.  If you purchase a coin to support a project in an in initial coin offering, or “ICO”, you do not have an ownership interest in the company.  If the project is sold, you are not entitled to any proceeds of the sale.  If the project fails, your investment will likely be worth nothing.  If the project is a fraud, the anonymous nature of cryptocurrency means that it could be very difficult or impossible to recover your money.  In fact, fraud is so common in ICOs that there is even a term for it: getting “rug pulled” or “rugged.”  

What are the risks?

With no financial or governmental regulation, there are going to be risks involved. 

• There is no recourse in cryptocurrency.  There is no way to undo a transaction if you invest cryptocurrency with someone else and they run away with it.  
• Crypto trading isn’t free.  Exchanges charge commissions.  The currencies themselves charge “gas fees” to process the transactions.  Gas fees fluctuate with demand for transactions.  If you trade too frequently or at the wrong time, transaction fees could decimate your investment.
• Anonymity makes it very difficult to investigate cryptocurrency scams and recover stolen money.
• Cryptocurrencies are vulnerable to being hacked.  Recently, the Ronin hack cost users $660 million.  The increasing complexity and size of the cryptocurrency ecosystem is making it easier for hackers to steal large amounts of investors’ money.
• Many projects turn out to be “rug pulls” with investors getting “rugged,” meaning that the projects were fake.  The scammers manufactured hype on social media to lure investors then disappeared with the money, leaving investors with a worthless coin.
• Minor or relatively unknown cryptocurrencies, known as “alt-coins,” are often thinly traded and vulnerable to pump and dump schemes.  If you see someone hyping them on social media, it is likely part of a scam.  The low trading volume of alt-coins makes their prices easy to manipulate. 

What should I do?

If you are going to invest in cryptocurrency, do your research. Keep in mind the old adage that ‘if it looks too good to be true, it probably is.’  

• You should not be investing in cryptocurrency if you are doing so simply out of fear of missing out (FOMO). FOMO may be real, but it’s not an investment strategy.  
• Just because a sports star or a famous entertainer has endorsed the product does not mean you should invest. 
• Do not invest in cryptocurrency if someone you have met online is pressuring you to make a quick decision on something you have not had time to research. Online scammers work to build trust, acting as your friend—or even a potential romantic partner—investing their time with an eye toward taking away your hard-earned money.
• Never invest more than you can afford to lose. 
• Spend considerable time researching any investment you might make. 
• Do not invest in projects that use high-pressure sales tactics.  

If you have decided to invest in cryptocurrency and plan to use a cryptocurrency exchange, you should read our alert about cryptocurrency exchanges here:  What is a cryptocurrency exchange? Is It Safe?

Before you invest, visit the resources below to learn more about how you can protect yourself and what to do if you get scammed.

• FTC –What to Know About Cryptocurrency and Scams
• File an SEC complaint