What is a cryptocurrency? Cryptocurrency is a digital asset (money, only expressed not in paper or gold, but in the form of a computer code), the accounting of which is completely decentralized. That is, there is no single “center” that would issue cryptocurrency.
Interest in cryptocurrencies has grown significantly since the creation of the first of them in 2009 – Bitcoin. In 2016 alone, its rate increased by more than 300 percent. Cryptocurrencies are now a rapidly developing alternative to existing payment systems and banks. In Western countries, there are ATMs for transactions with cryptocurrencies, and on the Internet, you can sell and buy virtual currencies for a long time. For Bitcoin, you can even buy a plane ticket or pay for tuition at the University . In addition, many well-known financial analytical companies have begun tracking fluctuations in the rate of cryptocurrencies and forecasting investments.
Such popularity is due to the many advantages of cryptocurrencies. For example, this is an easy start – there is no complicated registration, age or any restrictions. All you need is Internet access. Download the Bitcoin client to your smartphone or computer, it generates your wallet address and from that moment you can receive and send currency.
The second is the absence of any intermediaries in transactions, such as correspondent banks, which significantly reduces the time for a transaction, its cost and reduces the risk of errors.
The third advantage is that the source codes of Bitcoin are in the public domain and anyone can study them to make sure that the program performs only the declared functions and nothing more. This system does not depend so much on the human factor, trust in the regulatory authorities or the issuer has been replaced by mathematics, algorithms and cryptography.
These are just the main advantages of cryptocurrencies, in fact, they can be listed for a long time. Like any other means of payment, Bitcoin, even though it is not a secured currency, is integrated into the existing economy. And this means that, like everything else, it carries certain risks. Although many see the future of cryptocurrencies as promising, unexpected price fluctuations make even experienced investors seriously wary.
Top 10 Risks of Investing in Bitcoin and Other Cryptocurrencies
Consider the main risks of investing in virtual currency:
- Theft or loss through negligence
If some attacker gains access to the investor’s private key, he can steal absolutely the entire contents of the digital wallet. And if this, in general, can be dealt with by storing secret keys offline – the so-called “cold storage” – then there is another problem. Among the users of virtual currencies, there have been cases when, due to an unfortunate set of circumstances or their own negligence, they lost access to secret keys and, as a result, to their Bitcoin wallets. Also, the hard drive of a computer can simply break down, and one awkward movement will entail the deletion of a file with secret keys.
- Lack of security
One of the biggest risks is that the Bitcoin virtual currency is not backed by anything. Absolutely all national currencies of different countries of the world are backed by state assets. Electronic currencies are backed by the assets of the companies that created them. But cryptocurrencies do not have such security!
- Cyber Security Risks
Hackers can hack virtual currency trading platforms. For example, in August 2016, one of the largest cryptocurrency exchanges, Hong Kong-based Bitfinex, was hacked and 119,756 BTC, that is, 72 million US dollars, was stolen, which led to an instant drop in the Bitcoin price by 23 percent. Zane Tackett, Public Relations Manager at Bitfinex, said that the hack somehow managed to bypass Bitgo’s security, including two-factor authentication and multi-signature mechanism, as a result of which he was able to perform a bulk withdrawal from the individual wallets of cryptocurrency exchange users.
Another telling example is the case of the digital currency exchange platform Cryptsy, which lost 13,000 BTC and 300,000 LTC during a hack on July 29, 2014. But the most interesting thing is that she did not even begin to inform her users about this because of her unwillingness to cause mass panic.
One of the latest high-profile cases is a hacker attack on the South Korean exchange Bithumb, as a result of which hackers stole several billion South Korean won from BTC customers’ accounts. Bithumb is the largest Bitcoin exchange in South Korea and the fourth largest exchange platform in the world. It accounts for 75.7 percent of all payment transactions in South Korea. The turnover of the Bithumb exchange is approximately $33 million per day, which corresponds to a tenth of the total global turnover of Bitcoin. It is reported that hackers stole the personal data of 31,800 users of this exchange – about 3 percent of the entire client base. As you can see, even such a large exchange can be hacked.
- Virtual currency fraud
Since the inception of Bitcoin, its adoption has grown exponentially, making it the most popular virtual currency in use around the world. Unfortunately, with the growing popularity of cryptocurrencies, the number of scammers who want to make money on it also increases.
Potential investors should be wary when someone promises them, for example, guaranteed high returns; offers to buy Bitcoin when no one posted any offers to sell them; when a sale or purchase is too attractive; or when unknown people try to create a false sense of investment urgency, leaving little time for quiet reflection. Unfortunately, this risk accompanies operations with both virtual and real money.
Phishing is also a popular way to scam virtual currency today . Phishing is perhaps one of the most common ways for cybercriminals to obtain personal information from users. Fraudsters often use e-mail, where, under various pretexts, they ask gullible users to follow some links or enter their confidential data – passwords from wallets or e-mail. Very often scammers disguise themselves as well-known resources, copying their design.
For example, one of the largest cryptocurrency web wallets in the world, Coinbase, has been phished since 2014 and still is. In the fall of 2016, the TrickBot Trojan was discovered, which is distributed through email spam, which also targets Coinbase.
Earlier, in July 2016, after the disappearance of Bitcoin mining company HashOcean with millions of dollars in BTC, phishers attempted to force victims to part with their funds, claiming that they could return the stolen BTC. In an effort to seduce gullible victims, the phishers used mailing lists and fake Facebook pages and websites.
To avoid becoming a victim of phishing, do not open unverified sources. Also, as the specialists of the aforementioned Coinbase advise, make sure that the operating system and important software on your computer is always updated to the latest versions. Avoid installing applications from dubious sources and do not use “cracked” versions of official software. Browser plugins must also come from official sources.
- Lack of consumer protection
The unfortunate fact is that Bitcoin does not provide any kind of consumer protection. Completed transactions can no longer be undone. All you can do after a failed trade is to try to convince the recipient of the funds to voluntarily return them. This is a consequence of the fact that there is no intermediary guarantor, as is the case with bank cards.
Bitcoin transactions are like regular cash transactions where there are only two parties. However, it is worth noting that this fact of the irreversibility of transactions and the absence of intermediaries in itself affects the popularity of investing in Bitcoin as an asset. But investors should be aware of the other side of the coin as well.
- High volatility
Bitcoin price fluctuations are, in general, almost unpredictable in the short term, and this adds to its riskiness. Financial professionals can predict the value of the dollar, euro, and other real currencies or stock quotes with relative accuracy. But no one can predict exactly what the price of Bitcoin will be tomorrow.
In the long term, some experts are trying to do this. For example, the Chappuis Halder & Co company in its new report concluded that by 2019 Bitcoin will equal fiat currencies in terms of volatility. The authors of the report tried to create a model that would make it possible to predict the value of Bitcoin. Similar models already exist for other assets. The researchers concluded that the coming years will be quite successful for Bitcoin, but success will be associated with speculation and exchange rate instability. The report sees cryptocurrencies as a new type of asset that can be used as a currency and investment vault. But the market still needs more time to get to know and accept Bitcoin, the authors of the report say.
The factors that cause Bitcoin price volatility are large exchange trading volumes, legislative initiatives from regulators, virtual currency integration with various companies, and much more. In addition, experts in the field of finance and economics, who pay attention to cryptocurrency, note the high sensitivity of the Bitcoin rate even to news reports.
- Risks associated with the development of technologies
The technological component often develops very quickly, and sometimes even uncontrollably. Everyone knows that Bitcoin already has and continues to have a huge number of competitors almost every day. Although Bitcoin is the most recognizable and popular cryptocurrency, there is still a very real technological risk that another more advanced virtual currency will appear. Investors simply may not notice the moment when their virtual funds lose their real value.
- Currency regulation
Today, each country approaches the regulation of cryptocurrencies in its own way. The lack of a single well-thought-out system for regulating cryptocurrencies only increases the uncertainty factor regarding their future. Regulators in many countries are concerned that Bitcoin and other cryptocurrencies can be used for speculation, drug trafficking, money laundering, terrorist financing and other illegal operations. With the growing popularity of cryptocurrencies, government agencies in many countries are beginning to actively come up with various legislative initiatives to regulate the circulation of Bitcoin and other virtual currencies.
For example, in Ukraine, the Verkhovna Rada recently registered the country’s first draft law on the circulation of cryptocurrencies, developed with the assistance of the Ukrainian Blockchain Association. The draft law proposes to assign the responsibility for regulating the virtual currency market in the country to the National Bank of Ukraine. He will have to develop an operating procedure for cryptocurrency exchanges. Income generated by such exchanges will be taxed. Taxes will also need to be paid from the mined cryptocurrency, but the taxation mechanism has not yet been determined. But at the same time, the state will not bear any obligations to the owners of the cryptocurrency (that is, it does not provide it as a classic currency, in case of depreciation or loss of the cryptocurrency, the state will not help its owner in any way).
And on October 10, another bill was registered by Sergiy Rybalka – “On stimulating the market of crypto-currencies and their derivatives in Ukraine.” In this bill, virtual money is already recognized as a financial asset, and not as an exchangeable item, as was the case in the previous one. Accordingly, cryptocurrency exchanges will have to obtain a license for their activities and will have the right to open cryptocurrency accounts for both residents of Ukraine and foreigners.
Also, the second bill on cryptocurrencies more clearly spells out the tax responsibilities of crypto exchanges. They will be required to pay an additional fee for pension insurance on purchases and sales of virtual currencies, and after that they will have to report to the Pension Fund.
At the same time, it was proposed to introduce some incentives for miners. For example, reduced electricity rates for those who mine cryptocurrencies at night.
The countries that have introduced the regulation of virtual currencies also include Switzerland, Japan, the USA, Canada, the UK and others. China completely banned ICOs (Initial Coin Offering – initial placement of coins), announcing that 99 percent of ICOs are fraudulent schemes.
In Singapore, according to the Deputy Prime Minister, the regulator did not recognize Bitcoin as a means of payment, so control will be exercised over the activities of companies providing services for the sale of Bitcoin, and not the cryptocurrency itself. At the moment, the financial regulator is developing new rules for making payments that will eliminate the risks of money laundering and terrorist financing associated with the anonymity of making payments using virtual currencies.
The situation is quite different in Australia. The Australian government intends to make the country a world leader in FinTech. Temporary legislative relief was announced, allowing foreign initiators to conduct ICOs in Australia, operate and test new financial technologies for up to two years without a license. The international organization for standardization ISO even appointed Australia to head the international committee on the development of standards for blockchain technology (ISO / TC307). Therefore, now it is Australia that develops the rules of the game in the blockchain.
- Taxation of virtual currencies
This factor follows from the previous one. Investors who are going to invest in cryptocurrencies should also take into account that there is considerable uncertainty regarding the taxation of the circulation of virtual currencies in different countries. In certain jurisdictions, cryptocurrencies are considered an asset, in others they are not.
For example, in Israel at the beginning of 2017, the tax office decided to treat Bitcoin as a commodity, which makes transactions much more difficult and imposes a whole bunch of taxes on them. When selling BTC, individuals must pay a capital gains tax of 25 percent. In this case, it will be necessary to prove the costs of acquiring virtual currency, otherwise you will have to pay tax on the full amount of the sale. And trading and mining of virtual currencies is now considered as a business, so companies operating in these areas must pay income tax and charge VAT (VAT) at a rate of 17 percent from customers.
- Network scalability problem
The problem of scaling the Bitcoin network has not yet been fully resolved. Network bandwidth has long been a concern, and the growth of commissions makes small transactions not entirely profitable (for example, transactions that are associated with the sale of BTC mined on Bitcoin faucets), and transactions with a large commission are also increasingly “stuck” in the network. Of course, they have been working on a solution to this problem for a long time, but so far none of the proposed options is an ideal solution. And if the network congestion problem worsens, it will affect the position of Bitcoin as a payment instrument.