Ari Paul, CIO of cryptocurrency hedge fund BlockTower Capital, recently sat down with Business Insider’s Sara Silverstein to discuss the three main risks associated with investing in cryptocurrencies.
1. Investment Risks
The first area of risk, according to Paul, is investment risk, by which he predominantly refers to the volatility of cryptocurrencies. All anyone has to do is take a look at Bitcoin’s performance over the past month to understand what he is talking about. Bitcoin started off the month trading at just under $10,000 – a point of tremendous growth in and of itself – and in less than three weeks it more than doubled in value, peaking at just over $20,000.
Everybody was all about the bitcoin. CBOE and CME Group rolled out Bitcoin futures, Nasdaq said it would be following suit in 2018, there was even talk about Bitcoin ETFs once again becoming a possibility. Bitcoin had finally arrived on the mainstream financial stage and it was all going to be gravy from there.
Until it wasn’t.
Since its peak, Bitcoin has tumbled more than 40%, to a low of just over $12,000 as of this morning. Does this mean that the Bitcoin bubble has finally burst? Considering that Bitcoin has “crashed” and recovered after a so-called “bubble” at least three times previously – once in 2011 and twice in 2013 – I think it’s a little early to be throwing in the towel.
My point – and the point that Paul makes in the interview – is that these massive price swings are one of the biggest risks in cryptocurrency investment. Just like stocks and equities, any cryptocurrency can fall. Maybe they rebound, maybe they fall all the way to zero. It’s a crapshoot and a risk that investors need to understand and be willing to take.
2. Operational Risks
The next area of risk is operational risk. In a nutshell, operational risk is anything having to do with how you interact with your cryptocurrencies. This can include storage, transferring, converting, etc.. The most significant point of risk in this area, however, is storage. Where and how cryptocurrencies are stored has a lot to do with how secure they are.
Talking about storing cryptocurrency, Paul stated:
[It’s] a tremendous target for hackers, it’s a target for thieves, including insiders, and in a large operation, and there’s potentially no recourse. So you have to be really, really careful that you’re storing cryptocurrency securely. And that’s a serious concern.
Currently, there are three primary methods of storing cryptocurrencies that most investors use:
- On an exchange
- In a software wallet
- In a hardware wallet
Storing Your Cryptocurrencies on an Exchange or Online Wallet
While definitely the most convenient storage method, especially if you are an active trader and/or have many different cryptocurrencies in your portfolio, keeping your coins on an exchange is the absolute most insecure way of storing them.
Paul and Silverstein discuss storing cryptocurrencies on Coinbase as an example, but as far as online wallets and exchanges go, they are the exception rather than the rule. They insure their users’ crypto and fiat deposits against losses due to physical or cyber security breaches as well as employee theft.
Most exchanges and online wallets do not insure their users’ deposits, however, so if the exchange or wallet gets hacked or the owner decides to close up shop one day and head off to a non-extradition country with your coins, you’re unlikely to ever get them back.
Storing Your Cryptocurrencies in a Software Wallet
Software wallets are applications that you download and install on your computer or mobile device. There are several Bitcoin software wallets to choose from and each altcoin (alternative cryptocurrency) generally has its own software wallet client as well.
That last sentence illustrates the main problem with software wallets. Aside from Exodus and Coinami, there really are very few proven multi-currency software wallets available. If you only dabble in one or two cryptocurrencies, it doesn’t pose a real problem, but if you have a large diversified portfolio of crypto assets, having to download and install a software wallet for each one individually can be a real inconvenience.
Another drawback to software wallets is that it is easy to lock yourself out of them. If you forget your password or lose your seed key or private keys, there is no password reset function. Barring the slight chance that a crypto recovery service might be able to unlock it for you, those coins are gone, never to be recovered.
Like the online wallet, there is still a chance that a software wallet can be hacked. Granted, it is more difficult, but it can still happen. All it takes is for your computer or mobile device to become infected with a keylogger and a trojan virus and a would-be hacker can see your password as you type it and can later go back and access your wallet with you never being the wiser until the next time you open it up.
Storing Your Cryptocurrencies on a Hardware Wallet
Unlike the two “hot wallet” options above, the hardware wallet is the only “cold wallet” featured in this list. The terms “hot” and “cold” refer to whether or not the wallet maintains an internet connection. A hardware wallet is a physical device contains software that allows users to store one or more cryptocurrencies. The main benefit of a hardware wallet is security. Because you only need to connect it to the internet when you want to transfer coins, it is inherently less vulnerable to being hacked than online or software wallets.
Although hardware wallets are the best bet from a security standpoint, they suffer from the same drawback as software wallets. You still need to remember your password (a pin number) to gain access. If you forget it or lose your private keys, there is no reset function.
Trezor, Ledger, and KeepKey are three of the most popular examples of hardware wallets. All three have easy to use browser interfaces and support multiple cryptocurrencies.
3. Regulatory Risks
The last area of risk that Paul discusses is regulatory risk. The laws regarding cryptocurrencies are far from standardized. What is accepted and legal in one country may be illegal in another. For example, the president of Belarus announced today that cryptocurrencies and ICOs would now be legal in the country.
On the other hand, in China, ICOs are banned outright and, in countries that bother to classify it at all, bitcoin is considered a financial asset rather than a form of currency. The U.S. has some of the strictest regulatory guidelines on ICOs, resulting in many ICOs not being open to U.S. investors.
Then there is the issue of taxes. Is it taxable? If it isn’t considered a currency, how is it taxed? Do you only pay taxes on the cryptocurrencies you convert to fiat currency or are like-to-like transactions taxable as well?
The cryptocurrency space is a regulatory minefield and it is important that you be aware of the laws and regulations regarding cryptocurrencies in your country. After all, ignorantia juris non excusat – ignorance of the law is no excuse.
Still Thinking About Investing in Cryptocurrencies?
So what is the takeaway from Ari Paul’s interview? When you distill it down to the basics, it’s really quite simple:
- There is no ‘sure thing’ in cryptocurrency investing so investors need to understand and be prepared for the fact that prices are going to fluctuate – often dramatically;
- Store your cryptocurrencies securely and – I can’t stress this enough – keep your password and private keys stored in a safe, secure location like a fire safe or safety deposit box ;
- Do your due diligence and make sure you understand the laws and regulations regarding cryptocurrency investing in your country.
I would add one more item to the list and it is something that applies to any kind of investing – don’t invest more than you can afford to lose.
Do you agree with Paul’s assessment of cryptocurrency investment risks? Is there anything that you would add to the list? Let us know in the comments below.
Images courtesy of AdobeStock, Business Insider, Wikimedia Commons
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