Here's the top 9 risks you need to know before investing in Bitcoin

Retail investors are vulnerable to wild price movements, particularly if a top holder of the cryptocurrency decides to liquidate their position

FILE: A coin representing Bitcoin cryptocurrency sits reflected on a polished surface and photographed against a photo illustration of electronic data indicating stocks falling in this arranged photograph in London, U.K., on Thursday, Feb. 8, 2018. The great cryptocurrency crash of 2018 is heading for its worst week yet. Bitcoin sank toward $4,000 and most of its peers tumbled on Friday, extending the Bloomberg Galaxy Crypto Index’s weekly decline to 25 percent. That’s the worst five-day stretch since crypto-mania peaked in early January. Photographer: Luke MacGregor/Bloomberg

The spectacular surge in Bitcoin's price and the growing adoption by the mainstream financial industry, including legacy establishments such as Visa, MasterCard and BNY Mellon, has had investors rushing to crypto exchanges to grab a piece of the digital currency action.

While the stratospheric rise in Bitcoin prices and wild media headlines have whipped up a Fomo frenzy, the fundamentals of investing haven’t changed. The same investing rules and due diligence apply to Bitcoin as any other asset class.

If anything, a slew of factors makes Bitcoin a far riskier investment than the traditional alternatives. Investors would do well to become familiar with some of the most significant issues in the wild and woolly world of cryptocurrencies.

Here are some key Bitcoin risks to weigh whether you’re considering wading in for the first time or have already placed your Bitcoin bets.

Price volatility risk

The price of Bitcoin is prone to wild swings. The market is extremely sensitive to news and new developments, which causes frequent and volatile upswings and downdrafts in the digital currency's price. “Bitcoin is likely to remain very sensitive to shifts in global interest rates, especially US interest rates, as well as to the broader dollar exchange rate,” Arnab Das, global market strategist at Invesco, says.

Furthermore, Bitcoin sees little use as its stated purpose – a transactional currency. "The price volatility makes it harder to be used to buy and sell goods," Kristoffer Inton, an equity analyst at Morningstar, says. Mr Inton uses the example of the man who bought a couple of pizzas with 10,000 Bitcoins in 2010. "At today's prices, those pizzas cost him millions of dollars," he says.

Loss of demand risk

As a relatively new product and technology, Bitcoin may be some way from widespread acceptance. The demand and usage of Bitcoin are beholden to the underlying technology. That technology needs to first get to a place where it can be trusted by large risk-averse retail investors and other institutions, New York-based financial analyst, Mitchell Yousem, says.

“Right now, real time technology and infrastructure is a bit lagging and there have been issues not even associated with crypto or BTC,” he says, referring to instances when digital banks and trading platforms couldn’t handle incremental increases in transaction volumes.

The lack of a major use other than investment further adds to the coin’s volatility. “Gold is an investment asset, but it also has strong underlying demand in jewellery,” Mr Inton says.

“If you invest in gold, you know there’s going to be a buyer at some price, [but] it’s hard to say the same thing about Bitcoin since it’s not being used for anything else, other than maybe NFTs.”

On the other hand, Bitcoin is far too volatile to serve as a medium of exchange or a store of value to any meaningful degree, thus it’s not used widely enough in exchanges, Mr Das points out.

Cyber security risk

Attacks from hackers have caused millions of dollars worth of losses in stolen digital tokens, including Bitcoin. As events like Mt Gox revealed, cyber security is a real risk associated with Bitcoin.

The Tokyo-based Bitcoin exchange was the target of a multimillion-dollar theft that exposed the risk inherent in the unprotected digital wilderness. “Lots of coins were lost or stolen, and there isn’t much an investor can do to rectify it,” Mr Inton says. “An asset built around anonymity like Bitcoin makes it particularly attractive for cyber attacks.”

Established payments systems and accounts benefit from extensive experience in avoiding attacks and fraud. Unlike these institutions, “cyber warfare or cyber terrorism on the Bitcoin network, or other private cryptocurrency networks, are a major risk”, Mr Das says.

Regulatory risk

Increased regulation of Bitcoin could have implications for the future use of the digital currency. "Indeed, some countries have already outlawed Bitcoin, notably China," Mr Das says. India is in the process of restricting its use with some outright bans.

“Restrictions in two of the world’s largest money systems in emerging markets, along with restrictions in the world’s deepest financial systems in high-income economies is likely to prevent mainstream use of Bitcoin to replace conventional moneys,” Mr Das cautions.

FILE PHOTO: A collection of Bitcoin (virtual currency) tokens are displayed in this picture illustration taken December 8, 2017. REUTERS/Benoit Tessier/File Photo

Western economies are feeling their way to regulating Bitcoin and other cryptocurrencies as commodities or assets rather than money. At present, regulators in the US and Canada treat Bitcoin as a commodity, while the European Union, Russia and Japan regard it as a currency.

In fact, some countries – namely Russia and Iran – are circumventing US-imposed dollar financial sanctions by turning to Bitcoin to avoid the dollar payments system. The same goes for individuals seeking to avoid regulatory and tax nets of governments. “These risks of Bitcoin usage are probably a major reason why [entities that are] subject to ‘know-your-client’ or ‘anti-money-laundering’ rules are unlikely to accept Bitcoin as freely as they do other forms of electronic funds transfer or payments,” Mr Das says.

Transaction fees risk

All Bitcoin transactions must be verified by Bitcoin miners who collect fees for each confirmation. If miners can manage to collude and demand higher transaction fees, they could dampen the attractiveness of the Bitcoin network for users.

“The risk of untransparent pricing or other techniques is a risk in many types of asset markets and has also figured in transaction costs for many types of exchanges of money – for example, retail cross-border transfers affecting remittances by migrant workers, or simple tourist/retail foreign exchange transactions,” Mr Das says.

Quote
Right now, real time technology and infrastructure is a bit lagging and there have been issues not even associated with crypto or BTC

A lack of competition, lax or no regulation, and a captive client base can conspire to be a real challenge. “Bitcoin users need to factor in these risks, which have been realities for generations in other non-policed corners of the global financial system,” he notes.

The internet risk

From mining to transfers and transactions, cryptocurrencies are heavily reliant on internet connectivity. Both buyers and sellers of goods and services that trade using Bitcoin access the digital currency blockchain via the internet. The entire cryptocurrency system, therefore, is exclusively reliant on seamless internet connectivity.

“Bitcoin shares the risk of exposure to the internet with virtually every other financial or payments system these days,” Mr Das says. However, he stresses that while traditional systems can – and do – have an analogue back-up, Bitcoin, almost by definition, cannot offer that security.

That users opt into that uncertainty, armed with full or sufficient knowledge of the consequences of cyber terrorism, is “presumably because they want other perceived benefits such as anonymity and a veil with the tax or other official authorities”, Mr Das says.

Ownership concentration risk

Approximately 20 per cent of Bitcoin is currently being held by 115 Bitcoin wallets. A large holder can have an outsized impact on the coin’s price. This renders small investors vulnerable to wild price movements, should one of these top holders decide to liquidate their position.

“This is a huge unknown,” says Mr Yousem, who works at a $10 billion long/short equity hedge fund in New York City. “If a couple of those guys fully liquidated, it would crash, and fast – this is definitely a risk to consider.”

There’s also risk of general market manipulation. In the absence of regulatory oversight, there is no mechanism in place to “limit the activities of these big holders like there is in stocks or assets traded on regulated exchanged”, Mr Inton says.

To compound the issue, it could all be owned by one person who has the ability to pull the trigger, since one wallet does not necessarily mean one unique holder, Mr Yousem says. “This adds another layer of risk on BTC, but does not apply to all crypto currencies, current and future,” he says.

Transfer error risk

Bitcoin transfers are irreversible. An erroneous transfer – whether accidental or resulting from a foul play – can cause a significant and irreversible loss. There have been instances where a user accidentally transferred incorrect amounts or to an unintended recipient and was unable to recover the lost Bitcoin.

Quote
The price volatility makes it harder to be used to buy and sell goods

“There are limitations and downsides to retail consumers,” Mr Yousem says. “If you wanted to scare those people away, it’s definitely with the loss of private keys or unintentional transactions since there is no central authority.”

While there is transaction fee and execution risk associated with most securities, Mr Yousem says it’s certainly a different beast with Bitcoin.

Loss of private keys risk

A user requires certain numerical codes, known as private keys, to access Bitcoin. The loss or destruction of these codes could prevent the owner from accessing their Bitcoin. Many Bitcoin owners were horrified to find the loss of these private keys could be irreversible and carry a substantial financial cost.

“Bitcoin users are subject to a variety of specific risks that are more immediate and potentially with much greater downside, including loss of private keys, than conventional moneys,” Mr Das says.

Arguably, some Bitcoin worshippers are aware of these risks but accept them in exchange for anonymity or avoidance of authorities. “That said, this aspect of Bitcoin risk should be distinguished from the price volatility risk or potential for capital gains when used as a speculative investment vehicle [as opposed to a transaction or payment vehicle,” Mr Das adds.

EDITOR'S PICKS
NEWSLETTERS