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What You Need to Know About Cryptocurrencies Before Investing

February 26, 2018
Cryptocurrencies
(Photo credit): istockphoto.com/D-Keine

Bitcoin, Ether, and other cryptocurrencies are going mainstream: what are the risks?

The rise in popularity and trading volume in cryptocurrencies has spiked the interest of many investors who are examining the potential value of bitcoin and others amid the increased volatility. No longer a niche investment limited mostly to fans of blockchain applications, the digital tokens are now part of mainstream discussions on investments and trading strategies. Before you jump into the fray, professional brokers and analysts say the risks must be considered.

Virtual currencies such as bitcoin are merely digital tokens and are not backed by a physical commodity or any government entity or central bank. Over the last year, the number of initial coin offerings (ICOs) has risen exponentially and values have risen by as much as 100,000 percent. In December, the value of bitcoin skyrocketed and reached an all-time high of almost $20,000, but the extreme volatility remains a concern with financial experts: bitcoin dipped below $6,000 in early February, but rallied a week later to pass $10,000. In February, it crossed $11,000 for the first time after the crash. The expansion of digital currencies has created a new set of other cryptocurrencies called Ripple, Litecoin and Ether, among others.

“Bitcoin and other cryptocurrencies are intended as a type of currency backed by computing power, rather than by a national bank,” says Robert Johnson, president of The American College of Financial Services in Bryn Mawr, Pa.

Entrepreneurs who are considering investing in bitcoin should consider it as a small portion of their investment portfolio, says Daniel Flynn, an energy and currency trader at The PRICE Futures Group in Chicago.

“You don’t want to have all your eggs in one basket, and limiting it to 5 percent of your portfolio will decrease the amount of risk,” he says.

Others advise investors to stay away from it altogether. “It may eventually evolve into an effective way of transferring money, but I believe it is a terrible investment,” Johnson says.

How bitcoin works

The rapid rise and fall of bitcoin prices has garnered worldwide attention. The volatility in its prices is due to a supply inelasticity, because the maximum number of bitcoins is limited to 21 million coins.

The “mining” of bitcoins is the process of using advanced computers to verify previous bitcoin transactions by solving complex math problems. As a reward, the miners are “paid” with bitcoins. These math problems become increasingly harder and requires even more computational power over time, pushing up prices of bitcoin.

Like other commodities and currencies, bitcoin undergoes bear and bull cycles. From 2010 to 2011, prices declined by a whopping 93 percent and prices rebounded during the bull market in 2013. Another bear market occurred from 2013 to 2015, when prices dipped again by 83 percent.

Small business owners and consumers can buy bitcoin through digital currency wallets and platforms such as San Francisco-based Coinbase, the largest exchange for trading cryptocurrency. The sector has evolved, and in December, both the Cboe Global Markets and the Chicago Mercantile Exchange began trading bitcoin futures. The futures market is one option for investors to manage the volatility and lower the risk in their investment. During the past five years, the total value of all bitcoin has reached over $300 billion, from under $1 billion.

People investing in bitcoin do not trust the government to control the money supply, inflation or deflation, says Andrew Wilkinson, chief market analyst at Interactive Brokers in Greenwich, Conn.

“Cryptocurrencies have gained increasing acceptance from a significant number of players,” he adds. “It seems to be well thought out and has reached critical mass as the market has become more mature.”

Now investors can buy future contracts for bitcoin, which is legitimizing the market and adding a mechanism to stabilize prices and attract money.

“The ability to hedge is vital, and the volume on the exchanges is substantial,” Wilkinson says.

Small business owners should view investing in cryptocurrencies like purchasing oil futures because the risks are greater than stocks or bonds, he said. Investing in these digital coins should be a consideration for owners, and they can discuss the advantages and risks with a financial advisor.

Where the risks lie

Owning bitcoin comes with many risks. Even the U.S. Commodity Futures Trading Commission has issued a warning, stating that “virtual currency is a digital representation of value that functions as a medium of exchange, a unit of account, or a store of value, but it does not have legal tender status. Virtual currencies are sometimes exchanged for U.S. dollars or other currencies around the world, but they are not currently backed nor supported by any government or central bank. Their value is completely derived by market forces of supply and demand, and they are more volatile than traditional fiat currencies.”

Since bitcoins are currencies based solely on “the Internet, the lack of a solid backing does not give me a good comfort level,” said Flynn. “It’s all like the Wild, Wild West. Everybody has heard the potential upside and finds it hard to hear the downside news.”

Many investors of bitcoin are buying the coins and hoarding it in the hopes that the price will rise, Flynn comments. In his view, the bitcoin market is a bubble, and while there are some investors who have been successful in making a profit from it, investors can “lose everything and more than their initial investment,” he said. “You want to be very careful with it since it is a very, very risky endeavor.”

Entrepreneurs who choose to invest in the market should only invest an amount that they can afford to lose and should not utilize retirement money to buy cryptocurrencies, says Flynn.

Hacking danger

Another risk that cryptocurrency owners encounter is having their account hacked. The number of breaches is rising, even with established companies such as Coinbase. Hacking into an investor’s bitcoin wallet or the exchanges is popular since cybersecurity criminals can digitally erase their footprint and victims do not have any options legally or criminally.

Since the criminals can remain anonymous, the number of cases continues to rise. In 2016, the FBI's Internet Crime Complaint Center received reports of $28 million in losses from investors, as the incidents of crimes derived from the virtual currencies increased threefold from the previous year.

Unlike money held at banks that are backed by various safety nets such as the Federal Deposit Insurance Corporation, bitcoin lacks a similar recourse, says Giacomo Santangelo, an economics professor at Fordham University in New York and Seton Hall University in South Orange, N.J.

“People have every right to be concerned,” he says. “There is a great deal of risk. The market is currently being driven by speculation and will only continue to have value if people continue to believe it has value.”

Although many people are clamoring to participate in the 21st century gold rush and become the next bitcoin millionaire, the risks of investing in bitcoin are “enormous” and are akin to the tulip mania experienced in the Dutch Republic in the 1630s, says Johnson. During this period, a single tulip bulb sold for multiples of what a skilled laborer could earn in a year, despite the fact that these bulbs had no earning power. “This is a purely speculative market,” he says.

China crackdown

The increasing risks of cryptocurrencies have driven the Chinese government to take a stance against digital coins in 2017. Despite a history of being one of the most active markets for bitcoin trading, the government has taken measures to block domestic and offshore centralized trading platforms. According to data from Chainanalysis Inc., from December 2017 to January 2018, China accounted for almost 80 percent of the world’s bitcoin mining power.

Cryptocurrency miners are being forced to leave behind big mining operations in China, causing a rift in the global digital token market. Analysts speculate that this clampdown from the Chinese government could have contributed to the sudden drop in bitcoin prices early this year.

Vanguard Group founder Jack Bogle advises people to “avoid bitcoin like the plague,” since it has no underlying rate of return like gold. Investing in stocks is a better option, since they generate earnings and dividends, and bonds pay interest, he says.

Most recently, Vitalik Buterin, the co-founder of the cryptocurrency platform Ethereum, sent out a Tweet reminding everyone that cryptocurrencies could drop to near-zero at any time. His advice to investors? “Don’t put in more money than you can afford to lose. If you’re trying to figure out where to store your life savings, traditional assets are still your safest bet.”

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