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Investing in cryptocurrencies is a high risk/high return activity. There is currently no other asset class that is this lawless yet has such high returns potential — as this year’s exuberant price rallies of bitcoin (BTC) and ether (ETH) illustrate. Bitcoin rallied by over 720 percent while ether has rallied by over 4,300 percent year-to-date. With high reward comes high risk, however, and crypto investors face a multitude of them in this largely unregulated and immature market.
In general terms, cryptocurrencies and digital tokens are an extremely volatile asset class. While the volatility of bitcoin has reduced substantially over the years as the world’s leading digital currency matures into an internationally-accepted investment asset, other cryptocurrencies can still experience intra-day price movements of 50 percent or more in either direction.
As the crypto market is largely news-driven and each cryptocurrency has its own idiosyncratic risk, sensationalist headlines, rumors, and malicious media campaigns from rival blockchain projects can result in significant intra-day and intra-week price drops.
Diversification is the key to reducing market risk. Most crypto portfolios are composed of large holdings in bitcoin and ether, and smaller holdings in promising altcoins to mitigate idiosyncratic market risk. Alternatively, hedging your crypto portfolio with BTC futures can also reduce market risk.
Liquidity risk is another challenge, especially for those who invest in mid-cap and small-cap coins. While the average daily trading volume of bitcoin is currently above $2 billion, once you leave the 10 largest cryptocurrencies by market share, investors are looking at daily trading volumes of less than $100 million, and in many cases less than $10 million. This poses a challenge for anybody wanting to make larger investments.
Furthermore, trading volumes are spread out over several exchanges, which makes it even more difficult to execute large orders without moving the market, let alone exiting a large position. To mitigate liquidity risk, it is advisable to stick to the most liquid coins, especially when trading in large ticket sizes.
One of the biggest risks that crypto investors face is regulatory. Every time a major bitcoin trading hub announces adverse cryptocurrency regulations, the market gets rattled. A recent example of that was China announcing a ban on initial coin offerings, which resulted in a severe drop in prices of Chinese digital tokens. NEO, for example, dropped by 40 percent on the day the ban was announced.
On a broader spectrum, the legality of bitcoin and decentralized cryptocurrencies is a topic that crypto investors need to follow closely. While it seems unlikely that lawmakers in major bitcoin economies such as the U.S., the U.K. or Europe will change their minds about allowing the use of decentralized digital currencies (given the innovation and jobs the sector is creating), should these governments and financial regulators reverse their position, the effect on cryptocurrency prices would be potentially devastating.
Unfortunately, regulatory risk is effectively impossible to mitigate against. The only thing investors can do is keep a close eye on bitcoin media and stay informed of any potential policy changes that could impact their crypto holdings.
Operational risks abound when trading on bitcoin exchanges and storing funds in cryptocurrency wallets. Centralized bitcoin exchanges are regular targets for cybercriminals and there remains a long list of users whose funds have been lost due to exchange hacks.
But even when storing your coins in private wallets, losses can still occur if you do not store your holdings in cold storage. The recent Parity wallet hack that froze over $280 million worth of ether and ERC20 tokens is a painful reminder of how nascent this market and the technological ecosystem that supports it still is.
To mitigate operational risk, crypto investors should use decentralized exchanges, such as EtherDelta, as much as possible in order to reduce the risk of losing funds because of operational errors at exchanges. Also, investors should always store their holdings in hardware wallets.
If you are a crypto investor, you are a target for hackers. The pseudonymous nature of the majority of decentralized digital currencies makes them an ideal hunting ground for cybercriminals — as it is much easier to steal bitcoin than say US dollars or any other fiat currency which require that users operate through regulated financial intermediaries.
The cryptocurrency space is filled with phishing email campaigns, fake websites that capture wallet or exchange log in details, and targeted hacking of vulnerable bitcoin exchanges. Cybercrime is a major risk for crypto investors. Unfortunately, the list of crypto users and exchanges that have fallen victims to cyber theft is very long. It is up to each crypto investor to ensure they use sufficient cybersecurity measures when it comes to securing their crypto holdings and when transacting on crypto exchanges
Bitcoin investment schemes promising unrealistically high ROIs are often heavily promoted across social media and are even advertised on reputable bitcoin media outlets. Usually, they are nothing more than pyramid schemes. At the same time, fraudulent initial coin offerings are regularly launched by scammers to dupe new investors out of their money. The recent Confido ICO exit scam, for example, is an unfortunate reminder for crypto investors that scams are plentiful in this market.
The risks of falling victim to fraud can be mitigated by conducting thorough research on the cryptocurrency, investment platform, or initial coin offerings you are planning on placing funds into. The mantra ‘DYOR’ (do your own research) applies more than ever in this new digital asset class.
While the risks of investing in cryptocurrencies are plenty, so are the potential rewards. Investing capital into a diversified portfolio of stocks and bonds provides investors with relatively stable returns compared to crypto. However, effectively no diversified portfolio composed of traditional asset classes is able to generate the kind of returns we have witnessed in the cryptocurrency markets. While it’s true that many investors entering this space are willing to accept the above-mentioned hazards in the hope of cashing in on the crypto gold rush, it is also true that it’s possible to take at least some prudent steps to minimize those risks.
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