Crypto 101 – Risks and Potential Downsides

By J. Ferguson and M. Ferrandi
Posted February 15, 2022

Needless to say, nothing is perfect and in the world of cryptocurrency and digital assets this is especially true. We have identified a few of the risks and potential downsides; however, this is by no means an exhaustive list!

1. VOLATILITY
One of the key characteristics of crypto has been extreme price volatility. The price change in Ether from Feb. 2021 – Feb. 2022 Illustrates this volatility well:

 

Source: ETH/CAD 3,947.67 (▲5.81%) | Google Finance

If you had bought Ether during this period at the low on Feb. 28, 2021, and sold at the high on Nov. 8, 2021, you would have been handsomely rewarded, as Ether increased in value 332%. However, if you bought at the high and sold at the subsequent low on Jan. 22, 2022, you would have lost just under 50% of your investment in less than two and a half months. These wild price swings make investing in crypto not for the faint of heart.

2. LACK OF REGULATION
In the last couple of years many financial institutions have opened the world of crypto investing to individuals by creating investments such as crypto ETFs or mutual funds. These vehicles, while still exposed to the inherent volatility of the underlying assets, are subject to oversight by securities regulators. However, there are many unregulated offerings – sold in private markets – affording no investor protection.

In a Jan. 11, 2022 article in “Wealth Professional,” NASAA’s (North American Securities Administrators Association) Enforcement Section Committee vice-chair, Joseph Rotunda, is clear about the concern regarding unregulated offerings:

“Investments in cryptocurrency trading programs, interests in crypto mining pools, crypto depository accounts and securitized tokens should be seen for what they are: extremely risky speculation with a high risk of loss,” he said.

The overall stability and credibility of crypto would be improved with coordination among countries on the legal, tax and regulatory treatment. Unfortunately, the regulatory bodies in many countries have been slow to act and are still coming to terms with the rapid evolution of the world of crypto. China, Russia, and the UK have recently moved to restrict trading and the use of cryptocurrencies in the economy.

3. FRAUD
While decentralization is considered a positive characteristic, in a decentralized, unregulated environment it is easier for criminals to commit fraud, money laundering and other financial crimes. Victims of such crimes have little recourse to recover lost funds, just like the experiences of traditional fraud victims. While there have been cases of recovery of stolen crypto, like when the US government recovered over $2.3 million of cryptocurrency from the hackers of the Colonial Pipeline in 2021, these cases are few and far between.

4. PASSWORD SECURITY
We have all most likely experienced the dismay of losing passwords and being locked out of online accounts or websites. Albeit tedious, in most cases one can reset their password and regain access. However, because crypto transactions occur without an intermediary, there is often nobody to assist in the case of lost passwords or compromised accounts. Over the years there have been some incredible stories about individuals who have lost, thrown away or forgotten their passwords or codes. The link below, which garnered many headlines in January 2021, is a good illustration of this: This man owns $321M in bitcoin — but he can’t access it because he lost his password | CBC Radio

Since technology is ever evolving, it is possible that this challenge will be overcome.

5. ENVIRONMENTAL IMPACT
In our previous post we defined “mining” as the complex mathematical process by which cryptocurrencies such as Bitcoin and Ether are created. These algorithms use enormous amounts of energy. A Sept 2021 article by Columbia University’s Columbia Climate School refers to “a  University of Cambridge analysis published in Feb 2021 which estimated that bitcoin mining consumes 121.36 terawatt hours a year. This is more than all of Argentina consumes, or more than the consumption of Google, Apple, Facebook and Microsoft combined.” Considering their pledges to cut carbon emissions, countries like China have started to restrict bitcoin mining. It is likely that this trend will increase.

If you delve into the world of crypto mining, you will come across the terms “Proof of Work” and “Proof of Stake.”  The former is an older method used to verify Bitcoin and Ether as they are created on the blockchain. A major disadvantage of this method is that it uses larger amounts of computational resources – and thus energy – than the latter, which (for reasons too complex for this blog!) is faster, more scalable, and therefore less energy intense.

6. MEME COINS AND SCAMS
In many ways the internet provides a great way to generate “hype.” The world of crypto exhibits characteristics which often facilitate hype even more. The Merriam-Webster dictionary defines a meme as: “\MEME\ noun. 1: an idea, behavior, style, or usage that spreads from person to person within a culture. 2: an amusing or interesting item (such as a captioned picture or video) or genre of items that is spread widely online especially through social media”.

A meme coin is a cryptocurrency which is created from a humorous internet meme. Perhaps the most well-known of these coins is Dogecoin, a cryptocurrency created in 2013 using the image of a Shiba Inu dog. In 2021 Dogecoin experienced wild fluctuations as celebrities posted numerous tweets about it. In May, as retail investors bought into the hype and the coin, the price rose significantly. Subsequently it declined in value by 85%, and it has yet to recover. As a result, many individuals experienced huge losses. Some of you may recognize this type of behavior similar to the pump and dump scams involving worthless penny stocks that were common in financial markets years ago.

As has been the case in history with emerging technologies and industries it may take years before governments, regulatory bodies and society are able to manage the risks and downsides associated with crypto. In the meantime, beware of its many pitfalls and proceed with caution if you decide to navigate this brave new world.

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