With the seemingly meteoric rise in Bitcoin and Ether prices in the past year, mainstream media and attention is once again trained on the crypto space. In response to this rally, investors have been piling into all sorts of altcoins, hoping to catch this wave.
Ripple (XRP) was one of the beneficiaries of this rally, with its price rising by over 250% at its peak in the last month. The positive price action didn’t last long though, with the Securities and Exchanges Commission (SEC) of the US suing Ripple Labs, the company behind XRP, and its founders this week for conducting a unregistered sale of securities. This prompted a cascade of delistings from major exchanges in the US.
After reading through the 71 page complaint filed by the SEC, I felt it was a good case study that illustrates the risks associated with crypto.
With increased interest in crypto among readers, I think its important for readers to understand these fundamental risks before diving in crypto.
I personally would classify the risks into 5 different categories:
- Custodial risk
- Regulatory risk
- Fraud risk
- Security / Technological risk
- Token specific risk
The first 4 risks are more general risks, with no.5 being more specific to a token you are investing in.
Custodial risk refers to risk associated with a counter party. This is present if your crypto is held on your behalf by a third party.
As mentioned in the my beginner’s guide to crypto investing, an investor can choose to invest through a third party platform like Binance or Coinhako. While there are benefits to such an approach (better customer service and UX for eg), one important downside is the lack of direct control over your crypto.
The implications for this risk can be massive. They include:
|Platform outages, especially during times of high volatility||Inability to take advantage of opportunities / exit positions|
|Difficulty in withdrawing crypto, potentially due to lack of crypto on hand||Inability to take advantage of external opportunities, potential loss of funds / crypto|
|Susceptibility to hacks, like the Kucoin hack last year||Potential loss of funds / crypto|
This risk could be minimised by choosing to self-custody of your crypto investments (holding your crypto on your own crypto wallet rather than leaving it on the platform). But I do understand that people may not understand the intricacies of self-custody.
Regulatory risk refers to the risk that a change in regulations or laws will affect a token.
To me, this risk is the biggest fundamental risk in the crypto space at the moment. The founding principle of crypto has been the decentralisation of the financial system away from governments and intermediaries.
As such, it is reasonable to expect governments and financial intermediaries feel threatened by this and want to regulate this new and emerging technology. In recent time, regulatory risk have taken several different angles.
In the US, you have regulators like the Securities and Exchange Commission (SEC) and Commodities & Futures Trading Commission (CFTC) constantly looking at tokens to determine if they’re unregistered securities (like the suit against Ripple earlier). You have Congress trying to regulate stablecoins, a debate that is quite fascinating to me. You also have the US Treasury even trying to regulate self-hosted wallets, a proposal that I find unrealistic.
China has taken an aggressive stance towards crypto by explicitly banning it and closing exchanges based there. That said, crypto lives on in a largely P2P form, while China has pursued innovation in this space by being the first country to launch a Central Bank Digital Currency (CBDC).
In Singapore, MAS have actually been quite accommodative to blockchain companies and have adopted a wait and see approach. However, the Payment Services Act has created a barrier to trading crypto by limiting fiat flows into and out of the crypto ecosystem.
How the financial landscape will eventually turn out is anyone’s guess, and regulation will play a huge role in shaping which tokens have value.
This is a risk that all crypto investors have to accept before investing, especially when investing in tokens that go beyond simple functions like being a currency or store of value.
My personal view is that we will eventually have a hybrid financial system of walled gardens, with governments and corporations having their own gardens, while having other decentralised protocols serve as alternative gardens. The trick is to identify protocols that have potential to form these gardens.
This is not a popular view among crypto natives, but I feel is a pragmatic and likely outcome given the competing motives at stake.
Fraud risk refers to the risk of losing your crypto to scams created by parties with ill intentions.
The unregulated nature and pseudo-anonymity of crypto creates the potential for fraud in the crypto space. These fraud schemes can take on various forms.
It can be in a form of a reskin of classic scams. Remember Nigerian and Ponzi scams? These have gotten updated to the crypto world.
Alternatively, it can be bogus crypto trading platforms that tell you that you’re making money, but face issues when you’re trying to withdraw your profits.
It can also come in the form of intentional weaknesses introduced to the smart contract code by token founders that allow them to steal investors’ funds. This is also known as a “rug pull”.
Possibilities are endless, and the pseudo-anonymity helps prevent the identification of the perpetrator’s identity.
I usually mitigate this risk by doing in-depth analysis of the founders, token design and incentive distribution of each project. If you’re able to read code, it’ll be even better.
That said, it is sometimes difficult to assess this risk and you have to balance between taking risk to earn returns versus missing out entirely. If I still insist on investing, I would usually size my position appropriately.
Security / Technological risk
Security / Technological risk refers to the risk of technological failure or bugs that result in loss of crypto.
As with anything new and untested, the security and technology risk is high. This risk is especially true of altcoins and new smart contracts.
Bugs may lead to vulnerabilities that smart hackers can exploit. Reliance on certain price feeds can lead to exploitation.
Similar to fraud risk, this can be mitigated if you read code. However, as a non-coder myself, I have to rely on non-technical indicators.
Factors like how battle-tested the contracts are, how long have the contracts been deployed and whether the contracts use the same code as another reliable contract should be considered when assessing this risk.
Ultimately, if I still insist on investing, I would also keep my position small.
Token specific risk
Token specific risk refers to risk associated with specific token that usually arises from its intended function and design.
This particular risk is difficult to explain as it varies from token to token. Examples of token specific risks, just to name a few include:
- Impermanent loss in Automatic Market Makers
- Credit risk in tokenised debt
- Volatility risk in options pooling
Token specific risk is largely understood based on fundamental analysis of token design and purpose. Understanding these risks will allow you to either choose to accept the risk or take steps to mitigate them.
In the future, if / when I would write about specific tokens, I’ll elaborate more.
All investments have risks, it is only when you are aware of them that you can make informed investment decisions. Investing in crypto is no different.
I hope this sharing about the major types of risks associated with crypto has been informative and useful.
Other crypto related articles:
Beginners’ guide to crypto investing
A Beginner’s journey into DeFi
Earn interest on crypto through BlockFi
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For simplicity and all risks calculated, I personally find CME Bitcoin future is the best!
I would say that is a derivative for trading rather than an investment. Also, the risks I’m talking about is applicable to crypto in general, not just BTC.
Frankly speaking, buying all these cryptocurrencies are definitely more than a simple investment given that different kind of risks you mentioned in this article. Look at all those leveraged tokens offered by ftx, why would an individual invest in a leveraged product those underlying with huge volatility already if it wasn’t for trading/speculation?
Hmmm I’m not sure I follow your point. I agree that CME futures and leveraged perps offered by FTX are trading tools. If all you’re concerned about is price volatility and trading, then you need not consider most of these risks most of the time as your timeframe is way too short in the first place.
The risks I’m highlighting are from a fundamental long term investor standpoint.