Cryptocurrency is a digital asset that has become increasingly popular in recent years. While it has the potential to be a lucrative investment, it also carries a number of risks that investors should be aware of. Cryptocurrency exchanges are particularly vulnerable to being hacked and targeted by other criminal activities, resulting in considerable losses for investors. Additionally, individual investors are responsible for reporting their cryptocurrency holdings on their annual tax returns, and there is often no standard practice for recovering lost funds when a cryptocurrency exchange is hacked.
Furthermore, the intangible and illiquid nature of cryptocurrencies makes them difficult to convert and insure. Finally, there are risks associated with social engineering and misinformation, as well as cyber threats such as ransomware attacks and AI-driven bots. One of the most important legal considerations for any cryptocurrency investor has to do with how central authorities view cryptocurrency holdings. In the US, this means that individual investors are on the hook for cryptocurrency holdings. This means that individual investors are beholden to capital gains tax laws when it comes to reporting their cryptocurrency expenditures and gains on their annual tax returns, regardless of where they purchased the digital coins. Another potential risk associated with cryptocurrencies as a result of their decentralised status has to do with the particularities of transactions.
In most other transactions, the physically present currency changes hands. In the case of e-money, a trusted financial institution is involved in the creation and settlement of deposits and credits. Neither of these concepts applies to cryptocurrency transactions. This issue is also related to the decentralised nature of digital currencies. For example, when a cryptocurrency exchange is hacked and customer funds are stolen, there is often no standard practice for recovering the lost funds.
Therefore, investors in digital currencies assume a certain amount of risk when buying and holding cryptocurrency assets. The real miracle of blockchain-based cryptocurrencies, such as Bitcoin, is that the issue of double-counting is resolved without any intermediary, such as a bank or banker. This feature, captured by the notion of digital singularity, where there can only be one instance of an asset, is powerful and one of the main reasons why this asset class has flourished. However, the intangible and illiquid nature of cryptocurrencies (combined with the previous point about narrow exits) makes their convertibility and insurability difficult. In fact, despite reports of growing insurer interest in the segment, most cryptoassets and crypto companies are underinsured or uninsurable by current standards. There is no deposit insurance "floor" for this asset class, which may help broaden the appeal and security for investors. When cryptocurrency holders seek to exit the intangible asset class to return to fiat currencies or other assets, which are often loathed by many cryptocurrency purists, their flight to safety or liquidity most often leads them to the dollar or the United States.
However, on exit, this market-to-market feature causes many investors to come under downward price pressure, highlighting the adverse effects of illiquidity, narrow exits and low participation in the asset class. These types of problems are being remedied as more institutional investors enter the space and more markets and trading platforms open. In the meantime, market participants would do well to be mindful of the inconvertibility of coins and the implied volatility of cryptocurrencies, which would make high-frequency traders shudder. While no investor should part with money they are not willing to lose, no matter how nominal the amount, cryptocurrencies are particularly prone to the risks of social engineering and misinformation. The na´ve can become easy prey to cyber extortion, market manipulation, fraud and other investor risks. The Securities and Exchange Commission (SEC) has gone so far as to create a fake initial coin offering (ICO) website as a way of alerting potential cryptocurrency investors to the threats of "shiny objects".As with cyber threats, which evolve according to Moore's law, the space between keyboard and chair (or smartphone and digital wallet) is as important as cyber hygiene and cryptocustodian defences.
Although in principle Bitcoin blockchain has proven to be one of the most cyber-resistant innovations to date, companies that connect to it are often new entrants with lax cybersecurity standards and means. In this sense, not all cryptocurrencies are equal in terms of their traceability, conduct of transactions and levels of trust or fiduciary responsibility. As such, risks as simple as "mysterious disappearance" and as complex as ransomware attacks and AI-driven bots scouring the internet for weak links and easy prey are complex and rapidly evolving dangers. You may also have heard of Initial Coin Offerings (or ICOs), which involve an investor buying cryptocurrency coins (sometimes called tokens) that can later be exchanged for the new cryptocurrency once startups create their own "coins to sell to investors".