Cryptocurrency Risks

Ms Scipio is an expert on political, economic, financial and taxation issues.

Before making investment decisions, investors should always consult a professional financial advisor and/or do their own extensive research.

The purpose of this article is to outline some of the risks to investors who may think that cryptos (cryptocurrencies) are a safe investment. This article assumes that readers already know what cryptos are.


Background

In recent years, cryptos have become firmly established as a major feature of the financial landscape. They are popular with speculative investors and have many enthusiastic supporters. Some think that cryptos are now permanently cemented into financial markets and consequently they assume that cryptos are a safe investment.

Investing in cryptos has been highly profitable for many people. Because the price of cryptos generally keeps increasing, albeit with many ups and downs, some people mistakenly believe that crypto assets have intrinsic value. They view cryptos as a store of value that provides a hedge against inflation. Some even think that cryptos are a better safe-haven asset than gold.

The future of cryptos seems assured. But is it? Perhaps in a few years from now cryptos will have become known as fool's gold.


Advantages of Cryptos

It is probably fair to describe a crypto as being a private currency that has its own exclusive currency transfer mechanism which handles all transfers. Like conventional currencies, but unlike gold, crypto assets have no intrinsic value.

There are valid arguments that cryptos are not really currencies at all, because they lack many of the attributes that are normally associated with conventional currencies.

Blockchain and anonymity appear to be the only two features of cryptos that have a genuine utility value that is greater than what conventional currencies provide.

Apart from blockchain and anonymity, all the other claimed advantages of cryptos appear to be contrived and illusory. Some of the claimed advantages are utopian ideals that are so absurd that it is difficult to comprehend how such hype can be taken seriously. For example, some people talk about cryptos having the effect of "democratising money". This appears to mean that every person on the planet can operate their own crypto.


Blockchain

Blockchain technology ensures that transfers of crypto assets are completed securely to the satisfaction of all parties. (Except maybe not to the satisfaction of law enforcement agencies.)

However, conventional interbank and intrabank transfers already have excellent security and are reasonably fast, so perhaps the superior security of blockchain is not really necessary for financial transactions.

This does not mean that blockchain technology does not have much merit. Blockchain can be useful in some non-crypto applications.


Anonymity

Without the advantage of anonymity, it seems likely that cryptos would not have become as popular as they have become. Anonymity is the only real benefit that cryptos have to offer.

Cryptos allow users to avoid scrutiny. Anonymity is of enormous value to those people who do not want their identity to be linked with their financial transactions.

Cryptos provide an anonymous financial transfer mechanism for black market buyers and sellers, scamsters, extortionists, account hackers, money launderers and tax evaders.

Anonymity is not so important to the large number of speculators who trade and hold cryptos, although when filling in their tax returns some of these people may be able to benefit from crypto anonymity.


Bubble Caused by Strong Speculative Demand and Limited Supply

The interaction of strong speculative demand and limited supply has an inevitable result.

On the supply side, the creation of new crypto assets is constricted by design. This limitation may have been deliberately engineered to ensure that the price of cryptos would rise even if there were relatively few users and hence little demand. The motive for this design flaw may have been to maximise profits for early holders such as the designers themselves.

Demand for cryptos comes mainly from three categories of people.

The biggest demand for cryptos comes from speculators and investors, who in this article are collectively referred to as speculators. They rarely if ever use their crypto assets to pay for goods and services. They hold on to their crypto assets in the hope that the price will rise. There has throughout the history of cryptos usually been more buyers than sellers, so there are usually plenty of buyers to soak up any crypto assets that become available from sellers. Speculators are by far the biggest net contributors to crypto demand.

There is significant use of cryptos by lawbreakers who need a money transfer method that shields their shady financial transactions from scrutiny. They would not need cryptos if they did not need anonymity. There are probably many such users and their numbers are probably continually increasing. They probably tend to sell most of the crypto assets that they receive because it is probable that criminals prefer to hold hard cash rather than crypto assets. With little requirement to hold onto crypto assets, their net effect on crypto demand must be small compared with the net demand from speculators.

Nevertheless, lawbreakers constitute the most fundamentally important category of crypto users because they are the only people who actually genuinely need to use cryptos, apart from their hapless victims who of course have no choice other than to buy crypto assets to make payments. Criminal activities ensure that there is always some demand for crypto assets.

The third category of people who use cryptos are ideological users who use cryptos to pay for normal everyday goods and services, just like other people might use a credit card. Most of the crypto assets used for their purchases are probably converted into real money by recipients, so the net contribution to crypto demand caused by the activities of ideological users is probably relatively small.

A crypto asset that is held by a speculator is not available to anybody else until the speculator decides to sell. Speculative demand causes crypto assets to be taken out of circulation, in other words hoarded. As long as the number of crypto speculators keeps increasing, there is competition for a resource that has only a limited supply. There is insufficient supply to satisfy the demand, so the price rises. What is more, people expect the price to rise. The more that people expect the price to rise, the more that the price rises.

Quite a lot of people seem to think that this is not a bubble. This is a classic tulip bubble.


Bubble Risk

Financial bubbles tend to keep growing and growing until they burst. The crypto bubble might grow much bigger yet before it bursts. Speculators can still make good profits before the day of reckoning finally arrives, provided that they can get out in time.

Crypto assets have no intrinsic value. Their price is set by the interaction of supply and demand. There appears to be nothing underpinning the price of cryptos except anonymity-related demand, ideology-related demand and strong speculative demand. The rationale for speculative demand is based on a belief that cryptos are, or will become, a necessity. However the only category of people who have a genuine need to use cryptos are lawbreakers with a need to transfer money anonymously.

Financial bubbles always burst sooner or later. If a financial bubble never bursts then it probably isn't a bubble. Bubbles that are ripe for bursting can burst unexpectedly at any time. The crypto bubble could burst because of any of several possible events, of which anti-anonymity legislation is one.

It seems inevitable that the eventual introduction of anti-anonymity legislation will burst the crypto bubble if by then it has not already burst.

Although profits are still being made at the moment, this analysis indicates that investing in cryptos is associated with an extremely high degree of risk.


Anti-Anonymity Legislation Risk

Governments the world over will eventually have no choice but to enact laws that clamp down on anonymity in crypto transactions.

This will become essential in the never ending fight against crime. For example, if cryptos are allowed to flourish then tax evasion will become more and more prevalent as people discover how easily they can use cryptos to conceal income. See the "Anonymity" section above for a list of some of the types of criminals whose activities can benefit from cryptos.

If financial transactions cannot be monitored, tracked and audited then the fight against crime is doomed and the fabric of society is threatened. For society to be able to function in an orderly manner, every type of automated financial transfer must be visible to regulatory agencies and to law enforcement agencies.

Few governments have yet done anything in relation to cryptos. For most politicians, cryptos are in the "too hard" basket. It has been reported that some banks and a few governments have started to embrace cryptos, but these projects are more likely to be related to digital currencies which are not the same thing as cryptos. A few governments have banned cryptos outright, although these countries have weak currencies that are threatened by the rise of cryptos.

Laws banning anonymity in crypto transactions could in theory be introduced any day. Legislative wheels turn slowly, so who knows when new laws will appear. Maybe such laws are still a few years away, or maybe they are just around the corner.


Downfall

When anti-anonymity crypto laws are eventually introduced by one country, other countries will soon follow.

People will no longer be able to use cryptos to make anonymous financial transfers, so most of the real users of cryptos will vanish. Without the advantage of anonymity, there will no longer be any genuine practical reason why anybody would need to use cryptos.

Some people will still use cryptos for misguided ideological reasons, but their numbers are not likely to be large because there has always been a complete absence of necessity for them to use crypto transfers in preference to conventional payment methods.

Cryptos will no longer have a solid base of users who have a genuine need to be users. Without this base there will no longer be any functional reason for cryptos to exist. Cryptos will become a curiosity that nobody needs any more, relegated to being used only by a few forever enthusiasts.

Speculative demand for crypto assets will collapse because there will no longer be any rational reason to justify the existence of cryptos. Many crypto speculators will hit the sell button as soon as it becomes clear that anti-anonymity laws are going to be introduced. The price of crypto assets will crash.

Meanwhile, until a crypto crash happens, it is likely that the price of crypto assets will generally continue to rise for as long as speculative demand continues to increase.


Other Types of Crypto Risk

Crypto exchanges, the online platforms that provide marketplaces to buy and sell crypto assets, do not have the same level of regulation as other financial institutions. Consumers have no protection against fraud or manipulation. For example, crypto assets have been known to simply go missing from crypto exchanges.

Acting on investment tips gleaned from social media is a mug's game. Social media fads can push markets up or down. Influencers sometimes make comments that cause investors to buy into a crypto, creating unusual demand. The price of the crypto skyrockets. When the price falls back down to earth again, losses are incurred by those who followed the fad and bought in when the price was high. Social media fads may appear to be benign and innocently spontaneous, but investors need to be aware that these phenomena are similar to "pump and dump" stockmarket scams.