Types of Risks Associated With Bitcoin Investing
Although Bitcoin was
not designed as a normal equity investment (no shares have been issued), some
speculative investors were drawn to the digital currency after it appreciated
rapidly in May 2011 and again in November 2013. Thus, many people purchase
bitcoin for its investment value rather than its ability to act as a medium of exchange.
However, the lack of
guaranteed value and its digital nature means the purchase and use of bitcoins
carries several inherent risks. Many investor alerts have been issued by
the Securities and
Exchange Commission (SEC), the Financial Industry Regulatory Authority (FINRA), the Consumer Financial Protection Bureau (CFPB), and other agencies.
The concept of a
virtual currency is still novel and, compared to traditional investments,
bitcoin doesn't have much of a long-term track record or history of credibility
to back it. With their increasing popularity, bitcoins are becoming less
experimental every day; still, after only a decade, all digital currencies
still remain in a development phase. "It is pretty much the highest-risk,
highest-return investment that you can possibly make,” says Barry
Silbert, CEO of Digital Currency Group, which builds and invests in Bitcoin and
blockchain companies.
Regulatory Risk
Investing money into
bitcoin in any of its many guises is not for the risk-averse. Bitcoins are a
rival to government currency and may be used for black market transactions,
money laundering, illegal activities, or tax evasion. As a result, governments
may seek to regulate, restrict, or ban the use and sale of bitcoins (and some
already have). Others are coming up with various rules.
For example, in 2015,
the New York State Department of Financial Services finalized regulations that
would require companies dealing with the buy, sell, transfer, or storage of
bitcoins to record the identity of customers, have a compliance officer, and
maintain capital reserves. The transactions worth $10,000 or more will have to
be recorded and reported.11
The lack of uniform
regulations about bitcoins (and other virtual currency) raises questions over
their longevity, liquidity, and universality.
Security Risk
Most individuals who
own and use bitcoin have not acquired their tokens through mining operations.
Rather, they buy and sell bitcoin and other digital currencies on any of a
number of popular online markets, known as bitcoin exchanges.
Bitcoin exchanges are
entirely digital and, as with any virtual system, are at risk from hackers,
malware, and operational glitches. If a thief gains access to a bitcoin owner's
computer hard drive and steals their private encryption key, they could
transfer the stolen bitcoin to another account. (Users can prevent this only if
bitcoins are stored on a computer that is not connected to the internet, or
else by choosing to use a paper wallet—printing
out the bitcoin private keys and addresses, and not keeping them on a computer
at all.)
Hackers can also
target bitcoin exchanges, gaining access to thousands of accounts and digital wallets where bitcoins are stored. One especially
notorious hacking incident took place in 2014, when Mt. Gox, a bitcoin exchange
in Japan, was forced to close down after millions of dollars worth of
bitcoins were stolen
This is particularly
problematic given that all Bitcoin transactions are permanent and irreversible.
It's like dealing with cash: Any transaction carried out with bitcoins can only
be reversed if the person who has received them refunds them. There is no third
party or a payment processor, as in the case of a debit or credit card—hence, no
source of protection or appeal if there is a problem.
Insurance Risk
Some investments are
insured through the Securities
Investor Protection Corporation. Normal bank accounts are insured through the Federal Deposit Insurance Corporation (FDIC) up to a certain amount depending
on the jurisdiction.
Generally speaking,
bitcoin exchanges and bitcoin accounts are not insured by any type of federal
or government program. In 2019, prime dealer and trading platform SFOX
announced it would be able to provide bitcoin investors with FDIC insurance,
but only for the portion of transactions involving cash.
Fraud Risk
While bitcoin uses
private key encryption to verify owners and register transactions, fraudsters
and scammers may attempt to sell false bitcoins. For instance, in July 2013,
the SEC brought legal action against an operator of a bitcoin-related Ponzi
scheme.14 There have also been documented cases of bitcoin price
manipulation, another common form of fraud.
Market Risk
Like with any
investment, bitcoin values can fluctuate. Indeed, the value of the currency has
seen wild swings in price over its short existence. Subject to high volume
buying and selling on exchanges, it has a high sensitivity to any newsworthy
events. According to the CFPB, the price of bitcoins fell by 61% in a single
day in 2013, while the one-day price drop record in 2014 was as big as 80%.
If fewer people begin
to accept bitcoin as a currency, these digital units may lose value and could
become worthless. Indeed, there was speculation that the "bitcoin
bubble" had burst when the price declined from its all-time high during
the cryptocurrency rush in late 2017 and early 2018.
There is already
plenty of competition, and although bitcoin has a huge lead over the hundreds
of other digital currencies that have sprung up because of its brand
recognition and venture capital money, a technological break-through in
the form of a better virtual coin is always a threat.
Splits in the Cryptocurrency Community
In the years since
Bitcoin launched, there have been numerous instances in which disagreements
between factions of miners and developers prompted large-scale splits of the
cryptocurrency community. In some of these cases, groups of Bitcoin users and
miners have changed the protocol of the bitcoin network itself.
This process is known
as "forking," and it usually results in the creation of a new type of
bitcoin with a new name. This split can be a "hard fork," in which a
new coin shares transaction history with bitcoin up until a decisive split
point, at which point a new token is created. Examples of cryptocurrencies that
have been created as a result of hard forks include bitcoin cash (created in
August 2017), bitcoin gold (created in October 2017), and bitcoin SV (created
in November 2017).
A "soft
fork" is a change to protocol that is still compatible with the previous
system rules. For example, bitcoin soft forks have increased the total size of
blocks.