CryptoassetsFeb 15 2018

Risks and rewards of cryptocurrency

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Risks and rewards of cryptocurrency

Cryptocurrencies are new, and because of this there is often a great deal of scepticism: people do not like change.

Just because bitcoin, Etherium, DentaCoin and others are new, does not necessarily mean they are bad. Just because these are traded and 'mined' online does not mean this form of transaction is anathema maranatha. 

Financial advisers are, naturally, sceptical in the main about internet-based transactions, especially when the intrinsic value is hard to discern and nobody even knows whether the Father of Bitcoin, Satoshi Nakamoto, even exists. 

In fact, even those advocating the use of blockchain to increase productivity in several industries are also sounding a note of caution. One such person is Clem Chambers, chief executive of stocks and shares website ADVFN, who says: "Be extremely sceptical".

The majority of Britons seem to feel the same way. In January, a survey from bridging lender Market Financial Solutions (MFS) revealed 53 per cent of UK adults, based on a representative survey carried out among more than 2,000 individuals, would rather invest in traditional asset classes in 2018 than in newer ones, such as cryptocurrencies.

At the time, Paresh Raja, chief executive of MFS, commented: "Despite the hype surrounding new asset classes such as cryptocurrency, the majority of investors are still placing traditional investments, such as property, at the top of their list in 2018."

Virtual reality 

Some commentators to this guide have suggested it is not so much the neological nature of cryptocurrency and the lexicon springing up around it that is driving people's aversion to crypto, but the fact few people really understand how cryptocurrency works.

It is a standalone 'asset class' in its own right and not bound by external forces. This makes it very attractive for people who want the freedom that online currency transactions can bring. 

I think Bitcoin may be used for more daily micro transactions as well. The payment-use case is totally under-represented currently. Matthias Kroner

Mr Chambers comments: "Cryptocurrencies are not shares, nor bonds, options or commodities. Bitcoin and all the other cryptocurrencies are their own ecosystem and obey rules that no-one fully understands.

"This is where high risk gets to equal high reward. The opportunities are vast in potential scope and we are only just at the beginning. Cryptocurrency is just the tip of the spear."

However, some would also point out that cryptocurrency is not even a currency.

As a result of its newness, its uniqueness and its 'uncontrollable' freedom, commentators have highlighted other inherent risks with cryptocurrency, over and above the usual risk/reward ratio on the basis of which most people invest. 

Matthias Kroner, co-founder and chief executive of financial entrepreneurial business Fidor, sums up the difference between speculators thinking the cybercurrency is an investment - these are the "speculators" - and those companies using cryptocurrency to fund special projects. 

With the difference in outlook between these two groups as to what the real use of this virtual asset class can be, comes the inherent risks. 

He outlines some of the main risks as: 

  • Volatility: Cryptocurrencies' value suffers extremely high volatility, as well as the business sustainability of the platforms which host bitcoin wallets.
  • Regulation: There's also the risk of a cryptocurrency simply discontinuing or becoming outlawed by the government.
  • Storage: Storing and ensuring your bitcoins and cryptocurrencies keys are safe is essential.
  • Criminal: Given its unregulated nature, the transactions may be more prone to fraud or scams compared to conventional transactions, and investors could also potentially become involved in transactions associated with criminal activities without knowing. Such criminal activities might be executed by organised crime or even state-driven initiatives.
  • Hacks: Once a cryptocurrency gets seriously hacked, trust will be destroyed, while value will drop to zero in minutes.

Lilian Chovin, investment strategist for Coutts, says at the "heart of the debate" as to whether cryptocurrency is an "epochal step that will transform the world of finance" or a "speculative bubble that will inevitably end in tears" is how people use this virtual currency.

She explains: "At the heart of the debate is the idea the cryptocurrency derives its value from its use as a payment system - a new and improved Visa or PayPal - and as a new form of fiat currency.

"How well it provides advantages over these may well be the defining factor in whether Bitcoin is a good investment."

Volatility 

The biggest risk is trying to time an exceptionally volatile market. Over December the prices of cryptocurrencies exploded; in January the air fizzled out of them like helium from a New Year party balloon.

People buying into them on the back of the hype and excitement in November and December will now be out of pocket because they bought at or near the top, and most of the currencies are now at or near the bottom.

In January, one Twitter user wrote: "Chatting to a barman last week, he'd dropped his entire savings on Ripple (XRP) having heard people talk about it in the pub. It's lost 67 per cent of its value since he bought in."

Dror Futter, partner at Rimon Law, fully believes the "greatest risk today" is the volatility of cryptocurrency. "It is difficult to run a business accepting cryptocurrencies when the value of the currency can drop 30 per cent in two days."

Ms Chovin adds: "On some days, if you had ordered a book in the morning, the value of the Bitcoin you used to pay for it could have fallen by a third by the time it gets delivered.

"This makes pricing items in Bitcoin a nightmare; vendors could potentially make huge losses, although some may have made huge gains. Either way, it adds a level of unpredictability to transactions."

Greg Carter, chief executive of online lending platform Growth Street, believes there are "plentiful opportunities" for the financial services sector when it comes to cryptocurrencies and blockchain technology.

However, he agrees with Ms Chovin that the "speed and efficiency promised by blockchain might end up being far less transformative in the UK market than it could be for the US".

He highlights the fact that the UK’s Faster Payments service already offers instant transactions up to a value of £250,000, while Bitcoin transactions, meanwhile, can take hours to clear, potentially leaving parties exposed to a fast-moving market.

Add to this latency and volatility the recent moves by banks to block cryptocurrency gains from being consolidated into sterling and used as a deposit towards a mortgage - as reported by sister title the Financial Times - and the transactional utility of cryptocurrency becomes less of a positive argument in favour of it. 

Regulation

When China starts cracking down on cryptocurrency because it cannot control it, then the rest of the world should sit up and take notice, especially so since, as at December 2017, data from Cambridge University's Judge Business School revealed China mined 58 per cent of bitcoin, compared with 16 per cent in the US and 26 per cent in the rest of the world.

The UK, France, Germany, US, South Korea and China have all in recent weeks announced measures to rein in the excesses of cryptocurrency trading. The Financial Conduct Authority in the UK has issued a public warning about initial coin offerings (ICOs) (see info box).

Banks such as Lloyds in the UK have banned people from using credit cards to buy bitcoin (aka, 'getting into debt' to buy Bitcoin and its crypto peers). 

Miles Eakers, chief market analyst at Centtrip, states: "Governments across the globe continue to clamp down on retail investors speculating on cryptocurrencies, with the People’s Bank of China stating it would step up measures to remove any onshore or offshore platforms related to virtual currency trading or ICOs, ‘to prevent financial risks’."

The announcement pushed the price of Bitcoin down, and Mr Eakers believes the next technical level will drop to $5,000 a coin (£3,571). 

With each regulatory announcement, the price of cryptocurrencies, led by their standard-bearer, Bitcoin, drops further.

Ms Chovin explains why: "As cryptocurrencies are seen by many as a way to evade taxes and fund fraudulent or criminal activity, the principal threat we see to their widespread adoption is government intervention."

She points out the effect of the measures announced by the South Korean government at the end of December to curb abuses of digital currencies.

This was a significant step by the country, as South Korea is one of the world's biggest users of Bitcoin. Following the announcement, the value of the digital currency fell approximately 11 per cent.

Protections

The very freedoms which, as Mr Futter points out, make for an attractive proposition for some, can prove to be a risk for others. "The crypto market operates in a developing regulatory market. As a result, investors cannot expect the same types of investor protections they typically receive when transacting with banks and securities exchanges.

"The decentralised nature of blockchain also means that, in most instances, there is no central address to go to if problems emerge, and due to the anonymity of much blockchain activity, often limited ability to identify and act against 'bad actors'.

"And, unfortunately", he adds, "the Gold Rush mentality has attracted many bad actors to this space."

Risks are "pretty well understood" however, according to Kara Ward, financial services regulatory and legislative attorney at Venable LLP, who comments: "Limited supply, varying demand and government regulation have been impacting the prices of currencies, causing dramatic fluctuation with very little predictability.

"It is also somewhat risky to use as a money transmission method, beacuse there are very few regulations and mandated consumer protections."

She adds that, in comparison to traditional money transmission, where there are disclosures and guarantees to cover fraud and loss, there are none of those with cryptocurrencies.

Hacking

During 2017 and early this year, various news stories broke of certain types of malware targeting cryptocurrency. 

One such malware, called CryptoShuffler, was spotted by security system Kaspersky Lab using a rather simple tactic to steal cryptocurrency from users: copy and paste.

Because many users copy and then paste the recipients' wallet identification into transaction destination fields, the code developed by CryptoShuffler can monitor clipboard activity until it detects these wallet string characteristics.

It is difficult to run a business accepting cryptocurrencies when the value of the currency can drop 30 per cent in two days. Dror Futter

It then intercepts the copied string and replaces it with one that will send the virtual money right into the hands of the hackers. 

The strings can look so familiar that unless the user double checks both codes, the recipient who has paid to receive the bitcoin will be out of pocket.

And, because this is not a regulated financial marketplace, investors cannot seek recompense from the Financial Services Compensation Scheme or any other jurisdictional body. 

Side-effects of crypto generation

There is also the huge environmental concern around the mining of cryptocurrencies, which draws significant amounts of energy from countries' national grid. 

While not all cryptocurrencies are mined - in fact, some of the newer tokens are valued purely on the basis of volume of ownership, rather than what a person can mine - some commentators have warned an unintended consequence of large-scale mining of Bitcoin is devouring energy, with a subsequent additional negative impact on the environment.

Advantages and opportunities

So what are the upsides to those who want to do web-based transactions without borders, without rules and without restrictions?

Flexibility and freedom are certainly high on the list. In theory, according to Ms Ward, the opportunities of using cryptocurrency and the ledger technology behind it are "limited only by imagination and functionality".

She says: "It if can be built, it may work."

For Philipp Pieper, chief executive of Swarm Fund, the opportunities are based on the fact you can create new models around existing-use case that cannot be done otherwise.

He explains: "One of the reasons that makes using blockchain technology so enticing to large financial institutions is the very reason Bitcoin appealed to the early 'cypherpunks': by using a decentralised protocol and smart contracts that execute automatically, you do not have to trust the person on the other end to do the right thing."

A cypherpunk, for the purposes of education, is described by Wikipedia as: "Any activist advocating widespread use of strong cryptography and privacy-enhancing technologies as a route to social and political change." 

However, this very flexibility and imagination can work against cryptocurrency. Take, for example, the use of tokens or cryptocurrency to fund development through ICOs. Ms Ward says while this has been successful for some companies, it has also been "ripe for misuse".

Decentralisation 

For Mr Pieper, another advantage is the way in which people have ownership of their own data and make their own choices. For example, Swarm Fund's platform is predicated on the ability of members to invest tokens into real assets, such as distressed real estate.

"The way in which our platform actually works is decided by the members who participate in it through liquid democracy voting. Since our system is decentralised, gaming that voting mechanism to a particular member's advantage would be extremely difficult."

Beyond this, Mr Pieper says, is the "realm of possibilities" that decentralisation can bring. "You can have new, meshed peer-to-peer networks, to the Internet of Things and even the ownership of one's own personal data.

"Beyond banking, it could apply to other applications, such as 23andMe, where individuals are currently giving the rights to their individual DNA sequence to a centralised company in order to find out more about their own ancestry.

"Wouldn't it be better to keep that data to yourself, and allow the analysts at the company to apply an algorithm remotely to the decentralised database that you alone have the key to?"

Getting into the crypto investment space

To help reduce the 'fear of the unknown' associated with cryptocurrency, some governments and companies have implemented ways to lessen the 'otherwordliness' of digital currency and give it a more legitimate public face. 

For example, Russia, Sweden and Israel are among some countries cited by Ms Chovin who are thinking about issuing government-backed cryptocurrencies based on blockchain technology. 

In January this year, FTAdviser reported the Bank of England had been considering launching a form of digital currency but has put this on the back burner for now, citing fears about the stability of the wider financial system.

There have also been measures to bring cryptocurrency into the listed investment space, with the launch of cryptocurrency exchange-traded funds (ETFs) and futures on various exchanges around the world.

Last year, the Chicago Mercantile Exchange (CME) Group announced it would be launching a futures product tracking the performance of the bitcoin crypto-currency. After a short delay, it went live and, in January, the president of the Chicago Board Options Exchange (CBOE) said he expects the exchange to launch more cryptocurrency futures products within the near future.

Later on in January 2018, Adena Friedman, chief executive of US exchange Nasdaq told US broadcaster CNBC it was also looking into bitcoin futures.

Investors interested in a passive tracker that can take advantage of Bitcoin could consider two different ETFs: the Ark Web x.0 ETF and Ark Innovation ETF.

According to its latest factsheet, the Ark Web x.0 ETF is a "thematic multi-cap exposure to fast moving internet technologies including cloud computing, big data, digital media, e-commerce, bitcoin, and the Internet of Things. Ark Web is the first ETF to include exposure to Bitcoin".

The potential for coins like Ripple to integrate with big banks and create efficiencies is certainly there. Greg Carter

The fund seeks long-term growth of capital. It seeks to achieve this investment objective by investing under normal circumstances primarily (at least 80 per cent of its assets) in domestic and US exchange-traded foreign equity securities of companies that are relevant to the Fund’s investment theme of Web x.0.

The fund will be concentrated in issuers having their principal business activities in the Internet information provider and catalogue and mail order house industry

There is also a Bitcoin Investment Trust (NPV) available to investors, although information on this can be difficult for the average investor to get hold of.

For example, users of Hargreaves Lansdown's investment service cannot view any information on this trust, because the party responsible for publishing the key investor information documents has not made them available to Hargreaves Lansdown for this stock and so it cannot be purchased. 

However, "even with the recent introduction of Bitcoin futures, the [volatility] is a risk that is very difficult to hedge", says Mr Futter.

Forward-look at uses and transactions

Fidor's Mr Kroner believes the use of cryptocurrencies will become increasingly widespread, as people become more confident and gain further knowledge about it.

He says this will lead to a "serious shift" towards consumer-friendly usage.

"For example, payments on e-commerce sites, such as Amazon, could integrate Bitcoin options sooner than we think, and other online retailers may be quick to follow this.

"Amazon has already registered the 'amazonbitcoin.com' domain name, but I think Bitcoin may be used for more daily micro transactions as well. The payment-use case is totally under-represented currently, with much of the focus on the speculation of Bitcoin."

At the moment, however, only a few of the 500 largest e-commerce retailers accept Bitcoin - and in fact the number has fallen over the past few quarters, according to the below table from digitalcommerce360.

Support of Bitcoin low among top 500 e-commerce retailers

Quarter

Number of retailers accepting Bitcoin

Q1 2016

5

Q2 2016

5

Q3 2016

5

Q4 2016

5

Q1 2017

3

Q2 2017

3

Q3 2017

3

Ms Ward believes the risks and rewards are equally visible when it comes to cryptocurrencies. She adds: "At this stage, there may be a significant upside - for example the freedom of choice to transact in a currency that is entirely transparent, but it comes with significant downsides as well."

Mr Carter adds: "The potential for coins like Ripple to integrate with big banks and create efficiencies is certainly there. But those evangelising about blockchain may be forgetting how important it is to forge personal relationships in finance  - even today.

"I’m interested in helping develop clear regulation and legislation, more transparency from lenders, and a market that rewards innovation and improvements to services.

"But in a sector that is facing challenges on multiple fronts, the importance of these fundamental elements seems to have bypassed the swelling numbers of cryptocurrency and blockchain enthusiasts."

Yet Mr Pieper believes the various risks outlined can more likely be challenges, and if you ignore the hype of the aforementioned "enthusiasts" and look at the underlying functionality, cryptocurrency, he believes, will play a much larger role in the future and lead to more innovation and technological development.

He says: "As people seek to fix the transaction speed issues and scalability issues, not to mention regulatory issues across different jurisdictions, as well as different tax treatments, so there will be applications developed to solve such issues for future users."

simoney.kyriakou@ft.com