Cryptocurrencies explained - what are the risks?

In 2021 approximately 2.3 million Brits held some form of cryptocurrency, up 400,000 holders when compared to the previous year according to the Financial Conduct Authority (FCA).

However, the cryptocurrency market is no less volatile and has been subject to frequent rises and sudden crashes.

So what are cryptocurrencies, and given they are prone to crashes in value, what does the future hold for this form of investment?

Cryptocurrencies are a form of currency which is stored online. What makes this form of currency different from conventional currencies, like the pound or dollar, is that it is not issued or regulated by a central bank.

Instead, it is based on a blockchain system, which in effect is a shared ledger which facilitates these cryptocurrency transactions. It also means its participants can verify its movements themselves, making it an easy means for criminal activity.

Ultimately, this removes any security to your investment. It means there is no financial watchdog to protect your investment if it goes bust, or even hacked which is a real threat.

According to research from Software company Chainalysis, more than $3 billion, or £2.46 billion, of crypto was stolen last year. More worryingly, this is more than six times the figure seen in 2020.

Otherwise, while it does not cover your losses in the event of a scam, those who have invested through other means, like a savings account for example, can claim up to £85,000 in the event their provider goes bust.  This is because it is covered by the Financial Services Compensation Scheme and, because crypto is not regulated, those who invested through these means cannot claim compensation in such circumstances.

In April 2022, Chancellor Rishi Sunak announced a new set of plans to help make the UK an investment hub for cryptocurrencies and its innovations.

“The measures look set to include an FCA-led CryptoSprint, work with the Royal Mint on an NFT, and crucially, the regulation of stablecoins which would eventually pave the way for their use as a recognised form of payment, amongst other regulatory action,” said Giles Coughlan, Chief Analyst at HYCM, a Forex Brokerage.

Given how unpredictable the market is, he explained that implementing these new plans would likely be a lengthy process. However, regulation might start with a crackdown on the advertisement of cryptocurrencies.

“FCA Chair Charles Randell has previously commented on the need to clamp down on the advertisement of crypto assets – particularly on social media – after celebrities like Kim Kardashian began encouraging their followers to invest in crypto,” he said.

“A first step to regulate the cryptocurrency market might look like tougher measures to ensure that fraudulent crypto firms do not lure people into untenable investments,” Coughlan also noted.

The price of cryptocurrencies can be manipulated by broader economic trends, influential celebrities, and crypto whales among other factors.

To some it seems unusual that a cryptocurrency like Bitcoin  rises and falls in a similar trajectory as the equities market. After all, Bitcoin does not produce dividends like shares in a company. Instead, its price is influenced through supply and demand. There are only so many Bitcoins in the world, which makes it, in theory, a scarce resource and a store of value in times of economic uncertainty. Much like a commodity like gold. 

Despite this, it is important to remember that most cryptocurrencies, like Bitcoin, do not hold their value in tangible assets. Other investments, like stocks or commodities, are backed by their own assets. For example, if you invest money into Apple’s shares you hold a percentage, however small it might be, of its assets. It means that there is an element of security to these investments , which cryptocurrencies do not share.

So, in times of economic downturn investing in cryptocurrencies is too much of a risk for most investors who simply cannot lose all their money in a harsh financial climate. This deters investment which sends the price of cryptocurrencies down. Periods of stagflation, for example, might send the price of cryptocurrencies downward. 

With Cryptocurrencies being a volatile, unregulated investment, their price can be highly sensitive to external events.

For example, in March 2021, Elon Musk, the owner of automobile company Tesla, said that his company would accept Bitcoin as a legitimate form of payment. The move sent Bitcoin’s price soaring to $62,000, or £50,000, per Bitcoin, a record high at the time according to Reuters.

However, just three months later Musk made a U-turn, citing its dependency on fossil fuels to mine and transact in the cryptocurrency. After the announcement was made on Twitter, a social media platform, Bitcoin’s price fell around 15%.

By contrast, the share price for Tesla also took a knock, but this was much less volatile at a drop of 1.25%.

The movements did not stop there; a series of further tweets from Musk sent the price of not only Bitcoin, but other cryptocurrencies such as Ethereum, up and down.

This is ultimately another risk investors need to factor when investing in Bitcoin, that the price of it can be swayed by celebrities and people of influence in this sector. As a result, it is almost impossible to predict its movements.

Not only can celebrities and people of influence affect the price of Bitcoin, but crypto whales can too.

Crypto “whales” are wallets or people who hold large quantities of a single cryptocurrency.

A recent article by the Telegraph found that around 2,500 wallets hold 40% of the crypto market. These owners would be described as whales, and have the power to move the price of their cryptocurrency easily.

In essence, large purchases of a single cryptocurrency will cause its price to rise. This will benefit those who hold the coin, but it can provide misleading information for those looking to make an investment in this cryptocurrency.

Alternatively, if they sell their holdings it will cause the price of this cryptocurrency to come down further.

For those looking for a less volatile, regulated investment can consider a number of other investments.

While they do not offer the chance of higher returns of cryptocurrencies, savings accounts offer investors a guaranteed return on investment. This is ideal for those who are looking for a less risky place to house their funds.

Those who still have an appetite for more traditional investment risk can always consider investing on the stock market. There are many investment platforms, like interactive investor or etoro, which allow its users to purchase their own stocks, effectively cutting out the middleman.

Otherwise those looking to make use of an experienced fund manager to take hold of their funds can consider a Unit Trust or Open Ended Investment Company (OEIC).