This article was updated on Dec. 5, 2017, and originally published on June 26, 2017.
You're not supposed to be able to throw a dart at an investment and make a lifetime's worth of money in a matter of months, but that's exactly what it's been like for investors in digital cryptocurrencies bitcoin and Ethereum.
Bitcoin has rallied from around $225 per coin in August 2015 to over $11,000 as of early December 2017, while burgeoning digital currency Ethereum has risen from $7.98 at the beginning of the year to roughly $460. In terms of percentage gains, Ethereum's performance actually trumps that of bitcoin. By comparison, it has taken the S&P 500 about 60 years to return the roughly 5,700% that Ethereum has in a matter of 11 months.
Here's why cryptocurrencies have been unstoppable in 2017
What on Earth is driving these phenomenal returns? I think it would be fair to argue that emotions and thinly traded exchanges are helping in a big way. Whereas reputable stock exchanges, such as the NYSE, have machine-assisted trading tools and tens of millions of people and institutions investing daily, bitcoin and Ethereum's trading platforms aren't centralized, nor are there institutions "making a market" in these digital currencies. A more thinly traded environment allows momentum and emotion to take form much easier than in the stock market.
It would also be fair to say that time in the limelight has helped all types of cryptocurrencies. A recent example is the WannaCry ransomware attack that prompted affected users to pay a ransom to have their computer unlocked. However, this ransom could only be paid in bitcoin. National attention has helped the cause for bitcoin and Ethereum.
We've also witnessed a rise in those willing to accept bitcoin, or other digital currencies, as legal tender. For instance, the marijuana industry is using bitcoin as a bridge currency to get around the fact that traditional banks often won't work with pot-based businesses since weed is federally illegal. This is because the federal government could, under a strict interpretation of the law, fine or file charges against a financial institution for providing services to a marijuana business. Bitcoin acts as an intermediary between a banked consumer and a weed-product retailer.
A weaker dollar may also be prompting investors to seek shelter in assets that hold their value. In other words, investors have sought finite resources, and since bitcoin is capped at 21 million coins, it's considered a "finite" resource.
Bitcoin and Ethereum carry a lot of risks
However, I'd opine that these digital currencies are a breeding ground of bad news for long-term investors. In June I laid out four reasons bitcoin (and really any digital currency) doesn't belong in your portfolio. Here's a brief rehash of my thesis:
- Anonymity is its enemy: One of the biggest problems with digital currencies is that they can be used by terrorists and criminals to fund their activities. There simply aren't sufficient safety protocols in place to keep bad apples out of the system -- which governments do not like. And adding those protocols takes away one of the main benefits of the currency.
- Security is a big problem: Adding to the previous point, digital currencies have to hope they remain decentralized, otherwise they could become easy prey to hackers. In the case of bitcoin, the block rewards paid out to miners that run the computers and maintain the system are set to decrease over time. If the reward dips, the number of miners could decline, pushing the system ever-closer to centralization and being hacked.
- Investment options are limited: Even if you wanted to invest in a digital currency, your options are almost nonexistent. One option is to choose a small exchange that has the potential of being hacked, like Mt. Gox. At its height, Mt. Gox handled 70% of bitcoin's transactions, but it succumbed to hackers looting 850,000 bitcoin and $27 million in the company's cash. The other option is the Bitcoin Investment Trust (OTC:GBTC) ETF, which is currently trading at a premium of 25% over the value of the bitcoin it actually owns as of November 8.
- Few understand cryptocurrencies: Finally, most people have no clue how bitcoin or Ethereum work, or understand how they're challenging monetary theory. That's a dangerous formula for volatility and potential money loss.
However, I have a brand-new reason investors should avoid bitcoin and Ethereum at all costs.
An even better reason to avoid digital currencies
According to a CNBC report, on Wednesday, June 21, the price of Ethereum cratered from $319 to $0.10 -- that's not a misprint; it really is ten cents -- on the GDAX cryptocurrency exchange in a matter of one second. In other words, it was a digital currency flash crash, similar to the flash crashes we've seen occur in the stock market.
According to Adam White, the vice president of GDAX, a multimillion-dollar market sell order, and not illegal activity, was to blame for the rapid decline in Ethereum's price. The order purportedly pushed the price of Ethereum from $319 to as low as $224.48 before it triggered roughly 800 stop-loss orders and margin funding liquidations, squashing the cryptocurrency to a value of just $0.10. It rebounded pretty quickly to about $325.
However, here's what White said in a blog post shortly after the incident:
Our initial investigations show no indication of wrongdoing or account takeovers. We understand his event can be frustrating for our customers. Our matching engine operated as intended throughout this event and trading with advanced features like margin always carries inherent risk.
He initially went on to note that all trades are final and will not be reversed . Let me repeat that. If you were one of roughly 800-plus Ethereum investors who were stopped out of your position over a freak movement in price in a span of one second, you weren't going to be getting your money back! Tough luck!
However, after a few days of bad publicity, White appeared to have a change of heart. White announced that GDAX would reverse course and credit those who were stopped out of their position, or pushed out due to a margin call, during the flash crash. However, he again insisted that GDAX's technology worked correctly.
By comparison, multiple flash crashes in the stock market have resulted in a number of errant trades being reversed. The liquidity and centralization that reputable stock exchanges provide won't allow for this sort of investor ransacking to occur. But for cryptocurrency investors, it's just another day of trying to keep your head above water in a thinly traded exchange with potentially weak security and few, if any, monetary protections.
If you need a good reason to avoid investing in digital cryptocurrencies like bitcoin and Ethereum, this is it.