10 Things That Should Scare You About Investing in Cryptocurrencies

Last year was truly something special for the cryptocurrency market. The aggregate value of all virtual currencies soared nearly $600 billion, increasing in market cap by more than 3,300%. This likely represents the single-greatest year ever for any asset class, and we may never see anything like it again, at least during our lifetime.

But the gains we’ve witnessed from virtual currencies in 2017 have proven somewhat fleeting thus far in 2018. While some folks have the perception that cryptocurrencies can keep heading higher, it’s become plainly apparent that cryptocurrencies, like all investments, aren’t perfect. They come with their own unique set of risks and concerns, and you can, indeed, lose money by investing in virtual currencies.

Should you be considering an investment in cryptocurrencies, here are 10 things that should seriously have you worried. 

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Arguably one of the scariest things about cryptocurrencies is that there’s no way to use traditional fundamental metrics to determine a proper valuation. With a publicly traded stock, you can examine a company’s operating results, balance sheet, and other pertinent financial metrics to make a reason-based assessment on whether you believe it’s heading higher or lower. With cryptocurrencies, there are no traditional metrics for retail investors to pore over.

What sort of information can you use when attempting to “value” a virtual token? If you’re lucky, you’ll have a pretty good understanding of the processing speed of the underlying blockchain network -- blockchain being the digital, distributed, and decentralized ledger responsible for recording all transactions in a transparent and unchanging manner. You may also be privy to average daily transaction data through a site like BitInfoCharts.com. Unfortunately, neither of these two metrics are singly or wholly as sufficient as an income statement or balance sheet is for traditional stock investors. 

One of the lures of the cryptocurrency market for some is its lack of regulation. The fact that virtual tokens have no government or financial backing makes them perfectly suitable for those people looking for a libertarian’s dream currency. Then again, when regulations are imposed, the downside reaction in virtual currency prices can be swift.

In late January, there were concerns that the South Korean government would crack down on virtual currency trading within the country, sending the aggregate crypto market cap lower by more than $200 billion. Behind the U.S. dollar, the South Korean won is the second-most commonly used currency in global bitcoin trading. Even though South Korea hasn’t fostered an anti-cryptocurrency environment, it has beefed up its anonymity rules, which now require banks to verify the identities of virtual currency investors before linking their South Korean bank accounts to decentralized cryptocurrency exchanges. Even something as benign as identity verification has rattled virtual currency markets.

And, to make matters worse, regulation varies from country to country. A handful of countries have completely banned cryptocurrencies, while others have mostly welcomed their presence. That piecemeal regulation is a recipe for confusion.

Another reason to be scared is that U.S. regulators may be limited in what they can do to protect virtual currency investors.

Back in December, a statement released by Securities and Exchange Commission (SEC) Chairman Jay Clayton outlined some of the steps that current and prospective investors should take when investing in cryptocurrencies. Advice such as “ask questions and demand clear answers” peppered Clayton’s memo.

But also included was a discussion about cryptocurrency markets and exchanges traversing the borders of the United States. Because significant trading occurs outside the U.S., the risk of fraud can be amplified. After all, this is a piecemeal-regulated market that varies by country. Should you lose money because of fraud, the SEC may be limited in what it can do to recover your funds. This would very likely not be the case with traditional equities in the stock market.

Investing is a two-way street. What goes up can also go down, and from time to time even the stock market exhibits incredible bouts of fear, uncertainty, and volatility. In February, the CBOE Volatility Index hit its highest level in nine years following the largest single-day point decline in history for the iconic Dow Jones Industrial Average and broad-based S&P 500. Yet, when compared to the cryptocurrency market, even the wildest moves in the Dow and S&P 500 appear tame.

For example, Ripple, the third-largest virtual currency by market cap, gained over 35,500% in 2017. Since then, its XRP token came close to losing 90% of its value since hitting an all-time high on Jan. 4, 2018. All the while, it’s had three separate instances on the way down where the XRP token has gained between 90% and 100% in value from a temporary bottom.

Double-digit weekly percentage gains and declines are commonplace among cryptocurrencies, and certainly no place for the faint of heart, or those unwilling to lose a substantial amount of their investment. These wild swings can also deter merchant willingness to accept digital currencies for goods and services.

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An even broader concern is what I like to call the “proof-of-concept conundrum.”

Most virtual currencies have an underlying blockchain network that’s responsible for recording transactions in a transparent and unalterable way. With the exception of a few virtual tokens, such as bitcoin and Litecoin, the vast majority of cryptocurrency developers are angling to tackle a perceived and existing real-world inefficiency with their proprietary blockchain technology.

Now, here’s the good news: most small-scale projects and demos have demonstrated that blockchain can successfully help a number of industries and sectors. In other words, the proof-of-concept is there that this technology works, at least in a controlled environment.

The downside is that virtually no real-world testing has been undertaken. This creates the following blockchain conundrum: no enterprises will deploy blockchain on a larger scale until the technology has proven itself scalable; yet it can’t be proven scalable if no businesses will give it a real-world chance. This quandary could take a long time to resolve, and that should be worrisome for cryptocurrency investors.

To build off of the previous point, the blockchain network that underpins most virtual currencies is where their true value lies. Though crypto developers are aiming to fix perceived real-world inefficiencies, they’re also marketing their product as a software solution for specific industries or sectors.

As an example, Ripple is a for-profit company based in San Francisco, Calif., that’s specifically targeting financial institutions with its blockchain-based payment and on-demand liquidity solutions. Though not all virtual currencies are for-profit like Ripple, the value for most lies with their blockchain.

Yet, virtual currency investors are merely buying tokens that can be used on a tethered blockchain network. Owning virtual tokens doesn’t -- I repeat, doesn’t -- entitle the investor to a stake in the underlying blockchain network. In other words, they have no ownership in the asset that actually matters. That’s scary! 

Investors should also be scared of the fact that diversifying within the cryptocurrency space generally doesn’t work.

Money managers often advise that investors “diversify their assets” in order to hedge against any downside and provide steadier long-term returns. Within the stock market, this might mean buying into utility or dividend-paying stocks to hedge against inevitable stock market corrections. Such diversification strategies can indeed be successful over the long run.

However, cryptocurrency diversification doesn’t work well, if at all. Whereas there are more than 1,600 digital currencies to choose from, most tend to move in tandem with bitcoin, Ethereum, and a few of the other larger tokens by market cap. There’s virtually no individuality in the cryptocurrency space, and frankly not enough time in the day to keep track of the partnerships, projects, and missions of each and every cryptocurrency. 

Cryptocurrency investors should also be very concerned about competition. The issue is that the barrier to entry among cryptocurrencies is exceptionally low. It only takes time, money, and a team that understands how to write computer code, to develop blockchain technology and a tethered virtual token. That’s why there are more than 1,600 investable virtual coins today, up from fewer than 1,000 in July. This suggests that at any point a presumed-to-be superior blockchain could become obsolete.

But it’s not just other developers that should worry investors. We’ve already witnessed big businesses developing blockchain technology of their own. In August 2017, a consortium of global banks -- Barclays, Credit Suisse, Canadian Imperial Bank of Commerce, HSBC, Mitsubishi UFJ Financial Group, and State Street -- announced that they were working together to create a “utility settlement coin” to function on a proprietary blockchain they were developing. In other words, no virtual coin is particularly safe from competition.

By investing in cryptocurrencies, you’re also putting your fate into the hands of emotionally-charged retail investors.

You see, nearly all virtual currency trading occurs on decentralized cryptocurrency exchanges. Institutional investors usually want nothing to do with these exchanges, meaning their access to the digital currency market is limited. This places retail investors almost entirely in control of the daily price fluctuations in virtual tokens. But there’s a problem: retail investors tend to be far more reliant on their emotions, relative to institutional investors, leading to that aforementioned heightened volatility.

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Last, but certainly not least, investing in cryptocurrencies can lead to an absolute nightmare come tax time.

In 2014, the Internal Revenue Service (IRS) introduced guidelines that referred to digital currencies as property. This meant their disposition should be treated as a reportable capital gain or loss come tax time. Of course, statistics show that only 800 to 900 tax filers each year between 2013 and 2015 reported cryptocurrency capital gains. Now, the IRS is done playing games. It’s actively targeting crypto tax evaders, which could lead to hefty fines and/or jail time for those who are caught failing to report their gains.

Making matters worse, there are no guarantees that cryptocurrency exchanges are going to provide a transaction history in a timely manner for investors. That places the onus of keeping an accurate cost basis and sale history on the investor.

Though cryptocurrencies could seemingly do no wrong in 2017, they’re far from flawless. If you’re going to dip your toes into the water, be prepared to deal with some, or all, of these risks.

Sean Williams has no position in any of the stocks or cryptocurrencies mentioned. The Motley Fool recommends Barclays, but has no position in any of the cryptocurrencies mentioned. The Motley Fool has a disclosure policy.