Cryptocurrencies continue to grow in popularity, but many investors do not fully understand how the asset class works. Learn more about crypto and some of the risks associated with investing in cryptoassets.
Investors should always understand the assets and instruments that they are investing in. Crypto is a relatively new asset class, and one that is widely misunderstood. With increased volatility and a lack of regulatory protection, it is essential that crypto investors understand exactly how cryptocurrencies work.
What are cryptocurrencies?
Cryptocurrencies are digital currencies that operate using blockchain technology. Cryptocurrencies do not have a physical form in the same way that cash does, although they can be stored securely using a virtual wallet.
Here are some key facts:
- Bitcoin (BTC) is the largest, best-known cryptocurrency
- Bitcoin has the highest market capitalisation of any cryptocurrency
- Cardano (ADA), Solana (SOL) and Avalanche (AVAX) are three popular cryptoassets
- ETH is the symbol for Ether, Ethereum’s native cryptocurrency
- Tether is a stablecoin, whose price is pegged to the US dollar
It is possible to buy and sell cryptocurrencies at cryptocurrency exchanges. Crypto exchanges, or other peer-to-peer platforms, allow users to convert traditional fiat currencies into cryptocurrencies — and back again!
How are cryptocurrencies created?
There are several methods of creating cryptocurrencies. Most cryptocurrencies are created and distributed among users who validate a block in the network’s blockchain.
On a Proof of Work (PoW) network, validators use a process called “mining” — which involves solving complex mathematical problems — to validate transactions. However, there are some environmental concerns linked to mining, due to its high energy consumption.
On Proof of Stake (PoS) networks, validators offer an amount of the network’s native cryptocurrency as collateral to be in with a chance of validating the next block. Stakers earn rewards for staking their cryptocurrency.
Cryptocurrency prices
Many cryptocurrencies are launched using an Initial Coin Offering (ICO). An ICO is similar to an IPO, and involves a company attempting to raise money to create a new coin, token or crypto-related service.
As with any asset, cryptocurrency prices are determined by supply and demand. A cryptocurrency’s “total supply” refers to the number of coins or tokens that are currently in existence. Total supply directly impacts the scarcity and value of a cryptocurrency. Geopolitical events can also influence market sentiment and prices.
Cryptocurrency prices can be incredibly volatile, and all cryptoassets come with an element of risk. It is possible to lose all of your money when investing in crypto.
Liquidity
Liquidity refers to a crypto project’s ability to raise, borrow or convert assets to cash. The price of a cryptocurrency is driven by liquidity, and, typically, newer cryptoassets have lower liquidity than more established assets.
Intraday liquidity refers to the liquidity required to enable an exchange or platform to make payments and settle obligations during a business day. Intraday liquidity impacts the availability of a cryptoasset on a trading platform. Low liquidity can lead to a cryptoasset being unavailable for trading.
Crypto liquidity is impacted by a number of factors, including the fact that many banking institutions are unwilling to provide banking services to cryptocurrency exchanges. However, there are specific liquidity providers for cryptoassets. High volatility — the measure of how much the price of a cryptoasset has moved up or down over time — can present higher liquidity risk for a liquidity provider.
Decentralised finance (DeFi)
Blockchain technology facilitates decentralised finance (DeFi), an alternative to traditional finance (TradFi). DeFi provides decentralised solutions for lending, borrowing, trading, and more.
Tip: Did you know that, during a “hard fork,” a cryptocurrency network splits into two separate blockchains?
Cryptocurrency regulations
It is important to note that cryptoassets are not regulated in the UK, and that trading with a US brokerage does not guarantee protection of your crypto investments. Regulatory changes could potentially lead to increased adoption and stability within the crypto market, although there is no way of knowing what form this regulation will take.
Tip: Bitcoin is not regulated by the Japanese Financial Services Agency (JFSA).
The Financial Conduct Authority (FCA) does not regulate cryptocurrencies either, although it does regulate crypto-related financial promotions. As a result, investors will not receive compensation through the Financial Ombudsman Service (FOS) or the Financial Services Compensation Scheme (FSCS) for crypto-related losses. However, the FCA does monitor the Anti-Money Laundering protections implemented by cryptoasset firms.
This lack of regulation means that poor segregation of client funds by irresponsible crypto firms could lead to unprotected losses.
Crypto theft
Your crypto investments may be at risk due to potential cyber attacks, financial crime or firm failure. The FSCS, FCA and FOS cannot protect someone if their cryptocurrency investment is stolen. They also cannot investigate or recover the stolen cryptoassets.
There is also no user protection if a cryptocurrency exchange or storage platform goes out of business, meaning that it is possible to permanently lose your investment.
Cyber attacks
When investing in crypto, there is a higher risk of losing your money through cyber attacks. Exchanges can be used to buy or sell cryptocurrencies, but they are a tempting target for hackers. In the past, security breaches have led to investors having their cryptoassets stolen.
Tip: A hot wallet is a wallet connected to the Internet, whereas a cold wallet is not.
It is important to employ good security practices to minimise the risk of theft. Despite the risks, there are some things that you can do to try and keep your investment secure:
- Never confirm your passwords to anonymous callers
- Consider using a cold wallet to store your cryptoassets offline
- Create backups to ensure you can recover your wallet if you lose your device
Crypto volatility
Crypto is often highly volatile, which means that it is subject to sudden and erratic market moves. These sudden moves can cause investors to lose all of their money. The volatility of the crypto market means that there is a higher likelihood for losses compared to other assets.
Implied volatility refers to the prediction of a cryptoasset’s future price movements.
Crypto volatility is one of the primary factors relating to the risk of an investment. The more volatile a cryptocurrency, the riskier it is considered to be as an investment. High volatility can create the possibility for higher returns, but also the potential for greater loss, which could occur over shorter periods of time.
Positive or negative news coverage or financial reports can increase a cryptoasset’s volatility. Unusually high spikes in crypto trading volumes will also often correspond to a growth in volatility. This high volatility is one of the primary reasons that unbacked cryptoassets are not suitable to be used widely as a form of money.
Tip: Stablecoin prices are pegged to a reserve asset, such as the USD, and are designed to have low volatility.
Diversification and risk management
Considering market volatility and the potential for lost investments is essential when trading or investing in cryptocurrencies. Conduct due diligence and research a project before investing in a cryptoasset. This can help you to understand the project’s fundamentals and any associated risks.
Diversification across different cryptoassets can help to manage — and potentially lessen — a portfolio’s volatility, while also improving its risk/reward profile. This can also provide more representative exposure to the industry, its adoption trends and growth potential.
It is also important to minimise risk by trading a variety of different instruments in addition to crypto.
Final thoughts
Crypto is continuing to grow in popularity, but not everyone understands the risks associated with the asset class. There is the potential for the increased volatility to lead to higher returns, but there is also the opportunity for investors to lose all of their money. Combined with a lack of regulatory protection, it is incredibly important that investors understand exactly what they are investing in before committing real money to a trade.
Visit the eToro Academy to learn more about cryptocurrencies.
This information is for educational purposes only and should not be taken as investment advice, personal recommendation, or an offer of, or solicitation to, buy or sell any financial instruments. This material has been prepared without regard to any particular investment objectives or financial situation and has not been prepared in accordance with the legal and regulatory requirements to promote independent research. Any references to past performance of a financial instrument, index or a packaged investment product are not, and should not be taken as a reliable indicator of future results. eToro makes no representation and assumes no liability as to the accuracy or completeness of the content of this guide. Make sure you understand the risks involved in trading before committing any capital. Never risk more than you are prepared to lose.