Very little in asset management today engenders as much buzz and moral hazard—in almost equal measures—as cryptocurrency.

Industry opinion is highly polarised about this emerging digital asset class.  Does it represent a type of manipulation executed out in the open, or a new financial nirvana, free from the rigid constraints of an arcane financial system?

Cryptocurrency is in essence a digital currency that only exists on an online, peer-to-peer, distributed network. The latter acts as a public and immutable record of all transactions in the underlying digital currency via ‘blockchains’, or chains of verified transactions. Cryptocurrencies are not issued by any government, bank or central organisation and are not supported by hard assets or any form of credit support.

The digital assets have mostly been used an alternative payment method for goods and services, but they are increasingly being accepted for financial assets such as conventional fixed income and equity investments. And new uses continue to emerge.

But while cryptocurrencies are designed to be secure, the risks of using them are evolving—and little understood.

SUSCEPTIBILITY TO MANIPULATION

Due to their digital nature, cryptocurrencies are potentially vulnerable to hacking, while the potential for fraud is also a major issue.

Certain popular cryptocurrency exchanges have completely disappeared, seemingly overnight. Pyramid and Ponzi schemes disguised as lucrative cryptocurrency investments have also sprung up at an alarming rate, defrauding ordinary investors of retirement savings.

At the core of the worst cryptocurrency scams to date is the dissemination of false or misleading information that is promulgated by sponsors of these schemes in the lead up to ICOs and related offerings. Because cryptocurrency is not regulated as a form of ‘money’ in most developed jurisdictions, it generally operates in a grey zone that underscores the hazards many unsophisticated investors face.

The Securities and Futures Commission of Hong Kong (SFC) has repeatedly warned that victims would struggle to pursue legal action against cryptocurrency exchanges or fraudsters where the activities in question take place in an online environment. Many of the worst examples of fraud exploit this intrinsic anonymity.  

Cryptocurrencies are also typically thinly traded, relative to mainstream financial securities. In many cases, this allows individuals to effectively ‘pump’ the target by using social media outlets to disseminate false or misleading information about a cryptocurrency. It is relatively easy for a single investor to move the market by taking a large position on a single exchange, while digital assets are often subject to rapid and unpredictable fluctuation in market prices.

INFRASTRUCTURE WEAKNESSES

Another intrinsic risk lies with the digital networks supporting cryptocurrencies. Many are based on open-source protocols that are maintained by uncompensated volunteer developers. Any individual can download the software that operates the network and make modifications to it.

There are dangers to this. First, there is a risk that overly large modifications could ‘fork’ the underlying blockchain records, and render some of the digital assets non-viable. Secondly, the developers often lack a financial incentive or the resources to adequately address such emerging issues or ensure the network’s security. This is a particular risk given that a lot of this cryptocurrency activity occurs in emerging markets that lack regulation or legal protection.

It’s also becoming increasingly common for third parties to assert intellectual property rights claims relating to digital networks. Such threats risk reducing the confidence in a digital Network’s long-term viability, which is likely to adversely affect the value of digital assets within it. 

The digital asset exchanges are also vulnerable. Most are relatively new start-up businesses with no institutional backing, a limited operating history and little or no publically available financial information. Added to that they are largely unregulated, leaving them inherently vulnerable to theft or failure. 

Over the past few years, several digital asset exchanges have been closed due to fraud, failure, security breaches, cybercrime, hacking, malware attacks and government regulation. 

Additionally, some digital asset exchanges impose limitations on each trader’s daily, weekly, monthly, etc., transaction volumes, or may limit or suspend withdrawals entirely. This can effectively render it almost impossible to convert digital assets into fiat currency. 

Look out for part two of this focus on the risks of cryptocurrency investing, to be published soon.