For many people investing in cryptocurrencies, this is their first foray into the world of investing. According to this report on data gathered through a poll of 331 cryptocurrency subreddit users, most cryptocurrency investors are in their 20s and roughly 20% of all investors have poured 90% or more of their savings into cryptocurrencies.
When I first started to learn about investing, I read that only individuals with a high risk tolerance should enter the stock market. I also learned that investors should be prepared to see their portfolio value change rapidly (and be willing to ride it out for 5-7 years). As someone new to investing, that seemed pretty scary to me.
Cryptocurrencies vs Stocks
Cryptocurrencies should not be confused with stocks, and they hold even greater risk for the investor. Consider their price volatility, which generally eclipses stocks’ volatility several times over (with many coins even going to zero). Hence, the best advice for investors is to do your own research and risk only what you’re prepared to lose.
Unfortunately, investors blinded by the allure of making a quick buck often overlook these golden rules. Then, when a coin drops sharply in value, Telegram and Discord channels are flooded with angry investors (perhaps “punters” is a better term) demanding answers: “why are we dumping?” being the query of choice.
Seasoned investors may claim such people only have themselves to blame, which to a certain extent is true as they ignored the golden rules. The fact is, however, not everyone is an experienced investor capable of performing in-depth research and identifying risk. It’s for this reason that overseers of stock markets (as well as other established markets) seek to protect investors through well-considered rules and regulations.
Cryptocurrencies, however, remain largely unregulated. Projects are able to launch questionable ICOs and operate relatively unchecked. Likewise, many cryptocurrency exchanges operate without reporting requirements; extensive identity checks are not needed, opening the door to market manipulation.
The following paragraphs outline the primary reasons I consider cryptocurrencies a risky investment relative to the stock market.
Not backed by assets, revenue or business models
The majority of publicly traded stocks are backed by revenue from a clearly-defined user base, assets, and tried-and-tested business models. In addition, stockholders share in company profits and have a say in critical business decisions. Moreover, if the company fails, shareholders may be entitled to a portion of the company’s liquidated assets.
In contrast, most blockchain projects currently offer only a white paper (perhaps a roadmap and an app if you’re lucky). Cryptocurrencies act as currencies or tokens that can be used to access specific services. Purchasing cryptocurrency gives you no legal right to claim profits, make company decisions, or receive company assets should the project fail.
No reporting requirements
Companies that issue stock (publicly traded companies) are also subject to reporting and auditing requirements that enable regulators to scrutinize company finances. If they discover any wrongdoing, company officers such as the CFO and CEO may face criminal penalties. In the US, the Securities and Exchange Commission (SEC) is responsible for overseeing this process. The SEC’s mission is to ensure publicly traded companies tell the truth about their businesses and treat investors in a fair fashion by putting the needs of the investors before those of the company.
Cryptocurrencies are not defined as securities, excluding investors from the protections that security investors enjoy, nor are they subject to specific cryptocurrency regulations (in most countries). Thus, bad actors operating within the cryptocurrency realm find such regulatory leeway highly enticing.
No deposit insurance
In the US, cash deposits and shares held by stockbrokers are insured up to a value of $500,000. However, the vast majority of cryptocurrency exchanges do not automatically protect against cash or cryptocurrency losses (even in the case of theft or an exchange going out of business).
Also, as cryptocurrencies are not legal tender in most countries, no legal protection is offered to investors. Alas, governments and banks cannot provide any guarantee about a cryptocurrency’s value.
Insider trading & market manipulation
Insider trading refers to the selling of assets based on information that is not publicly available. In particular, company employees and other insiders may be privy to information that outsiders do not have. They have an unfair advantage should they decide to trade an asset based on such information. Insider trading is not only unfair to outsiders, but it also hurts the asset when allowed to continue: people are unlikely to invest money if they suspect they are at a disadvantage and will choose to invest in other regulated assets.
Stock market investors are protected from insider trading by federal law. Investors who violate such laws are subject to punishment or fines. In contrast, cryptocurrency traders are not subject to such regulations as they’re not trading securities. Financial regulatory agencies will find it difficult to limit any insider trading involving cryptocurrencies until such laws are passed.
“Pump and dump” groups pose another risk to investors. These groups orchestrate massive cryptocurrency purchases over a short period of time to manipulate prices. Investors outside these groups notice fabricated news and chatter accompanying the rise in price and decide to buy, pushing the price up even further. Once it reaches a certain point, members of the pump and dump group decide to sell suddenly, causing a chain reaction and substantial drop in price.
However, pump and dump schemes are not yet illegal on cryptocurrency exchanges. As mentioned above, many exchanges do not require members to provide detailed identification checks. Moreover, they do not report to government authorities, making it relatively difficult to track and prosecute wrongdoers.
In contrast, stock markets expressly forbid pump and dump schemes. Indeed, some exchanges (e.g., the Tokyo Stock Exchange) even limit a stock’s daily price fluctuations.
The January crash in cryptocurrency prices was likely a wake-up call for the many new cryptocurrency investors who had ignored the risks. Don’t let that be you next time. Heed the warnings and educate yourself.
The above references an opinion and is for information purposes only. It is not intended to be investment advice. Seek a duly licensed professional for investment advice.