Managing crypto investment risks
By Lynette Tan
If you’ve only got a minute:
- Like every investment, cryptocurrency comes with its own set of risks - volatility, liquidity, operational and cybersecurity risks, for example.
- Investors can take action to mitigate these risks, for example by trading through reputable exchanges.
- Investors are encouraged to carry out the essential research and maintain a balanced portfolio, avoiding over concentration in one asset class.
If you’ve read the news in the past 12 months, you would have been aware of the rapid downfall of FTX – from being one of the largest cryptocurrency exchanges in the world to filing for bankruptcy. This was merely one of a series of major calamities affecting crypto service providers and exchanges during this time. The human cost of this has been immense, with individuals’ life savings in jeopardy as a result of issues with these platforms.
Even outside of major events, large amounts of cryptocurrency have been lost to simple mismanagement – you may have heard of the $181 million worth of Bitcoin that was lost when its owner accidentally put the wrong hard drive in the trash.
As such, although this asset class does offer diversification to one’s investment portfolio and offers an entry to emerging technologies with the potential to revolutionize various industries, investors must be aware of the risks involved in cryptocurrency trading.
Huge price fluctuations & volatility
Cryptocurrencies are highly volatile and their prices can fluctuate dramatically within short periods. This volatility can lead to substantial gains but also significant losses; there is even risk of losing the entire principal.
While price fluctuations are common amongst investment vehicles, the added volatility for cryptocurrency stems from the nascency of the asset class, swings in investor sentiments arising from evolving regulations, industry news and media hype. As an illustration of this, the cryptocurrency market peaked at approximately US$3 trillion in 2021, but fell drastically in value to below US$1 trillion in 2022.
Risk management options: One way to mitigate the risk of investing in crypto is to seek portfolio diversification and avoid concentrating your investments in one single investment vehicle. Furthermore, as with any investment, it is essential to do your own research - minimally entailing fact finding on the token’s (a) years in existence, (b) market capitalisation and (c) validity of potential use cases.
When we say an investment is illiquid, it means investors may face difficulties in buying/selling it and converting it into cash. Thin trading on lesser-known cryptocurrencies in particular has the potential to increase the risk of loss because it can translate to high volatility of prices, and market participants may find it challenging to liquidate their positions except at very unfavourable prices.
Investors may also experience a loss of access to their crypto investments due to trading platform downtime, or when exchanges temporarily pause crypto deposits or withdrawals. For instance, certain crypto exchanges may perform platform maintenance, causing a temporary loss of access to trading. This presents a risk should the investor want to buy/sell/access their crypto assets during this period.
Risk management options: One way to reduce liquidity risk is to trade in crypto assets with higher market capitalisation – they are likely to be more popular and hence more liquid. You can also use multiple exchanges to access liquidity across different platforms, avoiding being locked out of trading activity by a single exchange’s downtime.
Operational Risk from the Custody of Cryptocurrencies
One of the unique features of cryptocurrency compared to other asset classes is it allows any individual to self-custodise the asset, thereby removing the need to trust a third-party custodian for safekeeping. However, greater control over the asset comes with greater risk of private key mismanagement (private keys are used to access self-custodised cryptocurrency). For example, self-custody requires an individual to have the know-how and willingness to manage the private key through adequate back-ups and secured physical storage location(s).
For self-custodised keys, all cryptocurrencies secured by the set of keys will be lost with the loss of access to the private keys.
For third-party managed private keys, although there are typically recourses to lost credentials e.g., users forgetting their login credentials to these crypto platforms, users would have to trust the third-party service provider for proper controls and safeguards to protect their assets. It is therefore vital for cryptocurrency investors to be aware of the various risks depending on the mode of custody they choose.
Risk management options: Investors will need to ensure they keep their private keys safely or seek proper storage with a trusted custodian. You can retrieve lost credentials with a custodial wallet, unlike with a non-custodial wallet, where loss of keys would mean total loss of funds.
You can also diversify your storage options by using different custodians and approaches (non- custodial and custodial).
Read more: Storing cryptocurrency safely
Fraud, Theft and Cybersecurity Risks
A crypto hack occurs when hackers gain unauthorized access to your wallets and steal your cryptocurrencies. This risk is higher for hot wallets which are connected to the internet. Cryptocurrency exchanges are popular targets for cybercriminals – the lack of a regulatory framework, and the anonymity surrounding crypto transactions make them susceptible to cybercrime.
An example of a cybersecurity incident is the security breach of Binance in May 2019 where hackers made off with more than $40 million worth of Bitcoin. The hackers used a variety of techniques including phishing and viruses to obtain a large amount of user data, allowing them access to move Bitcoin off the network. Fortunately, the exchange had set aside funds for such incidents and was able to minimise its impact on customers.
Beyond direct hacks, fraudulent use of cryptocurrency that you have stored at an exchange is also a potential risk. For example, the founders of FTX have been charged with fraudulently using customer deposits to fund other business and political activities.
Risk management options: Similar to a loss of access to your wallet, it is important to ensure that the storage of your digital assets is as secured as possible. To protect against exchange’s insolvency, choose an exchange that has a credible reputation and provided segregated accounts for its investors.
When using a custodial wallet, choose a trusted company running the platform because they are managing the private keys for your cryptocurrencies (they hold the keys to your funds).
A trusted custodian company would have:
- Sufficient security measures in place.
- Demonstrated good risk management.
- Good financial standing minimising their risk of going bankrupt.
Like all investments, cryptocurrency trading comes with risk. Investors need to be aware of these risks and take the necessary mitigating measures to reduce these risks. Due to the uncertainty facing the cryptocurrency industry, investors are encouraged to carry out their own research and maintain a balanced portfolio without putting all their eggs into one basket.
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Disclaimers and Important Notice
This article is meant for information only and should not be relied upon as financial advice. Before making any decision to buy, sell or hold any investment or insurance product, you should seek advice from a financial adviser regarding its suitability.
All investments come with risks and you can lose money on your investment. Invest only if you understand and can monitor your investment. Diversify your investments and avoid investing a large portion of your money in a single product issuer.
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