Key points:
- 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, such as 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.
Explore how DBS DDEx provides Accredited Investors with a platform to trade crypto seamlessly on digibank.
For those following crypto news over the past year, you would have heard of FTX, which went from being one of the largest cryptocurrency exchanges in the world to declaring bankruptcy. This was just one instance among a series of significant challenges that impacted service providers and exchanges in recent times. The human cost has been immense, with individuals’ life savings in jeopardy as a result of issues with these platforms.
In addition, large amounts of cryptocurrency have been lost to simple mismanagement – for instance, US$181 million worth of Bitcoin that was lost when its owner accidentally threw the wrong hard drive away.
As such, although cryptocurrency as an asset class offers diversification to one’s investment portfolio and an entry to emerging technologies with the potential to revolutionise various industries, investors must be aware of the risks involved in cryptocurrency trading.
Risk 1: 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 in any investment, it's more pronounced for cryptocurrencies due to the nascency of the asset class, swings in investor sentiments arising from evolving regulations, industry news and media hype. As an illustration of this volatility, 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. At a minimum, this means knowing the token’s (a) years in existence, (b) market capitalisation and (c) how it could potentially be used in the real world – say, online payments or as a store of value.
Risk 2: Liquidity Risk
An investment characterised as illiquid implies that investors may encounter challenges when attempting to buy, sell, or convert it into cash. This issue becomes particularly significant with lesser-known cryptocurrencies. Due to their limited trading activity, these currencies could be more volatile in price, posing difficulties for investors seeking to liquidate their holdings without incurring unfavourable prices.
Investors may also lose access temporarily to their crypto investments due to unexplained or prolonged trading platform downtime, or when exchanges temporarily pause crypto deposits or withdrawals, say when they want to perform platform maintenance. This presents a risk for investors who 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.
Risk 3: Operational Risk from the Custody of Cryptocurrencies
A unique feature of cryptocurrency compared to other asset classes is that it allows any individual to self-custodise the asset. Thereby removing the need to entrust safekeeping to a third-party custodian.
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 if access to the private keys is lost.
For third-party managed private keys, although there are typically recourses to lost credentials (for instance when users forget 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).
Risk 4: 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, as they 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 US$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.
Explore how DBS DDEx provides Accredited Investors with a platform to trade crypto seamlessly on digibank.
