Cryptocurrency Pitfalls

Between the stories we see on the internet, the countless memes, and the growing library of buzzwords, it's hard to research today's economy without running into some references to cryptocurrency. This is especially true over the last couple weeks with the collapse of the second-largest crypto exchange, FTX, and the effects of that reverberating through the investment industry.

Cryptocurrency is a type of digital currency that exists electronically.¹ You can use crypto like the way you use cash. You can invest in it, use it to buy things, and keep it in your (digital) wallet.

Cryptocurrency could be a sound investment for one person and not a good fit for another. As with any investment or currency, there are a few pitfalls to consider before jumping headlong into the world of crypto. Below are some of the most significant drawbacks to consider as you research crypto and buying, investing, or transacting with crypto.

1. Lofty Promises

It's difficult to find an article about cryptocurrency that doesn't contain some hyperbolic claims about the currency's performance. An article from Bloomberg shares some tweets from bitcoin fanatics that say crypto will be the world's biggest benefactor, is the best monetary asset ever, has saved lives, and may one day hit $100,000 or even $1 million.²

To an uneducated investor, all of these claims might sound like magic, but as with any asset it's important to remember that we can't see into the future, and we have no idea how it will perform in the coming years. Approach these claims as hesitantly as you would those regarding any other asset.

2. Crypto Isn't FDIC-Insured

Another pitfall is that cryptocurrency accounts aren't backed by the government like traditional bank accounts. There are some third-party companies where you can store your digital wallets, but if something happens to those companies, the government has no obligation to step in to help get your money back. This is the big issue facing investors who stored their digital assets on the FTX exchanges, as well as other recent centralized crypto providers that also collapsed and filed bankruptcy such as Celsius and BlockFi.

In addition to not being backed by government protection, most cryptocurrency payments don't come with legal protections like credit or debit card purchases do. If you need to dispute a purchase you made using crypto, the process could be long and complicated, if not impossible. In addition, most purchases using crypto aren't reversible. This lack of purchase protection and insurance could be a deal-breaker to some.

4. Securing Your Crypto May Take Some Work

There are two main ways to store your crypto: on a centralized platform or exchange (Coinbase, Binance.us, Nexo, etc.) or self-custody. You can find more information about these two options in an earlier Escient Financial Insights article Cryptocurrency Wallets. The basics are that storing your digital assets on a centralized exchange is similar to keeping your money in the bank (i.e. Chase, Bank of America, Wells Fargo) or your stocks with a broker/dealer (i.e. Schwab, Fidelity, etc.). The issue there is, as mentioned above, your assets are not insured. If the centralized platform fails, you could lose some or all your assets. Failures can be in different forms. For example, there's always the risk of cybersecurity breaches, hacking, fraud/market manipulations, and other technological risks. Unfortunately, that's the current state of things with centralized platforms, but could change as the industry becomes regulated and standards are set.

When you self-custody you do have access to the various decentralized finance (DeFi) platforms and services that exist. However, DeFi presents its own set of risks, making self-custody not the perfect solution to avoiding the issue issues with centralized platforms. This is especially evident this year with the number of hacks on various decentralized finance (DeFi) platforms. DeFi platforms have the advantage of not being subject to the errors of individuals that run a centralized exchanges and trading firms (such as what happened with Alameda Research, FTX, Celsius, Three Arrows Capital, BlockFi, Voyager, and others), but each platform will only be as secure as its code. Hackers could find and exploit bugs and security holes in the code of platforms and smart contracts that could allow them to steal assets. That makes it important to research DeFi platforms and services before using them.

With self-custody, it's important to consider human error risks when deciding where to store it once you do purchase digital assets. What would happen if you forgot your password or someone stole your laptop? How would you access your digital wallet? The New York Times famously covered the story of Stefan Thomas, a German-born programmer who had two attempts remaining to guess the password to his digital wallet worth $220 million at the time of writing.³ Or James Howells of the UK who mistakenly threw a hard drive with 7,500 bitcoin on it (worth more than $500 million when bitcoin was at its all time high a year ago) and has been trying to convince the government to allow him to search the landfill for the hard drive.⁴ Cryptocurrency and digital wallets give a new meaning and horror to the prompt "Forgot your password?"

Before choosing where to store your digital assets, be sure to also read the Escient Financial Insights article Cryptocurrency Wallets. Also, wherever you choose to store your digital assets, a way to help protect your assets is to diversify where you store them. If you choose a centralized platform for storage, you can store your digital assets across multiple platforms and exchanges. That way if an exchange collapses, you wouldn't lose everything in one place. The same goes for self-custody. You could store your digital assets across multiple wallets, and store the wallets and private keys in different places, so if one location is compromised you don't lose everything all at once.

5. Crypto is Still Maturing

Lastly, cryptocurrency is still relatively new as an asset class and technology and needs more time to mature. You can buy more things with crypto now than you could in past years, but you can't buy everything with crypto. Being a new asset class, it has taken time off regulations to be put in place to make the industry safer for the general consumer. Crypto and digital assets can be complex and are not as user-friendly as some existing traditional finance services. It's not as difficult as it may seem once you get used to it, but there's still a learning curve. Over time, purchasing and transacting with crypto will become easier, and then it will be more welcoming to the average user. You can think of it how the Internet was in the 80's and early 90's, before the first graphical web browsers for the World Wide Web became available. You had to know UNIX commands and type everything you wanted to do instead of point and click with a mouse. In time, the Internet became easier to use, and the same will happen from crypto and digital assets.

Cryptocurrency and digital assets will only grow as a major player in the economy and in our lives in general. Before jumping in it's worth taking time to consider its drawbacks. Escient Financial is here to educate, guide, and advise clients with this new technology and asset class.