Know these risks before you invest in Bitcoin – The Hindu BusinessLine

Clipped from: https://www.thehindubusinessline.com/portfolio/big-story/know-these-risks-before-you-invest-in-bitcoin/article36536875.ece?homepage=true

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Are cryptocurrency investors tempting you to join the bandwagon? Check out these facts before you turn towards that high-octane world of virtual money

Ever since Bitcoin was conceptualised in 2008-09 post the global financial crisis, it has split the civilised world into two unequal halves: the haves and the have-nots. The early adopters, who ‘hodl’ the crypto asset, have become wealthy in line with the meteoric rise of Bitcoin market value (1 BTC now costs ₹35 lakh), notwithstanding countless ups and downs.

With the sharp increase in the price of bitcoins, newer cryptocurrencies have mushroomed. From just 66 cryptocurrencies in 2013, today there are over 5,800 of them commanding a value of over $2 trillion. Given the high stakes, a war is currently on between crypto backers and crypto adversaries. Be it social media, electronic media or the Internet in general, positive stories about cryptocurrencies appear everywhere, and all this could pique your curiosity. With the trusty smartphone in your hand that gives access to a multitude of crypto trading apps, it is all too tempting to jump onto the bandwagon that has an estimated 10 million Indians. But before you enter that high-octane world of get-rich-quick schemes, there are some key things you should know that can help you make an informed decision.

1 No safety net

Out of the $2 trillion market value of cryptocurrencies, Bitcoin alone accounts for 44 per cent. It is the first cryptocurrency and thus the first so-called system of global, decentralised, scarce, digital money. So, one would think that there is an elaborate system behind all this.

The reality is starkly different. Bitcoin is a virtual thing. A Bitcoin address is a particular virtual location where bitcoins are sent and received. It is like a bank account number and is represented as a 26 to 35 character-long, case-sensitive string of letters and alphabets. Each Bitcoin address is controlled through the use of a unique corresponding private key, a cryptographic equivalent of a password and whoever holds that key can authorise transfer of Bitcoin from that address to another.

Keep in mind that there is no central authority, no central server and no central storage. Sounds like the Wild Wild West in a new techno avatar? Small wonder then that the losses from cryptocurrency theft, hacks, and fraud in 2020 were at $1.9 billion, according to a report from crypto intelligence company CipherTrace. Fraud was the dominant cryptocurrency crime in 2020, followed by theft and ransomware.

In due time, cryptocurrencies such as Bitcoin aspire to gain the trust of people, most importantly, without most of the intermediaries that have helped the existing financial system become what it is today. So, when you trade in Bitcoin, Ethereum, Cardano, Binance Coin, or any cryptocurrency that a tech geek dreamed up, understand that you are in a system that lacks intermediaries such as banks, brokers, clearing houses, custodians, and their networks.

Crypto enthusiasts will tell you that the existing system’s intermediaries impose access limitations, hinder efficiency and rack up costs for end users. But, that’s only one side of the coin.

An elaborate group of intermediaries make sure that people are able to ‘TRUST’ the system. Right from the days of barter systems involving salt or cowrie shells to fiat money system involving dollars or rupees, trust has been the keyword. And when you have instances such as Titan token in June 2021 falling from $60 to 40 cents in less than 24 hours, that trust in this alternative system gets badly shaken.

2 Self-regulation only

Unless you live in El Salvador, which has become the first country to accept Bitcoin as legal tender, your investments in cryptocurrencies are not covered by regulation. The exact reasons that convinced El Salvador, the smallest Central American nation, to accept Bitcoin are unclear. As for India, the policy slant is towards a central bank digital currency, not cryptocurrencies floated by private parties.

Recent media reports indicate that the Indian government will not recognise any currency not floated by the Reserve Bank of India. Since Bitcoin is not currently recognised in India, there are no proper laws on holding such crypto assets, taxation and grievance redress from the side of authorities. If anything goes wrong, you are on your own against self-regulated entities. Everything else said about them at this point is conjecture, at best.

What about Indian crypto exchanges, the crypto platforms? Are these also unregulated? The answer is yes and no. Most of the exchanges are legitimate companies that operate on a marketplace model. There are also a few platforms that call themselves an aggregator of cryptocurrency exchanges. A few of the so-called popular crypto exchanges amongst Indians are based outside of India and one doesn’t know which country laws would apply in case of a dispute.

If you think these are like a stock or commodity exchange you are mistaken. Formal stock/commodity bourses are recognised as exchanges by authorities such as SEBI, but crypto exchanges are not. Typically, crypto exchanges have been started by a group of blockchain enthusiasts with no formal background in operating any other recognised exchange previously. They are usually techies, with e-commerce experience, in some cases.

It is important to understand the role of crypto exchanges during a time that crypto currencies are not legal tender. Similar to stock exchanges, crypto exchanges provide an online platform for cryptocurrencies. But they also enable trading of cryptocurrencies for fiat money such as Indian rupees. This makes crypto exchanges a connecting point between crypto and traditional financial systems. To attract new users, fiat money deposits are kept either ultra-low or zero. Once deposited inside a crypto platform, this fiat money can be used to buy crypto assets. Though centralised exchanges offer a single point of regulation and more reliability in terms of transactions, they act as a third-party between a buyer and a seller and thus should get to play that key role after due diligence. Currently, there is no diligence, which puts your investments at huge potential risk. Without a system where licences are issued based on compliance with strict eligibility requirements and scrutiny of governance, risk management and resources, blindly trusting exchanges/platforms to do the right thing would be foolhardy.

Recall how the Cajee brothers, who ran a cryptocurrency investment platform from South Africa, vanished along with $4.8 billion of bitcoin? Of course, the world is catching up with crypto criminals too. For instance, the US Department of Justice, in a June 2021 case, seized bitcoins paid as ransom. This was done by reviewing the Bitcoin public ledger. Law enforcement officers were able to track multiple transfers of bitcoin and identify the bitcoins paid to the criminals.

3Volatile asset-class

Bitcoin and many other cryptocurrencies are not backed by physical assets. Essentially, they are more like speculative assets. “They’re highly volatile and therefore not really useful stores of value and they’re not backed by anything,” Fed Chair Jerome Powell said during a virtual panel discussion on digital banking hosted by the Bank for International Settlements in March 2021. And when somebody like billionaire investor Warren Buffett says the recent craze over bitcoin and other cryptocurrencies will come to a bad ending, it calls for circumspection.

Huge swings in Bitcoin and Ether prices highlight the speculative nature of the asset. To recall, Tesla’s February statement (highlighting company’s embracement of the Bitcoin) sent it to a high of $65,000. However, Bitcoin price fell sharply (in mid-May 2021) after Tesla chief Elon Musk expressed concerns over its power consumption and said that the company would no longer accept Bitcoin as payment. Separately, the People’s Bank of China banned cryptocurrency to be used as a form of payment while announcing it will crack down on Bitcoin mining and trading activities.

If you invest in bitcoins, be ready to accept that it will show massive amounts of volatility based on somebody’s tweet or someone’s remark. Do note that a contributing factor to the extreme volatility levels in cryptocurrencies is likely to be the asset’s fragility associated with highly concentrated ownership — more than 90 per cent of all Bitcoins are held by just 2 per cent of accounts.

Also, there is a strong correlation between Bitcoin prices and Google searches. This indicates that it is perhaps more of a fad, underlining its highly speculative nature. An HDFC Bank report showed that Bitcoin prices likely to be driven by internet attention i.e. monthly Google trends for searches using ‘Bitcoin’ as keyword. What drives people to search for ‘Bitcoin’ on Google? The answer is regular news about Bitcoin price movements. Every time there is a sharp swing in Bitcoin prices, many feel compelled to read about this ‘investment opportunity’ as a 30-40 per cent price movement in a week is a normal thing in the crypto market!

When you compare Bitcoin with other asset classes, it is easy to understand why this has no comparable! Bitcoin has been three times more volatile than the S&P 500 or the NASDAQ composite over the past two years ended January 2021, and more than four-and-a-half times more volatile than gold.

According to World Gold Council data, Bitcoin has lost 2.5 per cent or more once in four weeks on average compared to once in 12 weeks on average for the S&P 500 or NASDAQ, or once in 13 weeks on average for gold. Finally, Bitcoin’s Value-at-Risk (VaR) has also been considerably higher. On any given week over the past two years, investors had a 5 per cent chance (95 per cent VaR) of losing at least $1,382 for every $10,000 invested in Bitcoin. Bitcoin trades like a ‘high-octane’ asset. At times, market participants have noticed ‘safe haven-like’ behaviour in Bitcoin, as it has appeared to directionally move in a similar way to some traditional hedges, such as gold. However, there is no consistent trend.

4 Scores high on gullibility

In an attempt to popularise cryptos, domestic platforms and exchanges have tried to ride the success of popular investment avenues. This has led to various products coming out from the crypto exchange stable. On paper, they appear seemingly harmless just like the products on the regulated traditional asset side. But users/investors should show extreme caution while dealing with such crypto products.

Firstly, crypto lending is emerging as a scheme to attract new users with the promise of loans. In many platforms, the verified users will be able to obtain an instant loan in a stablecoin (crypto assets backed by fiat money or other crypto assets) against pledging collateral in bitcoin. Leverage up to 4x is allowed. EMI plan lets user pay their loan and interest (15 per cent) in easy monthly instalments of 3 to 36 months, while flexible option lets users pay the interest and principal without any restrictions on repayment time. Such loans give you liquidity without having to sell bitcoins.

There is also another form of crypto lending where a verified user can lend digital assets through exchange or lending sites to get returns. Typically, users are asked to lend their coins to the crypto exchange and in return they will get simple interest depending on the cryptocurrency and tenure (open or fixed 7 days to 90 days). The most popular crypto assets for lending are BTC, ETH, USDT, MATIC, Binance Coin, DAI, etc.

Secondly, crypto SIPs are being marketed as a ‘disciplined’ way of long-term investing in crypto currencies. These borrow the mutual fund SIP concept. The crypto SIPs are offered through bundled plans, which spread the investment across crypto assets, or allow you to focus on one asset with ₹100/day (since cryptos can be bought in fractions). The SIP frequencies range from daily to quarterly. But they are advertised with unrealistic return potential such as ‘1,800% in a five-year plan’. Given the massive volatility of cryptocurrencies, such high rates of returns are plain misleading.

The important point here is that crypto exchanges are giving retail investors full access to complex products without adequate disclosures. Given that crypto is itself a young field and a volatile asset, there are not many advisors as well who can guide investors on product suitability. Thus, mis-selling can easily happen and without proper regulation, it would almost be impossible to enforce investors’ rights, even in courts, and press for recovery. Investor protection is weak in cryptos even though underlying technology may be advanced.

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