Crypto means you are in total control of your money. Thats sounds good but then if something goes wrong who do you call?
Owning crypto and complaining about the risks is a bit like owning a sports car and complaining about the costs. You just cannot have the former without the latter. Although most people associate crypto risks with bubbles or the tulip mania, owning crypto comes with various risks. In this lesson, you will learn:
- What risks exist when owning crypto
- Why these risks arise
- What you can do to prevent them (if anything)
Losing your private key
Your private key is the literal key to your crypto assets. You need it to access your wallet and sign transactions. If you lose it, you cannot access your wallet, and you cannot retrieve your coins. They are irretrievably lost.
How you interact with your private key depends on your choice of wallet. One option is to have a custodial wallet, meaning you let someone else manage your private key. If you store your coins on Coinbase or Paypal, you are using a custodial wallet. You log in with a password and can retrieve that in case you lose it.
Non-custodial solutions are mobile, software, or hardware wallets. Every time you come across a twelve-word seed phrase, you are dealing with a non-custodial solution. The benefit is you retain ownership of your coins. As a saying in crypto goes, "not your keys, not your coins." However, you cannot ask anyone for help if you lose your login details and seed phrase.
There are differences between non-custodial wallets as well. A paper wallet is the safest option. You literally only have your public and private key written on a piece of paper. You eliminate the risk of a wallet hack but have a higher risk of losing the slip with your details. A hardware wallet is a USB flash drive that's designed to store cryptocurrency. It is not connected to the internet but can also be physically lost.
At the end of the day, you can only prevent the physical loss of your key by treating your wallet and seed phrase with the same care you would treat other valuable items. Otherwise, your coins join the countless cases of people who lost fortunes by not being able to access old Bitcoin wallets.
Immutability of blockchain transactions
Blockchain transactions are immutable, meaning they cannot be reversed. That is a big advantage of blockchain as a technology, but it's also a potential banana skin for inexperienced users and a gateway that malicious parties can exploit.
Since blockchain is a young industry and unregulated in large parts, it's also rife with scams, ponzis, and dubious projects. There is everything from scam trading sites over fake wallet addresses and seed phrase generators to clipboard viruses that will change the wallet address you are trying to send money to.
The user carries all responsibility for his actions, which makes him the easiest point of attack. Blockchain technology in itself is highly secure, but users and onramps like wallets and exchanges can be attacked. Malicious actors will use the immutability of transactions to trick users into sending coins to the wrong address. Once sent, these coins cannot be retrieved.
Common sense and vigilance are your best defenses against these risks. Double-check the address you are sending coins to. Keep your computer safe and don't interact with dubious projects or websites.
The biggest non-user-related risk is protocol-related risk. Three basic attack vectors are covered in this point and the next:
- Getting hacked
- Getting rug-pulled
- An error in the economic design of the project
Smart contract risks
Humans create software code, and humans can err. Therefore, a smart contract is always liable to a hacker attack even if it has been audited and used for a comparably long time. This is very much like a bank that can get robbed, only that the banks in crypto are often very new and easier to exploit.
There isn't much you can do here aside from doing your own research on the project you are interacting with.
Economic protocol risks
The two big non-IT risks are rug pulls economic design failures. The former is an industry term for a project attracting liquidity, which leads to a significant increase in the coin's price. Then, the team behind the project dumps their share of coins ("they pull the rug") and provokes panic-selling by the market. This is also known as "pump and dump."
A project can also fail due to an unintentional flaw in the token design that provoked a price collapse. Iron Finance was a project that created a stablecoin (a crypto equivalent of the dollar) but failed because an error in the economic design provoked a run on its liquidity. The market panic caused the price to collapse from $50 to zero within hours.
Both these risks are inherent to crypto and hard to avoid even with the best research. Even with the best intentions, a flourishing space like blockchain will have its fair share of failures. The unregulated nature of crypto offers massive opportunities to multiply your money, but these come at a cost.
No insurance or protection against theft
Another consequence of cryptocurrencies' decentralized and unregulated nature is the lack of a central authority to appeal to. Since there are no chargebacks in crypto, you cannot get your money back. On top of that, your money isn't insured, and no one can force the scammer or hacker to return the stolen funds. Law enforcement isn't an option either since they are nowhere near competent enough to deal with such cases of cybercrime.
This risk is slowly getting mitigated because projects like Nexus Protocol do provide insurance against some cases of loss such as hacks, de-pegged stablecoins, and protocol code failures. However, you have to be a quite experienced user to understand and use such projects.
Lack of customer support
This is a shortcoming pervading the entire industry, so it's considered a macro risk for the purpose of this lesson.
Using crypto is very much sink or swim. Either you learn how to use it by yourself, or you will likely pay a few expensive lessons on the way. Unlike traditional banks and financial institutions, blockchain companies and cryptocurrencies have no customer support. Whether for basic things like sending coins to the wrong address or for more advanced problems like hacks, no mechanism helps to onboard new users. Since the user experience for many coins and projects isn't great, this is a real problem.
Like with previous risks, the decentralized nature of crypto comes at a cost. It's hard to build a permissionless space and have a customer support hotline since the latter is a feature of a centralized company. Hence, there is nothing you can do besides constantly educating yourself.
Lack of government oversight and regulation
This is a risk or a benefit depending on who you ask. In traditional finance, accounts and payments are covered by the law. Even if a bank fails, your money is safe up to a certain threshold. In crypto, you have neither governmental nor private institutions (so far) that can save your funds in case something goes wrong.
You could also see this as a positive since it teaches people to live with the consequences of their actions and teaches them responsibility in a straightforward way. More regulation would almost certainly stifle growth and innovation because less risky seldom goes hand in hand with more innovation. On the other hand, it would probably reduce the amount of scams and faulty smart contracts.
On a project level, governance risk can never be fully eliminated anyway. Even among highly regulated industries like traditional finance, there are rogue banks. On the contrary, more government regulation is a risk in itself since it would almost certainly lead to a massive loss of value in many assets, at least in the short run. As such, this is another inherent risk of crypto that has no easy or ideal solution.
Cryptocurrencies are famously volatile. Sometimes prices plummet or skyrocket for a reason, sometimes for seemingly no reason. High returns come with high volatility, and those that have held their assets for long enough have multiplied their initial investments several times.
Market risk is best mitigated through sound risk management when trading or investing in crypto. Not investing more than the amount one can lose and dollar-cost-averaging should be staples of every crypto investor. Doing your own research before investing, as mentioned several times, helps mitigate your downside as well.
Crypto doesn't go untaxed and since cryptocurrencies are classified as property by the IRS, you have to report your gains and pay taxes. That can be income tax or capital gains tax, depending on how you made money. This is less of a risk but more something that you need to know.
Some people think that crypto is tax-free or it's easy to avoid taxes with crypto. However, it's a lot like with cash. Only because you could avoid taxes doesn't mean it's a good idea. If you do it, you are taking a risk. Preventing this risk is quite easy: do some research on tax regulation in your country and figure out how much you have to pay and when.
Of course, other possible risks may not be known to the wider public. You could have systemic risks like market manipulation, leading to a price collapse. Mining bans can and have in the past impacted prices. A systematic crackdown on on-ramping to cryptocurrency exchanges would also depress the market. In the end, there might be unknown unknowns that only show up on your radar after the damage is done.