Cryptocurrencies - tread carefully before trading

5 February 2018

Bitcoin, Ethereum, Litecoin... cryptocurrencies are all over the press. Most of us are now broadly aware that cryptocurrencies are digital currencies which use blockchain technology. But how many people actually understand how the underlying technology works, what it means to ‘invest’ in a cryptocurrency, and appreciate the risks behind them? For anyone thinking about investing in cryptocurrencies, set out below is a summary of the main concerns, which should hopefully encourage you to stop and think before jumping on the crypto band wagon.  

Blockchain and the currency ‘revolution’

For centuries, traditional currencies have been subject to the control of the central banks of each nation. By using blockchain technology, cryptocurrencies are not subject to any central controls. A blockchain is a global network of computers which can be used to maintain a digital ledger of every owner of a cryptocurrency and the transactions they make. When, for example, a Bitcoin transaction is made (buying, selling, transferring or creating Bitcoin), the record of that transaction is securely encrypted, time-stamped and updated into a block which is added onto the historical record of all Bitcoin transactions. Each block in the chain is unique and it is virtually impossible to remove or change data which has been added to the chain. This means that transactions are verifiable without the need for a central authority, such as a bank, to oversee that process. In theory, Blockchain technology allows us to securely transact with one another via a peer-to-peer network without a middleman, such as a bank, charging us for the privilege of doing so. 

However, in practice, in order to trade in cryptocurrencies you need to use a cryptocurrency exchange (which facilitate sales between buyers and sellers of digital currencies) and a digital wallet provider (who provides software which maintains a record of your transactions on the blockchain relating to that currency). Unsurprisingly, all exchanges, and most wallet providers, charge transaction fees for the services they provide. In theory, blockchain technology cuts out the middleman from financial transactions. However, in practice, trading in cryptocurrencies still involves contracting with intermediaries, carrying out due diligence on those intermediaries to ensure that they are trustworthy, and of course, paying the associated costs.  

A cryptocurrency is not an investment

An investment relates to the process of buying an asset that creates products, services or cashflow. This means that, even if you were never to sell the investment, it would be worth owning from a financial perspective because it is intrinsically valuable. Currently, cryptocurrencies have little intrinsic value. We’re yet to witness a widespread adoption of cryptocurrencies as accepted methods of payments for goods and services. This means that, unlike a rentable piece of property, there is little value in owning a cryptocurrency unless you plan to sell it, and unless the cryptocurrency is in high enough demand at the time you decide to sell it. At the moment, most cryptocurrency purchases are not made on the basis of a substantiated belief that the cryptocoin will become a new global currency, but rather with an unsubstantiated expectation that they will rise in value. It is all mere speculation.

Of course, all investments involve at least some level of speculation – for example, when investing in property, there is always the risk that it might be worth less than the price you bought it for when the time comes to sell it. But regardless of whether its value eventually increases or decreases, at least that property will be financially valuable to you in the meantime. Conversely, when you purchase a cryptocurrency, you knowingly accept that it will have little financial benefit to you until you come to sell it, and that even then, there is a risk you might lose out financially.

Lack of regulation

An Initial Coin Offering (ICO) is the process by which a start-up sells tokens (coins) to investors as a way to fund its business, often in return for cryptocurrency. The coin an investor receives may represent a prepaid voucher for future services but, more often, is actually a new cryptocurrency itself.  An ICO therefore seems similar to an Initial Public Offering (IPO), by which a start-up sells securities (such as shares) to investors as a way to fund its business, in return for traditional currency such as the £ or the $.

Unfortunately, that’s where the similarities stop for investors because, unlike IPOs, ICOs are not currently subject to any definitive regulatory controls. An investor who has purchased shares during an IPO has access to regulatory protections (such as the Financial Services Compensation Scheme and the Financial Ombudsman Scheme) if the offer to invest was misleading in any way. Such protection is unlikely to be available for ICO token holders, which the Financial Conduct Authority (FCA) confirmed via a statement 'Initial Coin Offerings' released in September 2017. This statement also confirmed that whether a particular ICO falls within the FCA’s regulatory powers can only be decided on a case-by-case basis.

If the ICO does not fall within the FCA’s remit, there is no investor protection other than that set out in the investor’s contract with the coin issuer. Those protections (if any are in place) will be worthless for the innocent ICO investor who discovers there was never a legal entity behind the fundraising project, and that they’ve invested in a fraudulent business. Add this to the fact that the coins are likely to be subject to extreme price volatility, and it’s hard to think of a reason why anyone other than an extremely experienced ICO investor would want to invest in an ICO. 

Security risks

‘Mining’ is the process of adding transaction records to the blockchain which underpins a digital currency. In relation to Bitcoin, when a ‘miner’ (who will often run many of the computers which maintain the blockchain) adds a block to the chain, he is rewarded with new Bitcoin. However, a miner is only allowed to add a block to the chain if he solves a complex mathematical problem. Solving each problem requires an extremely high powered computer so, increasingly, unscrupulous miners are hacking third party computers in order to use their processing resources to mine more cryptocurrency. It was recently reported that, in the first eight months of 2017, more computers were infected with malware to enable hackers to mine cryptocurrencies than in all of 2016. Should the value of cryptocurrencies continue to rise, it seems likely that the number of crypto-related hacking incidents will also rise.

Environmental impact

As set out above, cryptocurrency mining has developed into a processing power arms race between miners. As a result, the higher the value of a cryptocurrency, the more energy it takes to maintain it. A recent article 'Bitcoin Energy Consumption Index' has revealed that 4,099,592 U.S. households could be powered by the energy it takes to maintain Bitcoin, and other statistics show that one Bitcoin transaction requires 215 kilowatt-hours of electricity to process - the same amount consumed by the average U.S household in one week. Even more terrifying is the prediction that, by February 2020, the Bitcoin network will “use as much electricity as the entire world does today” .

The Future

Given the current rampant speculation in cryptocurrency trading, it seems very likely that the cyprotcurrency bubble will burst at some stage soon, and that valuations will crash (last week, Bitcoin’s value fell by more than $44bn). When this happens (and ideally before it happens) the regulators should catch up with the rapidly developing sector and put in place some much needed investor protection.

In the meantime, if you’re considering trading in cryptocurrency or taking part in an ICO, we would strongly advise that you seek professional advice to ensure that you are protected as much as is (currently) possible.

See also our recent cryptocurrency blog by our Criminal team - 'Bitcoin and cryptocurrencies – regulation on the horizon to combat cyber-crime?'

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