American technology company Ripple Labs Inc. developed and launched the digital currency XRP to allow financial institutions to use its Ripple payment/exchange network, aimed toward offering an alternative way to process day-to-day transactions.
Ripple offered what it claimed was a secure system of engaging in cross-border transfers with security comparable to the current system. XRP joined the host of cryptocurrencies being traded on various cryptocurrency exchanges such as Coinbase.
However, a class-action suit was filed against Ripple in 2018 for its treatment of XRP to create money from thin air. In late 2020, the Securities and Exchange Commission (SEC) filed a lawsuit against Ripple, alleging that it raised over $1.3 billion from the sale of XRP without registering with the SEC. The currency’s value has tumbled since several exchanges suspended trading of XRP as a result.
This recent turn of events is a case study in the threats and opportunities that cryptocurrencies present. Institutional actors far beyond your control contribute to a higher level of volatility than most investments.
As an investment option, cryptocurrency provides a number of unique challenges and opportunities that should be considered before purchasing.
Technology of Crypto
Can you rely on the technology behind cryptocurrency?
- Cryptocurrencies are absurdly secure
- Anyone with access to a computer and the Internet can mine coins
- Nearly impossible to defraud
- Easy access to international markets
- Security is often only as good as the weakest link in the chain
- Most people, investors included, do not understand their crypto
- Mining might be a net loss
- Potential for scams targeted against the unwary
- Changing regulations can leave you exposed
What Is Crypto, Really?
You have likely heard a lot about cryptocurrency, blockchain, and other technological jargon thrown around about one coin or another. It is complicated.
In the simplest terms possible, cryptocurrency is a mathematical construct that creates finite units — coins — and uses a decentralized ledger to verify ownership and transactions. As individuals solve parts of the mathematical construct — mining — they are able to claim ownership of some of the finite units.
These coins are ascribed value due to the scarcity of coins, the effort expended in mining them, and the characteristics of a particular coin, regardless of whatever features the creators have included. Offerings of a coin for a value in another asset operate similarly to any foreign exchange (forex) market, resulting in the specific value for a single coin.
Miners — those who are solving parts of the mathematical construct — use the processing power from computers to do so, with each solved portion of the construct making future portions exponentially harder to solve. At some point, with enough processing power, the entirety of the mathematical construct will be solved, establishing the totality of a particular coin that exists.
In other words, once the construct is fully solved, the supply of the corresponding currency is exhausted.
This is a simplification to the point of losing some nuance, but any sort of simplification of the cryptocurrency technology will inevitably lose some of the specifics. A multitude of academic and technical papers have been written diving into the specifics of one cryptocurrency or another, or the technology as a whole, and complete understanding requires significant research.
Notwithstanding various scams that fool individual investors into parting with their coins, the focus of most conversations about the security of cryptocurrencies is the underlying technology for mining and exchanging the assets.
With Bitcoin having set the initial standard, most currencies have gone on to continue most of the best practices that this first mover demonstrated. For example, Bitcoin was designed to be an absolutely secure system.
The decentralized register means that if someone were to attempt to hack the underlying register to modify a record or falsify a transaction, they would functionally have to hack a majority of instances of the register itself in order to “convince” the system that the fake record was legitimate. In terms of resources, this is unrealistic and not worth it. To date, there has not been a single successful attack on the Bitcoin network.
Where the security threats emerge are on the other side of this equation. While the Bitcoin network itself remains unhacked, a number of the surrounding software that interacts with the network has been infiltrated and misused.
In practice, the difference is that rather than convincing every other computer that a transaction took place, a hacker is able to break into the computer in question and execute a trade. As a result, the supremely secure Bitcoin network isn’t worth a hill of beans if the surrounding infrastructure is full of holes.
Volatility: The Red Flag on Cryptocurrencies
Should you trade in cryptocurrencies to make earth-shattering profits?
- Massive potential for returns
- Low to nonexistent transaction costs
- Unparalleled transparency
- Massive potential for losses
- Difficult to understand
- No recovery options or insurance in case of loss or theft
- Nothing prevents a particular cryptocurrency from bottoming out
- May draw increased attention from government agencies
- Potential for shortage of resources if insufficient people are selling
Treating cryptocurrency trading as though it were a currency in terms of your investment approach may prove to be useful. Many forex strategies can be effectively ported over to cryptocurrency trading, although you may want to note that the volatility of cryptocurrencies is significantly higher.
Market Traders reports an average of 5% volatility for traditional currencies and up to 15% for cryptocurrencies. This, coupled with the relatively limited supply of available sellers for any cryptocurrency, presents a challenge that many investors will need to overcome.
A common factor in traditional markets are the de facto price walls that are created through institutional investors. In practice, a particular asset is less likely to experience drastic changes in price from major trades because other investors will have standing orders for buying or selling around certain orders. This is how an individual can sell thousands of shares of a stock and get close to the same price for all of them.
In nearly all cryptocurrency markets, these price walls have not yet been established, meaning that a single large investor unloading their crypto can cause a major swing in market prices as they go through filling the orders from the best price downward. This raises the volatility higher than it would be otherwise as sudden trades can lead to price shocks. This risk piles atop the currencies’ existing everyday volatility to create further shifts in the market.
Cryptocurrencies of any type have a number of cons to the investment, but the lure of massive returns and anonymity outweighs these concerns for nearly everyone who has made their way into the crypto markets, whether they are mining or taking part in an exchange.
Blockchain technology looks as though it may be the next gold rush. As with all gold rushes, there are many who make money, and many who lose — and those who tend to do the best in a gold rush are often the ones selling pickaxes.
Approaching cryptocurrency as part of your investment strategy can be incredibly effective, but should be tempered with patience and understanding. Anecdotes of high school students becoming millionaires overnight are the vast minority. The high volatility of cryptocurrency means there are key strategies to help mitigate these challenges, but it also ensures this is a place where you can make a great deal of money.