Despite how mainstream they have become, every cryptocurrency – including Bitcoin – carries various risks. The biggest difference between a digital currency and traditional currencies is that there is no physical representation. A Bitcoin does not actually exist tangibly; it cannot be withdrawn from an ATM like a U.S. dollar, yuan or euro. Proponents of digital cryptocurrencies tout that as an advantage: They cannot be physically lost.
Other oft-cited advantages include:
- They present a lower chance of identity theft than credit cards.
- They allow consumers to complete purchases without providing personal information.
- They do not require financial institutions or intermediaries, which results in lower transaction costs.
- They are not bound by exchange rates or interest rates, although they do have transaction fees.
- They are constrained by limited amounts in circulation (Bitcoin is limited to 21 million bitcoins forever), as opposed to governments, which can always print more money.
- They are universal and can be used by anyone with access to the internet.
Preparing to use cryptocurrency
One advantage above can also be read as a disadvantage: The lack of financial institutions and regulators means more risk. Users of cryptocurrencies like Bitcoin must be prepared for the security risks and pitfalls of cryptocurrency.
Digital currencies are based on blockchain technology: a digital public ledger that allows transactions to be processed without a central authority (e.g. a bank or clearinghouse). The buyer and seller interact directly, without verification by a trusted third party. Each record on the blockchain is sent to the network after the network accepts it as a valid transfer. Once verified, the blocks cannot be changed.
When someone buys or receives Bitcoins or other digital currencies, they are given a digital key to access and validate transactions. To keep the key safe, and avoid identity or actual theft, a cryptocurrency wallet should be employed. These can be desktop, online or mobile versions that enable the user to encrypt and store the keys.
To the layman, cryptocurrencies appear to be relatively secure. Like any technology, however, there are vulnerabilities to be aware of.
First, cryptocurrency holders do not own their money invested or received. Similar to owning stock, the entity in which one invests is the owner of the money, unless someone exchanges his or her digital funds for another currency. People using any currency are relying on an underlying infrastructure, security system, government or process to ensure that the money is protected, (a counterparty risk). However, banks and other entities have strict regulations as to how they handle money, and are backed by the FDIC.
Second, cryptocurrency market prices have at times been highly volatile. Cryptocurrencies still comprise a small part of the global financial picture, but regulators and policymakers are monitoring them for potential impacts to financial stability or any broader risk. That could lead to another risk: regulatory or government intervention. For example, China cracked down on Bitcoin use over concerns about the flow of funds and the ability to monitor taxable gains.
As a form of money, cryptocurrency brings with it the potential for fraud. There have already been a few high-profile cybercurrency exchange hacks. One of the largest digital heists affected the Decentralized Autonomous Organization (DAO), a fund involved with the Ethereum cybercurrency. Hackers gained control of more than $50 million from the fund. The hack caused the price of Ethereum to tumble, leading to broader cybercurrency market correction. With no FDIC or other insurer, there is the risk that those holding cryptocurrency could lose the entirety of their investment.
An additional fraud risk involves the private key. Keeping it or the information stored in a physical location, whether on the computer, a flash drive or papers, leaves one vulnerable to theft, fire or natural disasters, unless the information is backed up elsewhere. An estimated 25 percent of the Bitcoins that are in circulation have been lost. If true, that means approximately $18 billion in value is now unrecoverable.
Most pundits believe that cryptocurrencies are here to stay. More investors and companies are using cryptocurrency. The Chicago Mercantile Exchange reported that it would offer Bitcoin futures soon, which could result in a host of institutional investors. Only a handful of ETFs and other exchange-traded products exist that invest in and derive value from cybercurrencies, but more vehicles could emerge when they study the results of early adopters. For example, Grayscale's Bitcoin Investment Trust (GBTC) has reportedly attracted $1.2 billion in assets.
It remains to be seen, however, which cryptocurrencies will wind up as the eventual international leaders. If too many are issued, it could lead to a devastating devaluation of them all, and the “money of the future” might quickly become a thing of the past.