Breaking Down Cryptocurrency: Risks, Rewards and Red Flags

Disclaimer : This is not investment or legal advice. This article is for informational purposes only.

The year 2009 witnessed the birth of decentralized digital currency ,using blockchain technology. Bitcoin was created by Satoshi Nakamoto.Satoshi Nakamoto is the name used by the presumed pseudonymous person or persons who developed bitcoin. Fast forward to 2021 , Blockchain is the new ‘Buzzword’ on the block and the total number of cryptocurrencies is 7,812 with a total market cap of $324.716 billion (as of January 20, 2021) ( Source Coin Market Cap)

When the cryptocurrency boom first began, a huge number of people saw an opportunity to get rich by creating their own cryptocurrency. This led to a rapid increase in the number of currencies in circulation, as more hashing algorithms were added to the blockchain.

The crypto market has grown rapidly in the last five years. With all these cryptocurrencies,coins, tokens, blockchain companies, it becomes quite challenging to make sense of the crypto world.

Let's start with the basics.

What is crypto currency ? 

The easiest way to understand cryptocurrency is to look at it as a form of stored value (money) that is not linked to governments or central agencies like banks, states, or companies. All records of its creation and transfer between its users is stored in a big digital book. This digital “ledger” is referred to as the “blockchain”, which also serves to authenticate transactions. The central ledger is maintained online, through a network of servers. These servers are operated by members of the general public, who agree to lend their computing power for the verification process utilized on the ledger and “blockchain”, in return for the possibility of receiving newly “minted” cryptocurrency in their name. 

Most of the verification processes involved in cryptocurrency transactions are automated, and the digital currency “miners”, as they are called, usually download software and programs which run on their machines, to fulfill the requirements of their respective cryptocurrency. In fact, the authentication of cryptocurrency utilizes so much energy, that many recent environmentalists have warned that cryptocurrency mining is causing detrimental effects on the levels of carbon dioxide in the atmosphere. The carbon footprint left by cryptocurrency energy consumption is considered to be significant. Forex Suggest, a South Africa–based site that provides education on trading and financial markets, estimates that Bitcoin alone emits some 57 million tons of CO2 annually, more than double Ethereum’s (another popular cryptocurrency) footprint.

 With the use of blockchain technology, cryptocurrency is supposed to be  hard to steal or seize, and it may be used to facilitate transactions across the world. In fact, many banks are also incorporating blockchain technology to manage their own transactions and fiat (“real”) currency stores.The end result is that Cryptocurrencies make it possible to lend, sell, buy, or borrow without an identity, credit score, or even a bank!

What are the different types of cryptocurrency?

The classification of cryptocurrencies can be as complex as the concept. The simplest is to split these into three categories: Bitcoin, Altcoin, and Tokens.

Bitcoin

It’s a digital currency you can send to others; perhaps has a gift, or as payment for services and/or products.

Bitcoin acts like money in a purely digital form. In addition, Bitcoin transfers are completely decentralized as well. In other words, no bank or third party regulates it’s circulation.

When using Bitcoin, every transaction takes place between users on what is called a P2P (peer to peer) network. Since no third-party is needed to control transactions, there’s no reason to identify yourself. You could start making payments and remain anonymous while doing so.

Though Cryptocurrencies operate independently ,without a bank or a central authority, new units to the total supply of Bitcoin can be added only after certain conditions are met. For example, with Bitcoin, only after a block (a specific portion or section of the digital “ledger”, i.e. x amount of entries) has been added to the blockchain will the miner be rewarded with bitcoins, and this is the only way new bitcoins can be generated. The limit for bitcoins is 21 million; after this, no more bitcoins will be produced. 

In addition, the miner is not guaranteed the reward of newly minted Bitcoins, and the process of receiving the newly minted coin is determined by a lottery-like process, whereby the miners who are working to verify transactions must guess the system generated number or “hash”. The first miner to solve the cryptographic “hash” puzzle (required to verify the transaction), is rewarded with the newly minted bitcoin. Cryptocurrency transactions are also sometimes referred to as “smart contracts” between buyers and sellers of the cryptocurrency. Since no physical currency is exchanged between parties, the verifier can be looked at as a digital “witness” to this transaction of digital bits of information between two parties. 

Altcoins

Altcoins , as the name suggests, are alternatives to Bitcoin. Ether, Litecoin, Dogecoin, Ripple, and Monero are all examples of Altcoins.

However some Altcoins use different ‘hashing’ algorithms ,like for instance, Factom is an altcoin that’s using PoS or Proof of stake. Here, there are no miners, only stakers.

These are individuals who are verifying transactions in exchange for rewards, much like miners. Rather than verifying blocks before anyone else, they’re chosen one by one, while receiving turns to gain the suggested rewards.

Tokens

Among the three forms of cryptocurrency, some consider this category as being the most interesting. Tokens are totally unique in that they don’t have a blockchain of their own. They’re being used on decentralized applications or dApps. These dApps are made to make use of and verify smart contracts. The best way to understand a token is to look at it in comparison to cryptocurrency, in the same way as an object of value, such as a “gold coin”, is utilized in relation to physical money. “Non-Fungible Tokens” are often sold by celebrities, and can represent digital memorabilia, autographs, videos and photos (i.e. collectors items). 

How do I buy cryptocurrency?

While some cryptocurrencies, including bitcoin, are available for purchase with U.S. dollars, others require that you pay with bitcoins or another cryptocurrency.

To buy cryptocurrencies, you’ll need a “wallet,” an online app that can hold your currency. Generally, you create an account on an exchange, and then you can transfer real money to buy cryptocurrencies such as bitcoin or Ethereum.

Can I encash cryptocurrencies into physical cash ?

The safest method to convert any cryptocurrency into cash is through an exchange or a broker. This is quite similar to the currency exchange system at airports of a foreign country.You deposit your cryptocurrency into an exchange and request a withdrawal in the currency of your choice. The withdrawal will be paid into your bank account. The time for money to reach your account is about 4-6 days. In addition, crypto exchanges also charge a fee for the transaction, which differs from broker to broker.

It is worth noting that if you cash out your crypto assets, you will need to pay taxes on your profits — although crypto currently exists in a legal grey area in most parts of the world, investing in this asset is not outside the scope of tax liability.

What are the risks involved in buying crypto assets?

Market risks

The market risks are peculiar as the currency trades only on demand for its imagined or intangible value proposition. In the absence of a value proposition, cryptocurrency trading may rely heavily on “speculation” and false hype. This is the main ingredient from cryptocurrency fraud, where a popular fraudster will hype up a cryptocurrency, receive heavy investments, and then disappear with the cash, leaving the currency to crash. This is known as a “rug pull”.

In addition, there is always only a finite amount of the currency which means that crypto assets can suffer from liquidity concerns. Limited ownership may make the currency susceptible to market manipulation as well.  Given the limited acceptance of cryptocurrency and a lack of alternatives, the currency can appear more volatile than other physical currencies,as it is fueled by hypothetical demand and aggravated by hoarding.

Operational Risk

When a centralized body validates and controls your transaction , it also has the ability to reverse the transaction if there is a problem. No such actions are possible in the case of cryptocurrency. After confirmation, a transaction cannot be reversed, there is no safety net.

Business risk

Loss of confidence in digital currencies is a major problem to contend with, especially for a large number of altcoins. The developing nature of the currencies is subject to a high degree of uncertainty. Online platforms have generated large trading activity by speculators seeking to profit from the short-term or long-term holding of digital currencies. Cryptocurrencies are not backed by a central bank, or a national or international organization, and their value is strictly determined by the value that market participants place on them through their transactions. This means that loss of confidence may bring about a collapse of trading activities and an abrupt drop in value.

Cyber/Fraud risk

Cryptocurrency is highly reliant upon unregulated companies, including some that may lack appropriate internal controls and may be more susceptible to fraud and theft than regulated financial institutions. Furthermore, the software needs to be regularly updated and may be suspect at times. Sourcing blockchain technology to vendors may result in significant third-party risk exposure as well, leaving the problem of the reliability associated with the crypto “verification” process in a state that is difficult to gauge and difficult to repair.

There is very little in the way of recovery options if cryptocurrency is stolen as well. If the keys are stolen from a user’s wallet, the thief can fully impersonate the original owner of the account and has the same access to the money in the wallet that the original owner has. Once the digital currency is transferred out of the account and that transaction has been committed to the block chain, the money is lost forever for the original owner. Tracking down the thief is often difficult, as cryptocurrency exchanges are hesitant to violate the privacy and anonymity of their users, while authorities are also hesitant to investigate or force exchanges to violate their terms with users, when they do not fully understand the crime in the first place.

Regulatory/compliance risk and Money Laundering

Some countries are still weary of this new trend and are concerned with money laundering. Countries may prevent the use of the currency or may state that transactions break anti money laundering regulations. Due to the decentralized process a single Anti Money Laundering approach cannot be applied. The anonymity of the process also makes cryptocurrency a ripe target for money laundering. Any criminal or fraudster can freely transfer money across the globe, using cryptocurrency. Price fluctuations are also not a major concern for money launderers, as most criminals expect to lose large sums (sometimes up to half of their proceeds), when creating the appearance of a legitimate transaction. For example, if they use accountants or “legitimate businesses” to declare and legitimize their proceeds, commissions paid to third parties and sacrificed as expenses (in the process of “cleaning the money”) can often exceed the fluctuations experienced by using cryptocurrency. Oftentimes, an inflating cryptocurrency will allow money launderers to experience windfall gains as well.

 The usefulness of the crypto market for criminals is one factor fueling the crypto market which cannot be ignored or readily denied, and it is probably one major reason for the high demand for digital currency.

Are cryptocurrencies a good investment?

Cryptocurrencies generate no cash flow, so for you to profit, someone has to pay more for the currency than you did. Contrast that to a well-managed business, which increases its value over time by growing the profitability and cash flow of the operation.

For those who see cryptocurrencies such as bitcoin as the currency of the future, it should be noted that a currency needs stability so that merchants and consumers can determine what a fair price is for goods. Bitcoin and other cryptocurrencies have been anything but stable through much of their history. 

If bitcoins might be worth a lot more in the future, people are less likely to spend and circulate them today, making them less viable as a currency. Why spend a bitcoin when it could be worth three times the value next year? 

That being said, there are certainly investors who have made money on digital currencies. Their methods and techniques are complex, sophisticated, and perhaps lucky on some occasions. 

To conclude, investors in cryptocurrency should proceed with caution. 

Next week we will discuss cryptocurrency further in our blog post about Financial Crimes and Money Laundering. Stay tuned!

(For any anti-fraud, anti-money laundering and other compliance assistance, get in touch with us today at info@borderlesscounsel.com!).