In this article we will explain the risks that exist when investing in cryptocurrencies. Each asset class has specific risks that we will address in this blog.
We will look at the risks in the major asset classes such as cryptocurrencies, equities, commodities, fixed income and also financial derivatives (with particular emphasis on CFDs and binary options) which are financial products that use the aforementioned asset classes as a reference value (underlying).
The informative purpose of these articles allows us to summarise and synthesise, focusing on the most relevant aspects, so that all our readers are able to easily understand what we are trying to explain.
Market risk in cryptocurrencies
When we think about the risk of an investment, the first thing that comes to mind is market price variation. This risk is called market risk and tells us what the possible variation in the returns of an asset is as a result of being listed on financial markets. These variations are produced by the interaction between supply and demand.
In order to estimate the behaviour of an asset, we use historical data to perform a statistical analysis and extract a figure (ratio). These ratios allow us to characterise an asset and use it as an indicator to estimate its behaviour in terms of risk.
The measure that is generally used in industry to calculate that uncertainty in the behaviour of a financial asset in the market is volatility. Volatility measures the historical dispersion of an asset’s return relative to its average return. The greater the dispersion of results, the greater the uncertainty, and thus, the greater the market risk. Volatility uses historical data and is used to characterise the market risk of an asset and can help us to estimate its possible future behaviour.
The problem with cryptocurrencies is that in order to be able to carry out a statistical calculation of the data available to us and to extract a ratio that defines it so that it can be used as an estimator of its future risk, we need a sufficiently representative historical series. In addition, from a qualitative perspective, the data cannot behave in an unsteady or erratic way, since we are interested in use its historical past as an estimate of its future behaviour
Additionally, in order for historical data to be used to estimate the future risk behaviour of an asset, we must be able to identify the factors that cause the price movements of that asset. In a financial asset such as a share we have significant explanatory factors. Thus, in terms of risk, the analysis of the historical behaviour of a share is a good statistical tool for estimating its possible future behaviour, since the factors that explain its behaviour tend to be reproduced in the long term.
In the case of cryptocurrencies there are no relevant factors that can explain their behaviour. This means that their movements are due to factors we cannot determine and therefore the historical data that we could use to estimate their future behaviour does not help us for this purpose (Risk Analysis of Crypto Assets – Two Sigma).
The historical volatility of the major cryptocurrencies has been 4 to 5 times higher than the volatility of one of the major US stock markets, as represented by the S&P 500 Index. This data allows us to draw two conclusions: the first is they are very high risk and the second is that at those levels of dispersion, statistics no longer work correctly to estimate future behaviours.
Diversification into a portfolio of cryptocurrencies
Another issue we encounter with cryptocurrencies is that if we want to diversify by building a portfolio with some of them, the problem is that the behaviour of cryptocurrencies is highly correlated.
Diversification will reduce the risk of a particular cryptocurrency by its individual characteristics. But, unlike financial assets, faced with different market situations (market risk), the behaviour among them is generally very similar. Therefore, the diversification effect to reduce market risk does not have the intended result.
Other relevant risks
Cryptocurrencies, because of their particular characteristics, have some additional risks that must be kept in mind:
- They are highly unstable and unpredictable. They are subject to extreme uncertainty. Any arbitrary event on the part of a major investor can lead to sudden falls or disappear completely.
- Although work is being done on this, they are not yet regulated by any official body. There is no regulation or governmental body that monitors this market and its members or offers standard protection to investors.
- Lack of legal framework. It is not possible to claim damages, despite the fact that some of the exchanges are registered and the platforms act in some ways as a kind of virtual bank.
Cryptocurrencies are intangible digital codes for which there are no property rights. If they are stolen from a virtual wallet, the owner cannot identify the thief either. This is one of the reasons why they are so attractive to hackers and fraudsters.
Also, if the identification code of a virtual wallet is lost, it means the total and unrecoverable loss of its contents.
- Its “value” is a consequence of pure supply and demand without a real asset to support it. For example, when we invest in a company share, regardless of the market price, there is a real company behind it that supports its value.
- The mortality rate of cryptocurrencies is in the order of 50%. In many cases and for various reasons, small investors do not have time to withdraw their investments and lose everything. The reasons are not solely down to the hackers. To support the functioning of a cryptocurrency many resources are needed, both technological and financial, and many fail in the set-up stage or after a while.
Conclusion
Cryptocurrencies might be a financial asset of high interest in the not-too-distant future. Its success will depend, mainly, on the degree of acceptance it generates in the general economic and institutional sphere and on the evolution of the regulations of different countries and bodies in order to generate more security for the investor.
Currently, we can conclude that they are assets that, because of their risks, are considered speculative assets.
