Introduction to Crypto Risks

Though Bitcoin, Ethereum, and most cryptocurrencies have fallen from their historical highs, the asset class remains popular, especially among investors more willing to adopt new technologies. Over a quarter of Americans and one-third of men under 50 have traded or used a cryptocurrency.

Despite this engagement, the public has sensed that cryptocurrencies carry a lot of risk. Three-quarters of Americans say they aren’t confident that cryptocurrency is reliable and safe. The total market capitalization of cryptocurrencies has fallen to less than $2 trillion from waves of sell-offs since peaking at $2.62 trillion on Sept. 30, 2021.

When working with clients interested in the technology, financial advisors need to ensure that they understand the potential downsides. These risks may affect investment returns, so investors should adjust their cryptocurrency holdings according to their risk appetite.

Understanding Crypto Risks

Cryptocurrencies are a young and unique asset class that faces many risks regarding market cycles, laws and regulations, cybersecurity, and much more.

Legal and Regulatory Risk

Governments and regulatory bodies have pushed to track cryptocurrency transactions, strip encryption protections, and regulate major cryptocurrency exchanges, which could remove a core benefit of the technology that boosts its usage and price. In China, the government has banned cryptocurrency altogether.

In the United States, the federal securities regulator, the Securities and Exchange Commission (SEC), has been considering a raft of new cryptocurrency regulations, including whether to classify ether (ETH), XRP, and other widely traded assets as securities. Such a classification may make it prohibitively expensive or unlawful for investors to purchase crypto on the open market, or it may put them in the difficult position of deciding whether to engage in the costly process of registering the securities and operating as broker-dealers.

Another risk of cryptocurrencies resides in the legal and regulatory aspects. Changes in taxation and government regulations could affect the value and costs of holding these digital assets or may cause investors to dump them in a hurry when panic sets in.

Unlike fiat currencies, bank accounts, and trades on registered exchanges, trades using cryptocurrencies are not protected by law. There are no dispute processes or ways to reverse transactions, as traditional systems can do. Once a token's ownership is transferred, voluntarily or involuntarily, there is no getting it back unless the new holder sends it back.

Market Risk

Crypto can be subject to significant volatility, even among the major coins. For example, from Nov. 7 to Nov. 14, 2023, Bitcoin saw its price swing from a low of $34,620 to a high of $37,970, then back to $36,500.

That is an extreme level of volatility not seen in many other investments. These erratic price fluctuations have made them vulnerable to market manipulations, ranging from short squeezes and wash trading to painting the tape and pump-and-dump schemes.

Security Risk

Another notable concern is the security risks of locking down and transacting with cryptocurrency wallets. Crypto transactions can be instantly transferred without delay, and crypto wallet addresses are long strings of alphanumeric characters, making it easy to transfer assets to the wrong party and for investors to become targets of criminals. Billions of dollars have been lost to faceless crypto scams, lost or forgotten keys, and key thefts.

Liquidity Risk

One of the most often talked about aspects regarding many cryptocurrencies is limited liquidity. Bitcoin is the most traded cryptocurrency, and as of January 2024, exchange-traded funds backed by bitcoin are legal. These instruments reduce liquidity risks for this cryptocurrency, but many other coins face liquidity issues because of their lower trading volumes.

Investors who corner themselves into a cryptocurrency with low volume may have a hard time getting out of their positions.

Business Risk

Business risk is not often associated with cryptocurrency but can be present. If a blockchain-related company issues a cryptocurrency, that coin will inherit the risks internal to the issuer. For example, imagine a company is developing a blockchain service, and its cryptocurrency is available on the market. It failed to raise enough capital or budget properly, causing financial issues. The coin's value would likely fall as a result unless it had value tied to something else investors were interested in.

Concentration Risk

There are thousands of cryptocurrencies on the market, many of them with billions of dollars in daily trading volume daily. However, only a handful might be worth investing in, depending on the client's preferences, budget, risk tolerance, and goals. This might lead them to concentrate on one or a few coins. While not an issue if their portfolio's cryptocurrency allocation is tempered by less risky and volatile investments, it could become an issue if they decide to invest more than is practical for their circumstances in a few cryptocurrencies.

Mitigating Crypto Risks

Knowing that steps can be taken to mitigate risk could change the risk tolerance of clients who are ambivalent about investing in cryptocurrencies or weighing how their investment strategy should look if they’ve chosen to commit to the asset class.

Diversity

Diversification and systematic investment plans are some of the most basic and essential strategies for limiting risk. If a client’s crypto holdings are only a small percentage of their overall portfolio, then even a catastrophic fall in the value of crypto won’t entirely ruin their efforts to boost their wealth. It’s also possible to diversify within the world of crypto, holding not only Bitcoin but also multiple other coins.

Diversified products such as mutual funds, index funds, and exchange-traded funds (ETFs) with exposure to crypto assets and companies, and non-discretionary systematic investing methods such as buy-and-hold and dollar-cost averaging (DCA), are usually recommended by financial advisors to clients with high-risk tolerance for crypto—itself an asset class that is already riskier than average.

Stay Informed and Secure

Staying up to date on industry changes, double-checking where transactions are sent, holding cryptocurrencies in a multi-signature wallet that requires more than one party to approve transfers, and moving assets into a cold storage solution—an offline wallet—can minimize the odds of lapsing on efforts to hedge against a regulatory measure, sending money to the wrong destination, and becoming a victim of a hack.

Educating Clients About Crypto Risks

Financial professionals have many strategies and resources available for educating clients on the risks of investing in cryptocurrencies.

Readings and videos are widely available online. News outlets and books report on issues related to the cryptocurrency space. Financial institutions, government agencies, and policymaking entities offer fact sheets and other informational materials highlighting problems that plague these digital assets.

Simulation tools, paper trading, and interactive wallets can demonstrate the tensions of trading cryptocurrency. These resources can show real-time price slippages and volatility swings that shake up cryptocurrency markets daily and the difficulties of setting up, securing, and transacting with wallets.

Assessing Client’s Risk Tolerance

Sizing a client’s risk tolerance is essential if they’re considering crypto. Given the large upheavals in crypto prices, clients will naturally have more sensitivity to their investments.

Someone primarily concerned with capital preservation who fears losing even a small amount would likely prefer more conservative investments and, thus, isn’t a good candidate for buying cryptocurrencies. However, people less sensitive to large price fluctuations may be more open to investing in or trading this asset class.

Directly asking the client about their risk tolerance can help lead this discussion. While not everyone can give you a complete answer, many people know the level of risk that they can comfortably handle. If they aren’t prepared to give an answer, present surveys and explore hypothetical examples to pick up on clues and get a feel of their ability to handle risk another way. A questionnaire can help clients determine their cryptocurrency tolerances. For example, a young person might state they are investing for retirement, so they have a higher tolerance for risk than an older client who wants to retire in the next year.

Addressing Common Crypto Concerns and Misconceptions

There are many common misconceptions and concerns that people have about cryptocurrencies. Most are concerned about the technology's ethical, social, and cultural impact. Clearing these issues can help clients remove mental roadblocks to deciding whether crypto investing is right for them. Here are some of the more popular concerns:

• Myth #1: Digital currencies have no value. Value, as with everything else, is in the eye of the beholder. There may be no intrinsic value behind some coins, as defined for traditional investments, but historically, if a group of people believe something has value, it has value.
• Myth #2: Cryptocurrency is only used by criminals. The highest volume of cryptocurrency transactions related to illegal activities occurred in 2022, according to data from crypto forensics firm Chainalysis. But the data also indicates that these transactions accounted for just 0.24% of all crypto transactions that year.
• Myth #3: Cryptocurrency wastes energy. Some cryptos rely on energy-intensive mining that requires an ever-growing number of powerful computers. On Jan. 14, 2023, the Bitcoin network alone averaged an annual consumption of 137 terawatt-hours (TWh) of electricity, roughly equal to the yearly power consumption of the entire nation of Ukraine. But proponents point out that the existing financial system requires many more resources, such as employees (very expensive), networks and infrastructure, data storage, electricity, facilities, and more. Additionally, blockchains like Ethereum use far less energy than Bitcoin.
• Myth #4: Cryptocurrency creates extra e-waste. Environmental concerns are among the most significant complaints that people have about crypto. Introducing a new bitcoin is a competitive process, and because of its value, miners upgrade their facilities frequently as faster mining machines are developed. Other cryptocurrencies do not require the resources the Bitcoin network does, so they produce less e-waste. So, some cryptocurrencies produce a lot of waste, while others don't.

Clients worried about climate change and sustainability may want to consider environmentally friendly blockchains and tokens that use less power consumption and have a lower carbon footprint. Proof-of-stake (PoS) blockchains are much less energy-intensive, as are others that use alternative consensus protocols.

Communicating Crypto Risks in Client Meetings

Crypto is new and exciting, so many clients may be interested in diving in headfirst without fully grasping the risks. Financial advisors should communicate the risks of trading cryptocurrency when meeting with first-time clients and enthusiastic investors by setting realistic expectations. The asset class has seen periods of explosive growth in value in previous years. Some investors may hope to see immediate, significant gains by investing in crypto without knowing that most of this wealth went to a small group of lucky traders and elite insiders.

Visual aids and news coverage can be very useful to delineate these expectations. While Bitcoin’s price since 2010 has seen a strong upward trend, a graph of its price since 2018 will show wild swings and an overall decrease in price. Pointing to recent events affecting everyday investors, such as the collapse of crypto exchange FTX, can make the risks seem more immediate and relatable.

The Bottom Line

With interest in cryptocurrency continuing to hold, financial advisors should have a working knowledge of the risks of crypto markets while acknowledging the potential benefits to shield client wealth without missing investment opportunities.

The comments, opinions, and analyses expressed on Investopedia are for informational purposes only. Read our for more info. As of the date this article was written, the author does not own cryptocurrency.