For those who underestimated the risks of investing in cryptocurrency until recently, the collapse of crypto exchange FTX in late 2022 and its domino effect on other firms was a wake-up call.
The leverage and solvency quagmire associated with Alameda Research, the trading arm of FTX, led to its bankruptcy and the arrest of CEO Sam Bankman-Fried. Worse, the whole string of events led to a loss of billions in the cryptocurrency market, as investors’ confidence declined and crypto’s market capitalization plummeted.
The FTX brouhaha and ensuing “crypto winter” followed the fall of stablecoin TerraUSD (UST) and its companion token LUNA in May 2022, which already had officials up in arms about regulating the burgeoning crypto industry.
Cryptocurrencies as a whole, and Bitcoin (BTC) and Ethereum (ETH) in particular, have bounced back a bit in the first part of 2023, sending the cryptoverse’s market capitalization over $1 trillion and prompting some to speculate that the crypto winter is over. But many financial advisors are still recommending that investors use caution and keep these investments limited to a small portion of their portfolios.
Risks of Cryptocurrency Investments
The recent fraud charges and accusations of mismanagement among some of the crypto world’s top names have demonstrated that the alarms sounded by regulators such as the Financial Industry Regulatory Authority, or FINRA, and consumer protection agencies – Consumer Federation of America, for example – are well founded.
According to the Certified Financial Planner Board of Standards, also known as the CFP Board, there are at least six specific risks involved with cryptocurrencies:
- Speculation and volatility.
- Difficulty in evaluating assets (separating facts from hype).
- Custodial risks that may lead to theft or loss.
- Difficulty in valuing crypto assets.
- Unregistered assets and providers operating outside of regulatory frameworks.
- Unpredictable regulations.
These risks have become evident in the relatively short history of cryptocurrency. Prices rise and fall dramatically, assets thought valuable have lost all their value, and theft and loss have occurred on a large scale.
In addition, traditional valuation methodologies are hard to apply to crypto assets, the regulatory framework has been uncertain, and some providers have operated outside whatever framework has been established.
These risks might not be enough for many investors to close the door on cryptocurrencies. However, the CFP Board recommends that investors embrace certain risk management strategies if they wish to continue investing in crypto. (See this booklet from the CFP Board for an inside look at how financial advisors may address crypto risk with clients.)
How to Manage Cryptocurrency Risk
The following cryptocurrency portfolio management strategies can cut down on the risk for crypto investors:
- Diversify your crypto portfolio.
- Choose a credible exchange.
- Use cold storage.
- Do fundamental research on digital assets.
- Keep tabs on the news.
Diversify Your Crypto Portfolio
Not putting all your eggs in one basket is one way to manage the volatility risk associated with cryptocurrency. There are several different ways to achieve such diversification:
Asset classes. Cryptos such as Bitcoin and Litecoin (LTC) are mediums of exchange (payment cryptocurrency), but Filecoin (FIL) and Binance Coin (BNB) are examples of utility tokens. Still others, such as Tether (USDT), are stablecoins. Nonfungible tokens, or NFTs, are another popular asset class. Spreading your investments across asset classes is an effective way to spread out the risk.
Use cases. Different cryptocurrencies are designed for various uses. ETH is the native currency of the Ethereum network, which supports smart contracts and the creation of various decentralized applications. Other cryptocurrencies are useful in decentralized finance, Internet of Things, supply chain management and more.
Industry. Finance, gaming, retail, technology and social media are some of the industries where cryptocurrency has been making waves and providing value.
Location. Inventors across the globe are developing crypto projects. Diversifying by location can also be a way to minimize risk associated with a particular region.
Market capitalization. Like stocks, there are large-cap, mid-cap and small-cap cryptos. Diversifying across market caps can be a good way to combine stability and growth.
Blockchain platform. Ethereum, Cardano, Stellar, Polkadot and others are blockchain platforms that facilitate the creation of smart contracts and decentralized apps. Diversifying among them is another way to reduce risk.
Choose a Credible Exchange
Custodial risks and the risk of investing with unregulated providers can be managed by choosing well-established, credible, liquid exchanges.
Though this aspect of risk management is not foolproof – FTX was the third-largest exchange when it “crashed” – at least it brings a higher level of confidence compared with obscure, unknown and illiquid exchanges.
Liquidity is important because it puts investors in a better position to move their assets elsewhere if they smell trouble. It goes without saying that protecting capital is more important than loyalty to an exchange.
Use Cold Storage
Cold storage is another way to manage custodial risks. Cold, or offline, wallets are safer than hot, or online, wallets.
Crypto investors who don’t have to regularly buy and sell can switch to a cold wallet after purchasing their crypto assets and move them back to a hot wallet when they want to make a transaction.
Do Fundamental Research on Digital Assets
When it comes to crypto investing, the key question when considering an asset is: What value does it provide? Though market speculation can drive price in the short term, it is the fundamental value that a crypto asset provides that will determine its long-term price movements.
Investors should ensure they are not overpaying for an asset by conducting the necessary research to determine valuation. Though traditional valuation methods are hardly a match for cryptocurrencies, there have been recent attempts to apply some of them to crypto: implicit value analysis, the discounted cash flow (DCF) model, equation of exchange, relative value analysis and other methods.
Investors should determine for themselves whether any of these methods can be applied to the types of digital assets they are considering.
Keep Tabs on the News
Although they shouldn’t jump at every negative report they hear, investors who follow reliable media reports are better equipped to detect events that affect their investments, such as a crypto exchange starting to go off the rails. They’ll also know when new and updated regulatory frameworks are issued, and will be able to judge assets and exchanges by those standards.
Cryptocurrency is still in its infancy, and no one can be sure what the future holds. But investors who are bullish on crypto’s future trajectory must still exercise caution and adopt strategies to mitigate risk. Speaking to a financial advisor will also put investors in a better position to evaluate their risk capacity and tolerance.
Copyright 2023 U.S. News & World Report