Introduction to Crypto Risks

Though Bitcoin, Ethereum, and most cryptocurrencies have fallen from their historical highs, the asset class remains popular, especially among investors who are 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 risks, and investment has thus dwindled. Three-quarters of Americans say they aren’t confident that cryptocurrency is reliable and safe. The total market value of cryptocurrencies has fallen to $1.39 trillion from waves of sell-offs since peaking at $2.62 trillion on September 30, 2021, or by about fifty percent.

When working with clients interested in the technology, financial advisors need to ensure they understand the potential downsides. These risks may affect investment returns. Investors should, therefore, adjust their holdings of cryptocurrencies 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, and cybersecurity.

Crypto can be subject to significant volatility, even among the major coins. For example, from November 7 to November 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 manipulation ranging from short squeezes and wash trading to painting the tape and pump-and-dump schemes.

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.

Many cryptocurrencies are intended to serve as anonymous, untraceable ways of sending and receiving financial payments; this could contribute to money laundering. 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 Ethereum, Ripple, 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 having to decide whether to engage in the costly process of registering the securities and operating as broker-dealers.

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.

Dozens of crypto exchanges have suffered data breaches and hacks that have bilked millions to billions of dollars from customers. Large investors, nicknamed “whales,” have been threatened or coerced to hand over cryptocurrency wallets. Self-custody wallets, or wallets kept independently off third-party services, are prone to having access credentials mismanaged or discarded. Countless stories abound of investors making typos in receiving addresses and losing crypto forever because they deleted files or threw away papers containing their wallets’ private keys and seed phrases. Billions of dollars have been lost to faceless crypto scams.

Unlike banks, crypto services don’t offer physical sites to withdraw money, which means that other than passcodes for getting funds, there are no extensive, built-in authorization and user-friendly interfaces that reduce the risk of errors.

Bank transfers aren’t done by sending money to a bank account number, but by name, email address, and other readable identifiers. Crypto counterparties could use unregulated crypto services that don’t collect user information or comply with legal requests. Crypto can be stolen almost instantly without visibility into the thief’s identity, and recourse to recover it is by the crypto service plugged into a standard financial system with other exchanges and platforms, such as the ACH and SWIFT banking systems.

Educating Clients About Crypto Risks

Financial professionals have many strategies and resources to educate clients about the risks of investing in cryptocurrencies.

Readings and videos are widely available online. News outlets and books on issues related to the cryptocurrency space. Financial institutions and governmental and policymaking entities offer fact sheets and other informational materials highlighting problems that plague 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 up a client’s risk tolerance is important 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 and fears losing even a small amount would likely prefer other less volatile investments like bonds. and 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 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 survey can ask clients when they want to use the money they’re investing. A young person investing for retirement likely has a higher tolerance for risk than someone who wants to retire in the next year. Someone saving for a down payment on a home may have a lower risk tolerance because they want to meet a significant financial goal immediately.

Addressing Common Concerns and Misconceptions

There are many common misconceptions and concerns that people have about cryptocurrencies. Most have to do with 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.

Common misconceptions are that digital currencies have no value and that cryptocurrencies are primarily used for illegal activities.

Many cryptos, including bitcoin and ether, are tied to blockchain technology and applications with real-world use, giving them additional value. And while 2022 saw the highest volume of cryptocurrency transactions related to illegal activities, data from crypto forensics firm Chainalysis indicates that these transactions accounted for just 0.24% of all crypto transactions that year.

Environmental concerns are among the most significant complaints that people have about crypto. Many cryptos indeed rely on energy-intensive mining that requires an ever-growing number of powerful computers to run. As of November 2023, the Bitcoin network alone used 139.16 TWh of electricity over the last year, roughly equal to the annual power consumption of the entire nation of Ukraine.

Clients worried about climate change and sustainability may want to consider environmentally friendly cryptocurrencies designed to reduce their power consumption and carbon footprint. Proof of stake (PoS) blockchains rely on human consensus to mint new cryptocurrencies and validate transactions as an alternative to mining-dependent proof-of-work (PoW) blockchains. Some PoW blockchains substitute green energy like solar and wind power for fossil fuel electricity.

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.

Diversification and systemic 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, 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 just Bitcoin but 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 systemic 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 already riskier than average asset class.

Jay Zigmont, founder of Childfree Wealth, says, “If clients ask me about crypto, I tell them not to buy it, but frankly, it is their money. With some clients, we end up setting aside a small percentage of their investments, usually less than 10 percent, for ‘gambling’ in single stocks, crypto, or whatever they want. Setting aside a playground for them prevents them from going 100% into crypto or any single stock. I do not provide advice on their playground, and it is very clear that it is money they are risking.”

Technical oversight, quality assurance, and informational awareness also mitigate crypto risks. That means using high-grade and premium security products, exercising caution with back-up plans and failsafe measures, and keeping abreast of new developments in the space.

Staying up to date on industry changes in the news, 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 that cuts off Wi-Fi connection, can minimize the odds of lapsing on efforts to hedge against a regulatory measure, sending money to the wrong destination, and getting robbed or hacked in-person or online.

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 2021 will show wild swings and an overall decrease in price. Pointing to recent events affecting everyday investors, such as the collapse of crypto exchanges FTX, can make the risks seem more immediate and relatable.

Resources for Further Education

Cryptocurrency is a financial product and technology witnessing rapid changes from many directions. Reading educational material and keeping up to date on developments in the space are essential for financial advisors who work with clients who may seek out advice about crypto investments.

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.