If you were judging simply by their eye-popping climb in value, Bitcoin, Ethereum, and other “cryptocurrencies” might look like a surefire investment.
If you’d bought $4 worth of Bitcoins in 2010, today you’d be $4.4 million richer. In the span of a month this year, the price of Bitcoin increased 100%--from $3,000 in September to nearly $6,000 in late October, according to an article in Fortune.
Bitcoins and other cryptocurrencies have gained so much popularity as an asset class that some large-asset management firms even have filed initial registration paperwork with the United States Securities and Exchange Commission to offer exchange traded funds (ETF’s) that invest solely in cryptocurrencies. But before you convert your 401(k) into cryptocurrencies, considered that these investments come with a lot of risk..
What is a Cryptocurrency?
According to investment website Investopedia’s definition, a cryptocurrency is “a digital or virtual currency that uses cryptography for security.” A cryptocurrency is literally an entry on what is called a “blockchain,” a digital means of identifying the owners of all cryptocurrencies in existence. (Click here for a handy infographic about how blockchain technology works.)
There is no physical coin, but instead simply a master ledger that lists the owner of the virtual currency. The best way to think about cryptocurrency is like how the stock market operates in the electronic age. Owners of stock rarely (if ever) receive a share certificate, instead the investor’s ownership information is simply tracked by the company or its registration agent.
Cryptocurrencies rose in popularity after the 2008 financial crisis as part of an effort to create a currency that was not controlled by any government or central bank. Among Bitcoin or other cryptocurrencies’ greatest benefits are that they are very difficult to counterfeit due to their security features. There is also a finite amount available. In the case of Bitcoins, there is a “hard” limit of 21 million; once that many have been “mined,” then no more Bitcoins will be available.
The Risks of Cryptocurrencies
The flip side of cryptocurrencies’ enhanced security features and anonymity offered by investing in cryptocurrencies is matched by their riskiness. Japanese Bitcoin exchange Mt. Gox shut down in February 2014, leaving customers who had used the exchange to store their BitCoin without access to the virtual currency. According to a Cyberscoop post on the Mt. Gox scandal, nearly 850,000 Bitcoins worth more than $450 million at the time (and billions today) went missing when the world’s largest Bitcoin exchange at the time was mysteriously hacked.
Finding a place to securely store your Bitcoins is surprisingly difficult. Many users have their Bitcoins in web-based wallets like Mt. Groix that they access with a key, a private number like a debit card’s PIN, and those are vulnerable to hacks. A writer at Wired wrote about how he put his Bitcoins into a more secure “hardware wallet,” but then he lost his PIN and embarked on a harrowing journey to try and get his $30,000 back.
“If I’d lost my debit card PIN, I could contact my bank and I’d eventually regain access to my funds. Bitcoin is different,” he wrote. “No one owns the bitcoin transaction network. Instead, thousands of computers around the world run software that validates the system’s transactions. Anyone is allowed to install the bitcoin software on their computer and participate. This decentralized nature of the bitcoin network is not without consequences—the main one being that if you screw up, it’s your own damn problem.”
The new Wild West
Of course, if you put your traditional money in a bank, that institution could fail, too, but in the United States, the whole financial system is organized around credit ratings to offset risk and protect consumers. For instance, the federal government insures credit unions and traditional banks up to $250,000 per investor, so if they fail, you still get your money back. Newer technology in the financial space doesn’t come with these same protections.
Other cryptocurrency exchanges have abruptly shut down or filed for bankruptcy; cryptocurrency investors have had their email or cell phones hacked, allowing thieves to identify the security codes to access the investor’s cryptocurrencies holdings and make off with them; and governments have abruptly shut down exchanges, which happened recently in China.
While cryptocurrencies have offered dizzying returns in the past several years, multiple scandals have resulted in investors losing access to their money with no warning whatsoever. And while Bitcoin is the first and most well-known cryptocurrency, there are now more than a thousand of them—the rapper Ghostface Killah is even making one—some of which inevitably will be duds.
So before you sink substantial money into a cryptocurrency, consider the potential pitfalls. It’s still the Wild West out there—and the potential high rewards carry just as much as risk.
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