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Cryptocurrencies are alluring but associated with high volatility

Cryptocurrency is prone to cybercrime and fraud. Cryptocurrency's novelty and lack of information allow con artists to trap the less informed - often the elderly - easily.

Rushil Gupta Sep 16, 2022
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The cryptocurrency market has seen a volatile valuation: it rose from being worth 135 billion USD in January 2019 to 2700 billion USD in November 2021. It then fell to 945 billion USD in June of 2022. Its erratic loss in value unravels systemic flaws of cryptocurrency, which Bank of England's Vice Chair Lael Brainard believes may cause financial instability. 

Many investors lost considerable capital, even their life savings when the Terra ecosystem collapsed in May 2022: the price of the ecosystem's coin fell from about $80 to less than 1 cent. Moreover, these new assets' decentralized and unregulated nature correlates them with price volatility, leverage traps, and frauds.

Examining the impact of cryptocurrencies on retail investors, inexperienced individuals should stay vary of cryptocurrency due to its volatile nature. For instance, Bitcoin moves by an average of 2.6% daily, much more than the 0.83% average daily movement of the S&P 500 index. For novice investors, sustaining such volatility is stressful and can lead to emotional decisions, leading to higher risk exposure, which makes profits an anomaly.  

The impact of the volatility on retail investors is multiplied by the high leverage that cryptocurrency exchanges provide, which often leads to the complete loss of capital. Popular cryptocurrency trading platforms such as Binance and ByBit offer incredibly high leverage, as high as 500x. Leveraged trading is when a trader uses debt to increase their position size. High leverages in such volatile assets often result in forced liquidations. 

High volatility

For example, a 500x leverage would mean an investor loses 100% of their capital in a slight movement of 0.5% and is forcefully liquidated. In sudden crashes, many investors are liquidated, leading to "waves of liquidations," as witnessed in the fall of TerraLuna. These forced liquidations act like "death spirals," where the first wave of forced liquidation pushes the price down even more, which causes more investors to get liquidated. 

When the high volatility of cryptocurrency is combined with the high leverage trading platforms offer, traders can often get all of their capital wiped, which acts as roadblocks to their goals or even leads to traders quitting.

Moreover, cryptocurrency is prone to cybercrime and fraud. Cryptocurrency's novelty and lack of information allow con artists to trap the less informed  - often the elderly - easily. There have been many reports of such fraud. 

For instance, in India, 'fake' cryptocurrency trading platforms have accounted for more than 128 million USD being stolen. Even applications such as exchanges are prone to be hacked. To counter this, governments worldwide are creating rules and regulations. Yet, due to the decentralization and pseudo-anonymity of users, it is near impossible to have such control of most cryptocurrencies.

Asset bubbles

When looking at the impact of cryptocurrencies on a grander scale, and in the long term, they are also prone to forming asset bubbles. An asset bubble refers to a situation where the price of an asset exceeds its fundamental value by a large margin. What makes asset bubbles dangerous is that they are speculative and hard to recognize until they burst–when it is too late. When a bubble bursts, the asset price falls rapidly, and most investors' wealth is lost, especially latecomers. 

Throughout history, many asset bubbles like the "2008 Housing Bubble" and the "Dot-Com Bubble" have led to catastrophic effects and years-long recessions. If we look at the past, we notice that the cryptocurrency market has already formed and burst many bubbles, such as in 2011 and 2021. As the market grows, the effects of these bubbles would be on a grander scale. Consequently, they could cause economic impacts such as recessions or significant economic slowdowns.

While this flawed cryptocurrency ecosystem is not yet huge enough to threaten global financial systems, the possibility of its growth has made large-scale institutions take precautionary steps. These include the ban of cryptocurrencies in many countries, increased taxes to reduce usage, the introduction of central bank digital coins (CBDCs) to detract buyers from traditional cryptocurrencies, and more.

When the cryptocurrency market grows substantially in the long term, adopting stablecoins - cryptocurrencies pegged to another asset such as the USD - can threaten banks. Stablecoins, unlike traditional coins, allow investors to own cryptocurrency with virtually no fluctuation in value. Where banks charge hefty fees, they offer cheap international transfer fees. Moreover, with an estimated 5.4% of US households being unbanked, stablecoins allow investors (especially those unbanked) to access modern-day finance tools, such as loans, and fast transactions, acting as alternatives to banks. 

Wait for CBDCs

As a result, the effect of monetary policy is minimized, and central banks may lose control over the economy. To prevent this, many central banks have started to develop CBDCs, digital forms of their country's fiat currencies, allowing them to provide similar services as stablecoins while having complete control. 

With CBDCs getting introduced, the costs of central banks will also decrease, leading to cheaper and faster transactions, more privacy, and convenience. However, it must be noted that CBDCs cannot be implemented quickly due to the need for significant structural changes in the finance industry and ensured digital currency stability.

Conclusively, the cryptocurrency ecosystem provides a platform for investors to make outsized returns, but it is associated with very high risks. Therefore, for novice investors, it is best to stay away and not engage in the use of high leverage to prevent the loss of significant capital. However, cryptocurrencies offer various benefits which we cannot ignore. Therefore, most novice investors should wait for CBDCs to be launched and utilize benefits similar to that of cryptocurrencies.

(The writer is a student at Pathways School, Noida, India. Views are personal. He can be contacted at rushil.investing@gmail.com)

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