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Cryptocurrencies

The risks of investing in crypto

Page reading time: 7 minutes

Crypto-assets (crypto) also known as cryptocurrencies, coins or tokens are digital assets that do not have a physical form. They may not be backed by physical assets.

Crypto is a high-risk investment. This is because it is so volatile, often fluctuating by huge amounts within a short period.

As with any investment, you must be prepared to lose what you put in when investing in crypto.

How cryptocurrencies work

What is cryptocurrency

Crypto-assets (crypto) also known as cryptocurrency, virtual or digital assets, is an emerging type of asset class. It does not exist physically as coins or notes, but as digital tokens stored in a digital “wallet”. These digital tokens rely on cryptography and technology such as blockchain for security and other features. Crypto may or may not have an actual asset underlying it.

The Reserve Bank of Australia's website explains how cryptocurrency and blockchain technology works.

Crypto is used for payment systems, to execute automated contracts, and run programs. Anyone can create a crypto-asset, so at any given time there can be thousands in circulation.

Podcast: Crypto-assets for first time investors

Hear how crypto-assets work and what to think about before investing.

Why crypto is so volatile

Crypto is worth what people are willing to pay for it.

This means that the price of crypto-assets can fluctuate at extreme levels based solely on market speculation. Factors that can influence the price of crypto include:

How crypto is used

Crypto-assets were first developed as a digital form of currency, to be used as money. Some stores accept crypto as payment for goods and services, and some ATMs let you withdraw it as physical money. However, crypto is not legal tender in Australia and is not widely accepted as payment.

Crypto is more commonly used as a speculative, longer-term investment, as most people don’t access their balance for everyday transactions.

Buying and storing crypto

You can buy or sell crypto on a crypto trading platform using traditional money. Crypto is kept in a unique digital wallet or hardware wallet.

A user’s wallet has a set of private keys (unique codes) that are used to authorise outgoing transactions on the blockchain network. A wallet may be a software (hot) or hardware (cold) wallet. A hardware wallet stores these private keys on a secure hardware device not connected to the internet. This can protect the user’s wallet from hackers.

Scam alert: an increased number of Australians have reported losing money through crypto-asset or cryptocurrency scams.

Types of cryptocurrencies

Each cryptocurrency has different capabilities. Most were not created to be investments.

Some of the most common types are listed below, but this does not cover all of them. New cryptos are being created all the time, although many are not well structured and do not last.

Bitcoin

Name: Bitcoin (BTC)

What it is: Bitcoin is the native crypto-asset that runs on the decentralised Bitcoin network.

How it works: ‘Bitcoin miners’ use computer-intensive software to validate transactions that pass through the Bitcoin network. They earn new bitcoins in the process.

The Bitcoin network is a decentralised global ‘payment’ system that records transactions in a blockchain. Bitcoins are bought and sold in large volumes as a speculative investment.

Ether

Name: Ether (ETH)

What it is: Ether is the native crypto-asset used on the Ethereum network. Ethereum is an open-source platform, using blockchain technology.

How it works: Ethereum can process transactions, contracts and run other programs. So developers can create and run any program, in any programming language, on a single decentralised platform.

In the Ethereum blockchain, miners work to earn ether. Ether can pay for fees (called gas) and services within the network.

Litecoin

Name: Litecoin (LTC)

What it is: Litecoin is the name of a network and crypto-asset that was adapted from Bitcoin’s open-source code and modified. It is based on a global ‘payment’ network.

How it works: The Litecoin network processes transactions faster than the Bitcoin network. There are also more litecoins in circulation than there are bitcoins.

Ripple

Name: Ripple (XRP)

What it is: XRP is the native crypto-asset used for products developed by Ripple. Ripple is a network that allows real-time transfers between users in any currency or crypto-assets.

How it works: Ripple is a database in which users can store and transfer value in any currency on a protected network. Ripple uses crypto-assets created by others, rather than those mined or earned like on the Bitcoin or Ethereum network.

XRP and the associated technology has been popular with financial institutions.

Stablecoin

Name: Stablecoins

What it is: A ‘Stablecoin’ is a catch-all marketing term for crypto-assets that aim for low (or no) price volatility.

Many stablecoins aim to track the value of a government issued currency (for example, USD).

How it works: A stablecoin tries to stabilise its market value by various means such as by:

  • being physically backed by an external asset, such as government-issued currency
  • using algorithms to control the available supply of the asset, such as minting additional assets
  • using algorithms to control the demand for the assets, such as increasing an interest rate for holding the asset

Why investing in crypto is high-risk

Crypto is not regulated

Many crypto-assets and other digital assets are commonly not considered to be financial products. Because of this, the platforms where you buy and sell crypto may not be regulated by ASIC. This means you may not be protected if the platform fails or is hacked.

When a cryptocurrency fails, investors will most likely lose all the money they put in. In most countries, cryptocurrencies are not recognised as legal tender. You're only protected to the extent that they fit within existing laws.

The value depends largely on popular opinion

Investing in crypto-assets is highly speculative. The market value can fluctuate a lot over short periods of time, and is affected by things like media hype and investor opinion.

The price of crypto may depend on:

Your money could be stolen

Be aware that a hacker can potentially steal the contents of your digital wallet.

Your digital wallet has a public key and a private key (like a password or PIN). However, crypto-asset systems allow users to remain relatively anonymous and there is no central data bank. If a hacker steals your crypto-asset, you have little hope of getting it back.

Using a wallet that’s held offline, called a ‘hardware wallet’ or ‘cold storage’, may provide additional protection.

Technically complex

Crypto-assets can be technically complex and difficult to understand.

Unlike traditional financial products, there is usually no product disclosure statement or prospectus that explains in plain English, and in one place, how the crypto-asset operates.

A crypto-asset’s code may not always be available for users to review. In cases where it is available, it may be written in uncommon or obscure computing languages.

The processes for interacting directly with crypto-asset networks is also unfamiliar to many people. They may require special-purpose software and an understanding of how transaction fees operate. Unfamiliar users run the risk of:

Crypto scams are increasing

There are two main types of crypto scams.

  1. Fake opportunities to buy crypto
  2. Using your own crypto to invest or pay for something

Scammers try to trick people into investing in fake opportunities to buy crypto. Watch out for these tactics:

Read more about the tactics used by investment scammers.

Man sitting on stool using tablet.

Rhett is scammed $97,000 by a fake endorsement

Rhett saw an article on a news website about ‘The biggest deal in Shark Tank history, that can make YOU rich in just 7 days! (Seriously)’

The news article was really an advertisement. It took Rhett to a website that included endorsements from Shark Tank judges for Bitcoin trading software. The endorsements were fake.

Rhett was interested in trading Bitcoin, so he provided his contact details. Soon, an Account Manager named Max began calling Rhett. Max called often, pressuring Rhett to open a trading account and make a deposit. By depositing between $40,000 and $50,000 upfront, Max promised Rhett he could earn at least $15,000 per month.

Max promised Rhett that the money he deposited would be safe because he would have total control of the account. “It’s more or less moving your money in your left pocket from your right pocket,” Max said. Max promised Rhett that he could withdraw his money whenever he wanted to.

Max eventually convinced Rhett to open an account and deposit $40,000. Rhett started trading Bitcoin, but things didn’t go to plan. Rhett started losing money. Max encouraged Rhett to deposit more money so they could fix the situation. Max promised that in a week Rhett able to withdraw the money that he needed.

Rhett deposited more money in the hope he could recoup his losses. Rhett ended up depositing and losing a total of $97,000.