Many investors enter the crypto space not knowing how the foundational tech works (same can be said for traditional equity investing). They’ve never heard of Satoshi Nakamoto or have any inkling as to what a blockchain consensus algorithm is. They see regular people earning impressive gains by sheer happenstance, and often flaunting their newfound wealth on social media (replete with fancy cars and all the other trappings of new money). Lured by this fantasy of get rich quick, people dive right in for fear of missing out on the party. The idea of being an early adopter of tech promising the transform the world is hard to ignore. Especially for those who reminisce about the high-flying days of the dot-com era.
Due diligence be damned.
Investors, given the learning curve, shun attempts at truly understanding crypto technology or vetting grandiose claims made by developers. It is hard to ascertain the commercial viability of a project and conduct a thorough market an analysis if all you know is what is funneled to you through carefully curated media postings or announcements. Often, a flashy website plays host to what’s called a “white paper,” which basically conveys the technical information and purpose of a crypto offering. The problem is, a lot of these papers are poorly drafted, deliberately verbose (to impress and deceive the lay person), or completely plagiarized.
Bitcoin is a standalone in that its white paper reads like an entry into an esteemed science journal. You would really have to be intimate with the technical jargon (computer science grad) to understand what its brilliant founder outlined. With most cryptocurrencies being based on the ERC-20 token standard (or new derivatives), an individual or group can launch a new coin without necessarily having much technical know-how.
That Intrinsic Value Problem
Some people may look upon Warren Buffet and his value investing philosophy as vestiges of the past or hurdles to their ongoing crypto self-confirmation bias. The average crypto speculator has no use for tangibles or business fundamentals. Why would they? Look at the meme coin phenomenon, dubbed “Doge Coin” by its followers. It started as a joke between two engineers and at one point gained as much as 12,000% in the span of less than a year.
Nervous onlookers glued to their investment charts will note a volatility in crypto that really defies logic (unless you are a technical trader looking purely at indicators). If not really pegged to a physical good or unit of currency, no one really knows where the bottom is. Instill enough panic, and the only thing separating you from ruin is the time it takes for your investor colleagues to divest their interests (or push the sell at market value button on their trading platforms). Not really a big deal if you are playing with fun money, but for a lot of early crypto investors– they have refinanced mortgage funds, their entire life savings, or margin brokerage accounts on the line. Shaky confidence is what is keeping a lot of these coin values afloat. Often, a single unfavourable news report or word that a partnership has fallen out is all that is needed to really plummet these values to almost nothing, as many crypto traders have learned. To invoke a popular addition to the crypto vernacular: they are then left “holding the bag.”
Interestingly, the value of alternative coins (altcoins) tends to run in lockstep with Bitcoin, crypto’s undisputed reserve currency. This is not because the value of Bitcoin is pegged to a real asset, like gold or the US dollar. Bitcoin is as much a marketing powerhouse than it is a medium for exchange. You see people wearing shirts branded with its logo. ATM’s, kiosks, and online stores with Bitcoin insignia appearing alongside traditional payment forms like Mastercard, Interac, or Paypal. The benefits of first-mover advantage resulted in Bitcoin serving as the benchmark measurement for the value of all cryptocurrencies and controlling a dominant share of the world’s entire market capitalization (accounting for nearly half of $2-3 trillion).
When you ask what really gives cryptocurrencies their value, you need to understand that Bitcoin, with its tenets of decentralization, has already demonstrated practical applications for its technology which continue to change how we conduct commerce. Altcoins are essentially aiming to improve upon this base by aiming at their own specific directions (smart contracts, NFT’s, cross-border payments, etc.). I would say legitimacy is in large part garnered by a cryptocurrency when it demonstrates commercial viability (makes money by solving a problem). The intrinsic value problem with crypto is that many projects simply do not reach a stage where they become real businesses.
Exchange fees and scalping.
Exchanges will earn their keep simply by assessing a small fee on cryptocurrency trades or purchases involving fiat currency. While these fees are not prohibitively expensive when taken individually, they do tend to rack up once investors are feeling the stomach-churning volatility of crypto trading. This sort of fleeting confidence has been termed “loose hands” by the community, describing investors who constantly trade in and out of cryptocurrencies to limit losses (but really just actualizing them) or to capture a new “opportunity.” Crypto trading fees can vary from 0.16% to over 1%. Whether you win or lose, the exchanges are certainly making money off you. Now you see why the crypto business is a crowded market—it can be incredibly lucrative. Those seeking to open a new exchange, however, will need to be licensed with their respective regulatory authorities and have sufficient start-up capital for liquidity. It can also be quite a litigious environment if things go haywire, so it is common for your average exchange to have legal counsel on retainer.
Scalping is the simple process of buying a crypto asset (usually intraday trading) during a downswing period in the market price and selling during a marginal upswing. Traders will use technical indicators to try and predict a pattern of reliable market fluctuations. Overall price action can remain somewhat stable during the day, but scalpers will generally look for volatility and volume to earn their small returns. The trick here is to constantly repeat this action over and over to produce consistent wins. Scalpers have to be mindful of transaction costs and the speed with which price action can change, as often these swings can occur in a matter of seconds.
If you consider the latency of trading information reaching your computer, and then your brain engaging the requisite motor neurons to fire up a response, a lot of traders find themselves on the losing end simply because of their relatively sedated movement. This is exactly why there are Wall Street firms in the equity realm buying up order flows and real estate close to exchanges—the time to execute a trade is crucial and often measured in a fraction of a second. Not only that, but the professionals automate their trading (with software developed by PhD’s) to make it that much quicker than you are. The Wall Street sharks are increasingly treating crypto as any other asset class.
Ponzi schemes, Pump-and-Dumps, and Hacking
Bitconnect! If you haven’t heard about it: it was a Ponzi scheme centered around the Bitconnect Coin and some dubious trading software purporting to take advantage of crypto market volatility. How it “worked” is investors would lend the platform their funds and in return, they would receive guaranteed daily interest payments made in Bitcoin (around 1% compounded). Its founder and co-conspirators (now saddled with fraud and money laundering charges) were simply funneling new investor money back to early investors to keep up the ruse. Eventually they bilked their international following out of a whopping $2.5 billion.
You may not have been a victim of an elaborate cryptocurrency fraud scheme, but it is likely that at some point in your journey you were inadvertently caught up in a crypto “pump-and-dump.” Having its origin in the stock market, a pump-and-dump scheme is basically where a shady group of individuals come together to buy up shares of a worthless asset. Then, using electronic message boards, social media, news circulars, mass emailing, outbound calls– they create a phony story about how this asset is about to become incredibly valuable.
A hysteria is spread among investors, who fear that they could be potentially missing out on a “once in a lifetime opportunity.” The coin value goes up steadily as new investors continue to pile into the mix. A pump-and-dump usually has a set date where a supposed massive upswing in the price of a coin is to occur. This is where the fraudsters begin to unload their positions. They can either do this gradually, over the course of several days or weeks–or simply pull the rug from under the whole thing in one fell swoop. Pump and dump schemes were rampant in the initial years of cryptocurrency mania. Exchanges have largely put an end to them, but in the unregulated market, it is hard for any single legal authority to claim jurisdiction over what is considered global in scope.
Hacking cryptocurrency exchanges and digital wallets have become the modern thief’s bread and butter revenue stream. Not only relegated to individual actors: hackers acting on behalf of national governments have also been implicated in these activities (North Korea being the poster child). Coinbase.com, a company that quickly rose to market prominence to become a household name, touts itself as “the world’s most trusted exchange.” Hackers have exploited the platform to glean account login credentials of thousands of its customers. The security vulnerabilities are quickly patched, but it underscores the risk that investors undertake when holding funds on an exchange or “hot wallet” linked to the internet. Even on trusted platforms. Scammed Coinbase customers discovered a general lack of recourse available to them, as customer service was almost non-existent, and reimbursement was at the sole discretion of the company (at the time, things have since improved). On lesser exchanges that go bankrupt after a hack, investors simply receive a “tough luck.” In the case of a Turkish-based crypto exchange named “Thodex,” its founder and chairman stole $2 billion in investors’ funds and fled the country to Albania. He now faces an international arrest warrant but has so far eluded authorities.
Crypto scams involving private or peer-to-peer transactions are also rampant. It is a favored medium of exchange between fraudsters who have taken advantage of the daunting nature of crypto’s intricate transaction ledgers. For a single retail investor to investigate the origins of the scam would involve considerable effort. This is enough to discourage most victims from even trying, and so they swallow the loss. Consider that your average police authority would likely not have the know-how or time to investigate a smaller-scale, electronic crime that spans international borders. There is some encouraging action taking place, though. It is important to note that every transaction is stored on a public ledger that is inalterable. Many companies are launching with the sole mandate to assist authorities and others with transaction tracing.
Let’s Be Honest: You Gambled With Your Money
With all the issues plaguing crypto, surely no one can invest in it with complete confidence. If you dangle a carrot, in this case the opportunity for the poor or middle-class to become relatively rich with little to no effort, people will start running toward it exuberantly. You can forgive yourself for such reckless financial behaviour. We must realize that crypto’s explosive rise comes at a time when savings deposit rates are at lackluster and many people have a deep-seated distrust of the government, traditional banking institutions, and the stock market. Where wages have stagnated in the face of rising inflation and civil unrest. The time was ripe for an alternative. For the vast majority of us, getting rich off the advent of new technology like the blockchain remains a forlorn dream. That doesn’t mean, though, that opportunity is not abound. We just have to find it some other way.
