The Ultimate Guide To Understanding the Risks of Cryptocurrency Investments
Crypto is for criminals. If you’ve heard this sentiment, you’re not alone. The mainstream media likes to portray crypto in this light.
They’re not entirely wrong though. Look at the current FTX/SBF fiasco. That’s reason enough to stay in the legacy financial system.
The thing is, the legacy financial system has criminals too. Unfortunately, whenever dealing with money, you get people from all ends of the spectrum.
Cryptocurrency presents an interesting new phenomenon in the world of money. With any financial investment, there will always be a risk. In this guide, we’ll uncover the risk of cryptocurrency and how it compares to fiat.
Let’s keep reading to get the inside scoop, shall we?
What is Fiat Currency?
Fiat currency is money issued by the government. It is not backed by anything (gold or silver) other than that particular government body itself.
The supply, demand, and stability determine the value. Modern fiat currency examples include paper currencies like the U.S. dollar, Euro, or Yen.
When fiat currency came about, governments would mint coins from a valuable commodity like gold or silver. Printed paper money from the government could be redeemed for a certain allotment of one of these physical commodities.
Since there is nothing backing fiat currency, it, unfortunately, cannot be redeemed. In and of itself, fiat has no value—the value is maintained by the government.
What is Cryptocurrency?
On the flip side of fiat, there is cryptocurrency. Cryptocurrency is digital money that isn’t controlled by a central authority or third party (such as a government).
Cryptocurrency takes advantage of a couple of key technologies—cryptography and blockchain.
Cryptocurrencies use cryptography making them virtually impossible to counterfeit or double-spend.
“Crypto” is a blanket term you’ll often hear that refers to cryptocurrencies, encryption algorithms, and cryptographic techniques (elliptical curve encryption, public and private keys, and hashes).
There are several ways to begin cryptocurrency investing. For example, you could mine it or buy some via a cryptocurrency exchange.
Blockchain technology is the distributed ledger running on a decentralized network (network of nodes). With this said, some cryptocurrencies will be more centralized than others. Always DYOR (do your own research).
A blockchain is a set of blocks forming a chain that creates an online transparent ledger. The blocks each contain the transaction data. Every block is independently verified by each node on the network.
Blockchain is a robust technology that creates a secure network that makes it virtually impossible to forge transaction histories.
Since everything is visible on the blockchain, this makes it much more difficult for bad actors and hackers to get away with things.
Industries taking advantage of blockchain technology include supply chains, voting, crowdfunding, finance, payment processing, etc.
The Reward of Fiat
Fiat currency allows people to store value and provides them with a numerical amount, and the ability to exchange. This all depends on the current status of a nation and its government.
One benefit is that since fiat isn’t hinged to a commodity, it is more cost-efficient to produce (seigniorage).
Fiat isn’t scarce, fixed, or finite either (rather than gold or bitcoin). This gives central banks more control over supply which in turn gives them greater power over things like liquidity, credit supply, money velocity, and interest rates.
Do some more research on the Federal Reserve to see the level of control and power they have.
The interesting thing is why people find fiat still valuable given the fact that it isn’t technically backed by anything. If it is backed by anything at all it’s faith and trust in the government.
A government such as the United States government demands that you pay your taxes every year. If you don’t, you could face strict penalties or even prison.
The Reward of Cryptocurrency
We take it you’re interested in cryptocurrency investing. Before we dive into the potential risk of cryptocurrency, let’s look at what benefits they present.
Cryptocurrencies offer a new form of money that is completely outside of third parties. Transacting between two parties doesn’t need a middleman to enforce the trust or police it.
Most cryptocurrencies are decentralized which means there isn’t a single point of failure (unlike a financial institution like a large bank).
Peer-to-peer (p2p) transactions are made possible and are easier (sans the third party) thanks to public and private keys.
Your public key (a long string of random numbers and letters) is what allows you to receive cryptocurrency. It is also used to verify the digital signature. Your public address is a hashed version (compressed and shortened) of your public key.
When you wish to receive cryptocurrency, you would share your public address with that peer. It is similar to an email address in that regard.
Your private key signs transactions and proves ownership of a blockchain address. It is a secret number used in cryptography.
A private key (randomly generated number) is similar to a password which is why it is imperative to store them safely. Remember the mantra—not your keys, not your cheese.
The Risk of Fiat
As discussed, fiat is centralized meaning that it is central to one party such as a bank, government, etc. This means that there is one point of failure.
When compared to decentralized cryptocurrencies, there isn’t one central point of failure. You can think of it like hydra plants—when you cut the head off of one, another will grow back bigger and stronger.
Currencies tied to gold are more stable than fiat due to their finite supply. Since fiat can be practically printed out of thin air, this can cause risky things like bubbles, inflation, and even hyperinflation.
Unfortunately, fiat isn’t a fail-proof method for protecting the economy.
Then you throw in things that marginalize people or make things more difficult for them. For example, what are underbanked or unbanked people supposed to do? They can’t afford to keep their money in a bank account because of fees, income, or identification.
Speaking of identification, there is this thing called KYC (Know Your Customer). In a nutshell, it means providing some form of identification data for your finances. While it may seem like a good thing on the surface, it also provides issues.
For example, by providing identification for your finances, scammers and hackers have a higher probability of scamming or phishing you. Do you want people to know what you spend your money on and how much you have? We didn’t think so.
Cryptocurrency aims to solve many of these issues. You don’t need anyone’s permission to create a wallet. You can easily download one to your smartphone or purchase an inexpensive hardware wallet.
With crypto—you are your own bank.
The Risk of Cryptocurrency
The cryptocurrency market isn’t without its set of risks either. Let’s see what potential risks there are with this new technology and if there is anything you can do on a personal level to prevent them.
One risk of cryptocurrency is simply human error—incorrectly writing down your private key or seed phrase and shotty storage. Write down your private keys and seed phrases offline and keep them away from prying eyes.
For simplicity’s sake, more often than not you’ll be provided with a seed phrase. This consists of human-readable alpha-numeric characters of 12-24 words.
You will have access to a seed phrase when you download a hot wallet to your smartphone or computer.
A hot wallet is connected to the internet. This makes things a lot easier to get started, especially for newbies. While it is more convenient, a hot wallet is also more vulnerable to hacks since it’s online.
Popular choices here are Samourai, Exodus, Atomic, and MetaMask. Do not confuse hot wallets with exchanges.
For example, you don’t want to store your crypto on an exchange like Coinbase. This comes back to the mantra—not your keys, not your cheese.
A cold wallet isn’t connected to the internet. This is a much more secure way to hold your crypto. A cold wallet will look and feel like a thumb drive or hard drive.
Popular choices here are Ledger and Trezor.
The risk of cryptocurrency largely lies in the person interacting with it. Crypto takes time to learn, so do your due diligence and learn the ropes. Research and then research some more.
Cryptocurrency trading comes with its own set of risks like volatility, emotions, rug pulls, and slippage. For more on slippage, read this guide.
Crypto Is an Endless Onion
Whether dealing with fiat currency or cryptocurrency, there will always be pros and cons. When you can understand the risk of cryptocurrency and fiat, you’ll be able to reap the reward.
You’ll make mistakes along the way. Don’t let that stop you from becoming a financial wizard! You are on your financial journey to freedom.
One way to set yourself up for success is through budgeting. To step up your budgeting organization, be sure to read our blog.