Risks of Virtual Currency Trading or Investing
The following are some of the risks associated with Virtual Currencies and the trading or ownership of them.
Unique Features of Virtual Currencies. Virtual currencies are not legal tender in the United States and many people question whether they have intrinsic value. The price of many virtual currencies is based on the agreement of the parties to a transaction. Because of this and other risks associated with the unique features of virtual currencies a market participant may not be able to find or establish a price for the valuation of a particular virtual currency.
Price Volatility. The price of a virtual currency is based on the perceived value of the virtual currency and subject to changes in sentiment, which make these products highly volatile. Certain virtual currencies have experienced daily price volatility of more than 20%. These risks associated with the extreme price volatility of virtual currencies and the possibility of rapid and substantial price movements, which can result in significant or total loss of the value of virtual currencies for those who choose to participate in the Virtual Currency markets.
Valuation and Liquidity. Virtual currencies can be traded through privately negotiated transactions and through numerous virtual currency exchanges and intermediaries around the world. The lack of a centralized pricing source poses a variety of valuation challenges. In addition, the dispersed liquidity may pose challenges for market participants trying to exit a position, particularly during periods of stress. As well liquidity and prices of Virtual Currencies can vary significantly from one exchange or trading venue to another. Market participants should be aware of this risk and how it might affect their ability to enter or exit any particular Virtual Currency.
Cybersecurity. The cybersecurity risks of virtual currencies and related “wallets” or spot exchanges include hacking vulnerabilities and a risk that publicly distributed ledgers may not be immutable. A cybersecurity event could result in a substantial, immediate and irreversible loss for market participants that trade virtual currencies. Even a minor cybersecurity event in a virtual currency is likely to result in downward price pressure on that product and potentially other virtual currencies. Cybercriminals are ever present in the space and constantly attempting to gain access to market participants key information with the intention of stealing any virtual currency a participant might have. The loss of Virtual Currency from any such theft is not likely to be recovered.
These are some but not all of the risks of Virtual Currencies
Opaque Spot Market. Virtual currency balances are generally maintained as an address on the blockchain and are accessed through private keys, which may be held by a market participant or a custodian. Although virtual currency transactions are typically publicly available on a blockchain or distributed ledger, the public address does not identify the controller, owner or holder of the private key. Unlike bank and brokerage accounts, virtual currency exchanges and custodians that hold virtual currencies do not always identify the owner. The opaque underlying or spot market poses asset verification challenges for market participants, regulators and auditors and gives rise to an increased risk of manipulation and fraud, including the potential for Ponzi schemes, bucket shops, and pump and dump schemes. A market participant needs to be aware of these risks and others that could pose a risk of loss of the Virtual Currency a market participant has in a wallet, exchange, or custodian or technology device.
Virtual Currency Exchanges, Intermediaries and Custodians. Virtual currency exchanges, as well as other intermediaries, custodians, and vendors used to facilitate virtual currency transactions, are relatively new and largely unregulated in both the United States and many foreign jurisdictions. Virtual currency exchanges generally purchase virtual currencies for their own account on the public ledger and allocate positions to customers through internal bookkeeping entries while maintaining exclusive control of the private keys. Under this structure, virtual currency exchanges collect large amounts of customer funds for the purpose of buying and holding virtual currencies on behalf of their customers. The opaque underlying spot market and lack of regulatory oversight create a risk that a virtual currency exchange may not hold sufficient virtual currencies and funds to satisfy its obligations and that such deficiency may not be easily identified or discovered. In addition, many virtual currency exchanges have experienced significant outages, downtime and transaction processing delays and may have a higher level of operational risk than regulated futures or securities exchanges. If virtual currencies are traded or held through an exchange, intermediary or custodian the market participant is at risk of losing all of their Virtual Currency assets due to theft, human or technical error or the value can decline precipitously without the participant being able to engage in the market. Thus, any participant is at risk of losing 100% of the value in their Virtual Currency holdings.
Regulatory Landscape. Virtual currencies currently face an uncertain regulatory landscape in the United States and many foreign jurisdictions. In the United States, virtual currencies are not subject to federal regulatory oversight but may be regulated by one or more state regulatory bodies. In addition, many virtual currency derivatives are regulated by the CFTC, and the SEC has cautioned that many initial coin offerings are likely to fall within the definition of a security and subject to U.S. securities laws. One or more jurisdictions may, in the future, adopt laws, regulations or directives that affect virtual currency networks and their users. Such laws, regulations or directives may impact the price of virtual currencies and their acceptance by users, merchants and service providers. The risks associated with the current regulatory landscape for virtual currencies should be explained.
Technology. The relatively new and rapidly evolving technology underlying virtual currencies introduces unique risks. For example, a unique private key is required to access, use or transfer a virtual currency on a blockchain or distributed ledger. The loss, theft or destruction of a private key may result in an irreversible loss. The ability to participate in forks could also have implications for investors. For example, a market participant holding a virtual currency position through a virtual currency exchange may be adversely impacted if the exchange does not allow its customers to participate in a fork that creates a new product. The risks posed by this nascent technology should be explained.
Transaction Fees. Many virtual currencies allow market participants to offer miners (i.e., parties that process transactions and record them on a blockchain or distributed ledger) a fee. While not mandatory, a fee is generally necessary to ensure that a transaction is promptly recorded on a blockchain or distributed ledger. The amounts of these fees are subject to market forces and it is possible that the fees could increase substantially during a period of stress. In addition, virtual currency exchanges, wallet providers and other custodians may charge high fees relative to custodians in many other financial markets. The impact of these transaction fees on performance should be explained.