As with any investment, cryptocurrencies have their own unique risks and rewards. While some investors have reaped huge profits from these volatile assets, others have fallen victim to the market cycle and have lost their investment.

William Procasky, CFA, assistant professor of finance at Texas A&M University-Kingsville, says that new investors should stay away from crypto. But he also notes that more experienced investors, who understand how to cope with risk, could find a place for it in their portfolios.

“If you’re building a broad-based portfolio and want to add crypto to the 5% or 10% of your portfolio you’re setting aside for alternative assets, then you might be okay,” Procasky says.

Bitcoin and Ethereum are the two largest cryptocurrencies by market capitalisation, and are more established than many other crypto options. This makes them a safer bet for most investors.

“If you go for options like Bitcoin and Ethereum, which are more mainstream, there’s a bit more safety around them,” says Lauren Niestradt, CFP/CFA, senior portfolio manager at Truepoint Wealth Counsel.

When it comes to cryptocurrencies, the Australian Securities and Investments Commission (ASIC) offers a series of directives and insights that investors should take into account before deciding to invest.

ASIC points out that the regulatory landscape for cryptocurrencies is far from robust. As many cryptocurrencies and digital assets are not commonly viewed as financial products, the platforms on which they are bought and sold may not fall under ASIC’s regulatory jurisdiction. This could mean investors are left unprotected should a platform fail or become compromised.

Adding to this uncertainty is the volatile nature of cryptocurrency values. According to ASIC, the valuation of these digital assets is largely driven by public sentiment and can fluctuate wildly over short periods. Factors such as media hype, the number of users, ease of trade, the perceived value of the currency, and the viability of the underlying blockchain technology all play into the perceived value of a cryptocurrency.

However, the regulatory body cautions investors about the security risks tied to cryptocurrencies. While their decentralised nature provides a level of anonymity, it also creates a security gap. Without a central databank, once a cryptocurrency is stolen, it’s nearly impossible to retrieve. ASIC suggests that investors may find additional security in offline storage options, known as ‘hardware wallets’ or ‘cold storage’.

The technical complexity of cryptocurrencies adds another layer of risk. These assets can be difficult to understand for many, and clear, comprehensive disclosure statements are often lacking. The lack of standardised information and the necessary specific software and understanding of transaction fees can lead to costly errors, such as sending transactions to incorrect addresses or paying excessive transaction fees.

Finally, ASIC raises the alarm about the increasing number of crypto scams. The lack of regulatory oversight and the difficulty in tracing transactions make the cryptocurrency world a fertile ground for fraudulent activities.

Overall, while ASIC does not prohibit investing in cryptocurrencies, it strongly advises investors to be aware of the high-risk factors associated with such investments. The volatility and complexity of this digital asset class, along with the potential for scams and lack of regulation, should be carefully weighed before investing.

Several risks are associated with investing in cryptocurrency: volatility, government regulations and investment scams.

• Volatility. As crypto is such a small asset class relative to other traditional investment markets, smaller amounts of money can have a significant impact on a crypto-asset’s price. This means large investors or entities with lots of capital entering or exiting the market can have a significant impact on price.For those unaccustomed to this extreme volatility, it is easy to be ‘shaken-out’ of the market. This often happens at the worst time, when the market has gone down significantly and the investor decides to sell at a loss. As is human nature, this is often done at the worst possible moment, and many investors will have a story of selling at a loss, only to see their old investment shoot to the moon the very next week.
• Government regulations. According to Michael Collins, CFA, professor of financial planning at Endicott College, many governments have yet to fully regulate the use and trade of cryptocurrencies, making it difficult to know what to expect regarding legal and financial risks. The recent regulatory crackdown by the SEC in the US shows the use of ‘regulation by enforcement’ coming down on the digital asset industry. As with any new technology that threatens older, more established systems, there is always initial regulatory pushback before the new system is accepted. The question remains; how big will the regulatory battle be for crypto, and how long will it last? In Australia, the federal government has vowed to regulate crypto, and has released a token mapping paper as part of this process.
• Investment Scams. As with any investment industry, fraud and scams run rampant in crypto markets. Hastings says, “Cryptocurrency fraud soared in 2022, and the lack of regulatory oversight of the industry left many thousands of investors out of pocket.” Hacks are quite common with crypto. According to Chainalysis, over $3.2 billion of cryptocurrency was stolen from Americans in 2021. Many Australians have fallen victim to crypto scams: in 2021, we lost more than $700 million on investment scams, many of them crypto-based. Although many exchanges offer private insurance, if you lose your crypto in a hack, you may have no recourse for getting back your investment. With the right security measures and due diligence, it is easily possible to protect your assets from the prying eyes of fraudsters.

According to the 2022 Crypto Adoption Index by Chainalysis, the world of cryptocurrencies has seen considerable ups and downs in adoption, but on the whole, has been trending upwards.

In the second quarter of 2021, global crypto adoption peaked. While the trend has wavered since then, in line with crypto price fluctuations, overall adoption has remained higher than before the bull market of 2019. This shows that even during tough market conditions, cryptocurrencies have been resilient, attracting and retaining many investors.

Investors attracted by the soaring crypto prices in 2020 and 2021 have mostly chosen to stay in the market. Despite the value of their portfolios decreasing, many are holding on to their assets, hopeful of a market rebound. This is a positive sign of market health and investor confidence.

Countries with emerging economies lead the charge in crypto adoption. These include Vietnam, Philippines, Ukraine, India, Pakistan, Nigeria, Brazil, Thailand, Russia, China, and others. People in these regions often use crypto for practical needs, like sending money overseas, preserving their savings during times of economic instability, and more.

Vietnam has topped the crypto adoption index for two years running, with the United States climbing to fifth place. Interestingly, China also secured a spot in the top ten, despite its government’s recent crackdown on crypto activities.

Australia currently sits at rank 40 in global crypto adoption. While this is relatively low compared to leaders in the field, there’s potential for growth as awareness and understanding of crypto assets continue to increase.

With all the speculation surrounding crypto, many backers have touted the prospect of it becoming a global currency.

Recently, US Treasury Secretary Janet Yellen said that she expects a slow decline in the dominance of USD as a share of global currency reserves. While it is unlikely that any other currency will overtake the greenback anytime soon, cryptocurrencies, like bitcoin, are well positioned to take increase their share.

However, it is unlikely that any cryptocurrency will take over as the dominant global currency anytime soon.

“I don’t think governments will allow a competing currency like that on that scale,” says Procasky. “A global currency has to be very liquid and very deep, and there’s nothing that can compete with the U.S. dollar.”

Money is a tightly regulated and controlled asset. As was evident from the scandals of 2022—such as Terra Luna, Celsius and FTX—poorly regulated crypto projects can do significant damage to individuals’ finances if they decide to invest. The majority of the world’s governments would not allow their financial systems to be built on poorly designed currencies that have not stood the test of time.

“I think it’s years away,” Niestradt says, “and this is where some of the speculation lies. It’s not a certainty.”

Since 2011, Bitcoin’s cumulative gains equate to 0ver 20,000,000%, with multiple years returning well over 1,000% in less than 12 months. The average yearly gain for BTC since inception is over 1,400%.

In Australia, the annual inflation rate mostly ranged from 1-3% from 2009 to 2021. Due to the excessive use of monetary stimulus to keep the economy afloat during the Covid-19 pandemic, the annual inflation rate rose to above 7% during 2022, and is predicted to be above 5% in 2023.

When you compare the average yearly return of BTC and compared it with the inflation rate, it is quite obvious that the largest cryptocurrency has substantially outperformed inflation, even at the high levels it has reached in the past year.

There is some debate about whether BTC will continue to outperform inflation, with some critics using the recent poor performance of the crypto markets as an example of digital assets failing as an inflation hedge.

“Crypto failed the test as an inflation hedge. If it’s possible to give it an F-, that’s how it performed,” says Procasky.

However, it’s important to remember the stratospheric rise of the markets since the start of the pandemic. Bitcoin fell below $US5,000 when the pandemic really began to shake the world, yet rose past $US69,000 18 months later. Even after a tough year in 2022, it still sits at over $US28,000 as of June 21st 2023.

In Australia, the Australian Taxation Office (ATO) has specific rules regarding the taxation of cryptocurrencies. Understanding these is crucial if you’re considering investing in crypto assets, as they can have significant implications on your tax obligations.

Capital Gains Tax

In Australia, cryptocurrencies are subject to capital gains tax (CGT). The ATO considers cryptocurrencies not just as a digital currency but as an asset. This means that whenever a crypto investor disposes of their cryptocurrency—be it through trading it for another cryptocurrency, selling it for fiat currency, or using it to purchase goods or services—a CGT event occurs. Therefore, all such transactions need to be reported.

This even extends to crypto-to-crypto transactions, even if they are facilitated on a decentralised platform. For instance, if you exchange Ethereum for another token or NFT, this transaction would trigger a CGT event, and the capital gain or loss must be recorded and reported. The same applies when using crypto to purchase goods or services with some exceptions.

For longer-term investments, a CGT discount may be applicable if you’ve held the cryptocurrency for more than 12 months.

Income Tax

Beyond CGT, income tax also plays a vital role in crypto taxation. If you’re earning income through cryptocurrency mining, participating in DeFi protocols, staking, or earning interest on your holdings, these are considered assessable income and should be declared in your tax return.

It’s crucial to note that on-chain activities can be traced. Therefore, any earning activities from DeFi protocols and similar platforms need to be accurately reported. The ATO has made it clear that it is closely monitoring cryptocurrency transactions, and failing to report such income can result in penalties.

Crypto tax software can be extremely helpful to help maintain thorough records of your transactions.

As always, given the complexity and rapidly evolving nature of the cryptocurrency space, consulting with a tax professional who understands the intricacies of cryptocurrency taxation in Australia is highly recommended.

If the world continues to embrace technology and continue trending toward digitization, then there is a strong case that top crypto projects will continue to grow and carve out their niche in the new digital era.

The main concern for crypto’s long term adoption, and thus, its potential as an investment, are the tough regulatory headwinds that digital assets face by a few, significant countries. Namely, the US has been cracking down on crypto during 2023 with multiple allegations made to crypto exchanges like Coinbase and Binance.

Andrew Rosen, CFP, president of Diversified LLC, says, “While I think that the underlying technology of blockchain has innovation and practicality, until it is decoupled from the gamble of currency without regulation, it’s too risky.”

However, the potential reward if the digital asset industry can get past this initial regulatory battle could be tremendous for investors who play it right. The entire crypto market is still miniscule when compared to traditional assets like commodities, equities or property.

If regulation does stifle the crypto markets, rather than merely offering guardrails and consumer protections, there is every chance that crypto could experience a significant downturn and fade into oblivion. This is a potential scenario that every crypto investor should be aware of.