Cryptocurrencies_13. What are the risks involved in bitcoin trading

Lesson 13: What are the risks involved in bitcoin
trading

Historically speaking, few, if any, asset classes have outperformed the stock market
over the long term. Including dividend reinvestment and inflation, the stock market
has returned an average of 7% annually. It has run circles around other assets like
gold, bonds, oil, and even home prices.

But 2017 has been a year like no other. It has introduced the world, loud and clear, to
cryptocurrencies. When the year began, the aggregate market cap of all digital
currencies combined equaled just $17.7 billion. As of late, the aggregate value of
these cryptocurrencies soared past $225 billion. This represents almost a 1,200%
return in less than 11 months, which the broad-based S&P 500 has taken decades to
accomplish.

Leading the charge is the most popular virtual currency, bitcoin. The original
cryptocurrency began the year under $970 per coin, and as of December 14th 2017
is standing around the 16,500$ mark.
But this isn't to say bitcoin is without risks. In a span of just five months, bitcoin has
endured three bear-market-like crashes of 38%, 40%, and 29%, respectively. In no
particular order, the following six risks could derail the most popular virtual currency
in the world.

Firstly, Bitcoin's blockchain could lose its appeal.
The real value with cryptocurrencies lies with their blockchains. At the beginning of
August, following a soft fork that saw bitcoin separate into two separate currencies
(bitcoin and bitcoin cash), bitcoin's blockchain was upgraded. This upgrade moved
some information off of bitcoin's blockchain in order to boost capacity and transaction
settlement times, as well as reduce transaction fees, in an effort to attract
enterprises.

But what if bitcoin's blockchain fails to be a go-to option for businesses? Right now,
more than 150 organizations are currently testing a version of Ethereum's
blockchain, which supports smart contracts. These are protocols that help facilitate,
verify, and enforce the negotiation of a contract, and they provide marked distinction
from bitcoin's blockchain. If bitcoin's blockchain fails to differentiate itself and attract
enterprises, bitcoin's price could suffer.

Another possibility is that Brand-name businesses could stop accepting bitcoin.
Since 2014, a handful of brand-name businesses have accepted bitcoin as a form of
payment, with smaller merchants latching on in recent years. Some investors view
this growth in bitcoin's payment platform as a good reason to buy.

However, it could also be a source of investor frustration. If bitcoin remains volatile
there's the real possibility that merchants could bow out of accepting the virtual
currency. A potentially lengthy settlement period gives bitcoin time to move against
the grain, which could mean converting bitcoin into a lot less cash than when a
transaction was completed. If brand-name merchants bail on the virtual currency,
bitcoin's price could tumble.

Next there’s the double-edged sword of regulation.
In some ways the regulatory environment for bitcoin has been a positive in 2017.
Japan began accepting the currency as legal tender earlier this year, and the CME
Group, operator of the world's biggest derivatives marketplace, started carrying
bitcoin futures. These moves help to validate bitcoin as an investment and a form of
tender.

Then again, the regulatory environment can also keep bitcoin out of lucrative
markets. In September, both China and South Korea nixed initial coin offerings, with
China going a step further and announcing the eventual closure of domestic
cryptocurrency exchanges. Increased regulation could either help or hinder bitcoin.

Another possible threat is a cyber attack aimed at Bitfinex, or another cryptocurrency
exchange for that matter. This is a threat to all cryptocurrencies.
During 2013, Mt. Gox, which was handling about 70% of bitcoin's trading volume at
the time, was hit by a crippling cyberattack. In the bankruptcy filing from Mt. Gox just
months later, it cited the theft of 850,000 bitcoin, which are worth $6.8 billion today.
In the two years following this cyberattack, bitcoin wound up losing more than 80% of
its value.

Today, cryptocurrency exchange Bitfinex handles around half of all trading volume
for bitcoin. If it were to be hit with a cyber attack, it could destabilize the market and
send bitcoin significantly lower.

The recent development, with the CME Group listing futures for bitcoin, was viewed
positive by many on Wall Street. The ability for Wall Street firms to take a stake in
bitcoin, without having to dabble in decentralized cryptocurrency exchanges, could
introduce new money and reduce volatility.

However, there's another side to this story.

Futures trading will allow Wall Street to bet against bitcoin for the first time ever. It
will also allow all walks of investors to borrow on margin to enter those short
positions. If bitcoin's value were to swing violently up or down, it could lead to a flood
of margin calls that have the potential to destabilize the market for bitcoin. And
because there's no precedent for an asset like bitcoin, setting the margin limits is
nothing more than guesswork at this point.

Last but not least, investor sentiment, which has been a crucial catalyst of bitcoin's
growth, could also push this virtual currency downward. Since bitcoin's inception,
individual investors have controlled its value. Compared to Wall Street investment
firms, retail investors are far more prone to allowing their emotions to influence their
investing decisions -- which rarely ends well. Many of bitcoin's wild price swings owe
to retail investors' piling into or bailing out of bitcoin based on the latest news. It
wouldn't take much for investor sentiment to shift and send bitcoin's value
plummeting.