What are the risks of trading crypto?

by Ann deBruyn

A woman looks sadly at her smartphone

Photo by Ivan Samkov from Pexels

Thinking about getting into crypto? Bitcoin, ethereum and their multitude of smaller competitors have created a new world of investment opportunities. No doubt, the crypto economy is exciting, but proceed with caution. Cryptocurrencies are still considered highly speculative, and not only because of their massive price swings.

Dramatic gains are possible, but so are devastating losses, and investors should understand crypto’s wide-ranging risks. Here’s an overview of crypto volatility risk, technology risks, regulatory uncertainty and other issues that could affect the value of your investment.

Price volatility

Cryptocurrency prices can fluctuate wildly from week to week, or even within a single day. On May 19, 2021, for example, bitcoin’s price dropped 30%, after the Chinese government cracked down on bitcoin mining and trading.

Crypto prices may also rise and fall based on diverse factors such as changing public sentiment, world news, mainstream adoption, protocol upgrades, impending regulation, hacks, scams and more. Plus, crypto is a relatively new asset class, and the market is still in the process of price discovery.

Technology risks

Cryptocurrencies’ underlying blockchain technology is built with numerous security measures, including decentralization, cryptography and consensus mechanisms to confirm that transactions are legitimate. However, no blockchain is immune to every threat.

Backing up your crypto wallet regularly and storing it safely helps to protect you against computer failure, device theft and your own mistakes—such as accidentally uninstalling your digital crypto wallet. But it’s harder to guard against threats such as software bugs, data glitches and 51% attacks (when a group of crypto miners takes control of more than half of a network’s computing power).

Crypto investors and developers are also concerned about advances in quantum computing, the next generation of computer technology. Its potential computing power could allow bad actors to hack crypto wallets, forge transactions or rewrite parts of a blockchain to alter transaction records. If that were to happen, crypto values would likely plunge—even get wiped out. That day is likely still several years away, but Ethereum and other crypto organizations are already working on post-quantum cryptography.

Low liquidity

Liquidity means how easily and quickly you can exchange an asset for cash. Cryptocurrencies—especially smaller, newer ones—tend to be less liquid than other investments like stocks and bonds. That means trading or cashing in your digital coins may not happen as quickly as you’d like, even though crypto markets around the world operate nearly around the clock.

As a result, you might get “slippage”—a difference between the price you expect and the price you get once the trade has been executed. Slippage can happen if the bid/ask spread—the gap between what buyers are willing to pay and what sellers are willing to accept—changes while you’re waiting for your trade to be filled, perhaps even several times. When the actual price is lower than what’s expected, your buying power increases; this is called “positive slippage.” When the actual price is higher than expected, your buying power decreases; this is called “negative slippage.”

Slippage is common in crypto trading, and the amount typically ranges from 0.05% to 0.1%. For particularly volatile cryptocurrencies, it can be as high as 1%. To avoid or reduce negative slippage, check if your crypto trading platform offers limit orders, slippage estimates and slippage warnings.

Scams and fraud

Scammers and fraudsters are exploiting the public’s growing appetite for crypto with ruses large and small.

For example, you may have heard about QuadrigaCX, a crypto asset trading platform that collapsed in 2019 after its founder’s alleged fraudulent conduct and mysterious death—investors lost CAD$169 million. Or maybe you saw headlines about Squid Game, the 2021 “rug pull” scam that stole US$3.3 million from people who bought a coin named after (but with no affiliation to) the hit Netflix series.

Smaller crypto ruses are alarmingly too frequent. In Canada, investment scams were the highest-reported scams based on dollar loss in 2021—adding up to at least CAD$163.9 million—and the majority of reports involved people investing in cryptocurrency after seeing deceptive ads, reports the Canadian Anti-Fraud Centre. Other forms of crypto fraud: fake trading platforms, Ponzi schemes, tech support scams, viruses and pump-and-dumps (scammers lure investors into buying a cryptocurrency and then sell their own holdings, causing its value to fall, and run off with the money that was invested).

To protect yourself, be wary of any crypto “investment opportunity,” even if it comes from a source you trust. Scammers often hack into social media accounts and try to convince the victims’ friends to hand over their money. Learn about this and other common crypto scams and how to report them. Also, tread carefully around initial coin offerings (ICOs) and airdrops (free token distributions). These events are also ripe for scams and fraud. 

Crypto hacks

Hackers have targeted investors, blockchains and crypto trading platforms, and they’ve made off with hundreds of millions of dollars’ worth of coins.

High-profile hacks have made headlines around the world. In April 2022, thieves stole more than US$600 million from Ronin Network, a gaming-focused blockchain project—this is believed to be the largest crypto hack to date. In December 2021, crypto exchange BitMart was robbed of US$200 million when hackers stole a private key to one of its hot wallets. And individual investors have fallen victim to sophisticated hacks involving methods like SIM swapping, cryptojacking, crypto clipping and more.

Legal and regulatory uncertainty

Crypto blockchains are decentralized by design, which is both a benefit and a burden for investors. Having no intermediaries can mean faster transactions and lower costs, but it also means cryptocurrencies aren’t backed by financial institutions or government authorities. The lack of a regulatory framework also means investors have no recourse if something goes wrong, in contrast to Canada’s government oversight and investor protections for other kinds of investments.

Around the world, governments are inching closer to regulating crypto. In March 2022, U.S. President Joe Biden issued a long-awaited executive order for American government agencies to study digital currencies in depth. Biden’s order wasn’t the crypto crackdown many feared it would be, and it could eventually bring greater clarity, stability and safety to the crypto industry. Other countries are taking different approaches to crypto, ranging from outright bans to adopting crypto as legal tender.

Canada’s regulatory framework for cryptocurrency is also evolving. The laws for securities apply to crypto, and the Canada Revenue Agency (CRA) views it as a commodity. Crypto activity is taxable—more on this below.

Human error

News headlines are rife with jaw-dropping stories of cryptocurrency owners who lose or forget their private keys—essentially locking themselves out of their digital treasure vaults.

Other costly crypto mistakes: failing to back up a crypto wallet, sending crypto to the wrong address or blockchain, sending the wrong cryptocurrency, and “fat finger” errors where users buy the wrong asset or type in the wrong price. In December 2021, for example, an investor accidentally sold a Bored Ape NFT for 0.75 ETH (about $3,000)—one-tenth of his intended price of 75 ETH ($300,000). He later told a CNET reporter that he’d had a lapse of concentration.

Crypto companies make fat-finger errors too, such as transferring the wrong currency, paying excessive fees or accidentally flooding the market with billions of dollars’ worth of extra currency. The latter scenario happened to tether, a stablecoin pegged to the U.S. dollar, in 2019. The company destroyed its excess tokens, but the blunder unnerved investors so much that other cryptocurrencies, including bitcoin, dropped in value—another risk to consider.

Income taxes

Many people don’t realize that cryptocurrency earnings are taxable as either capital gains or business income, depending on the nature of your crypto activity. As a result, investors might trade, spend or give cryptocurrency for years without realizing they owe the government taxes—and perhaps penalties and interest charges.

If you mine or stake crypto, that has tax implications, too, and the same goes for trading non-fungible tokens (NFTs). Read more in our guide to crypto and taxes.

Protecting yourself from crypto risks

Crypto isn’t the only investment asset that carries risk, of course—investors should thoroughly research any investment before they commit. But with all the hype around cryptocurrencies, it’s easy to fall prey to FOMO. Take your time and understand the risks.

Crypto investments are inherently volatile, but it is possible to invest responsibly and avoid unnecessary risks. If you decide to invest:

  • Research each coin you’re interested in. Find answers to questions like: Why was it created? What is it used for? What is its market capitalization? Is its trading volume high or low? Is it stakable?
  • Do your due diligence in choosing a crypto trading platform. Ask questions like: Is it regulated? What are its security features? How much are the trading fees? Does it offer customer service?
  • Learn how to securely store your public and private keys and your seed phrase. Also known as a recovery phrase or mnemonic phrase, a seed phrase allows you to access and trade your crypto, using hot and cold wallets.
  • Always stay alert for fraud and scams. These are becoming ever more sophisticated and can be tricky to detect. Be skeptical of any promotions, including initial coin offerings and airdrops that sound too good to be true.

Even with these precautions, cryptocurrencies and other digital assets are best limited to a small portion of the speculative “explore” part of a core-and-explore investment portfolio. The bottom line: Never invest more than you can bear to lose.

Read more about crypto:

  • How to gain exposure to crypto without buying it
  • What is DeFi? And how can Canadians invest in it?
  • Trading tools that can raise your crypto game
  • Watch: Investing in cryptocurrency (and crypto ETFs)