Chapter 8

What Are The Risks Of Using Cryptocurrency & Blockchain Protocols?

1. Risks of Using Cryptocurrencies

Blockchain and the cryptocurrency universe is young compared to other products and sectors in the market. Vitalik Buterin, the genius behind Ethereum, claims that his creation and blockchain itself are undergoing their development phase. A phase marked by minor flaws and bugs that need fixing before maximum potential can be reached. Time and experience is needed to perfect blockchain technology and the industry it created.

Figure 35 - Stages of industry maturity over time: Introduction, Growth, Maturity and Decline
Unstable value

Cryptocurrencies are notorious for their high volatility. Meaning that the value of crypto assets can change drastically in short periods of time. It is considered a flaw in the system if Bitcoin, for instance, is meant to be used as a means of transactions. Drastic changes in price make it hard to value everyday items in terms of Bitcoin. Imagine wanting to buy a motorcycle with Bitcoin. In the morning, 1 Bitcoin is enough to buy the motorcycle, but later, in the afternoon with the same amount of Bitcoin, one could have bought two motorcycles.

Average Annualized Volatility

Figure 36 - Volatility on different commodity index markets

The cause of Bitcoin's unstable price is speculation. Speculation is not a thing of this century. Its roots go back to the Roman Republic, where merchants would buy and sell goods in hope that the price would rise or drop in the future. The stock market went through periods of uncertainty and instability at its premature phase -- led by speculation once again. It's a matter of time for Bitcoin and other crypto-assets reach the maturity phase in which speculation becomes background noise.

Volatility isn't all bad news for crypto investors. It's the motor that thrusts Bitcoin higher and higher. Especially when FOMO, or fear of missing out, kicks in when Bitcoin is in a bull market (a period of time in which the price rises substantially and is expected to continue gaining in the foreseeable future).

Cryptocurrencies, at the current early stage, are moved by theoretical beliefs, because there isn't a physical object backing the price. Thus, the price is based on faith in the technology. If crypto enthusiasts suddenly doubt the potential of the project, the price will plummet, increasing price instability. In a way, the system is designed to follow the laws of natural selection: only the fittest crypto and trader survive.

Figure 37 - Graph of a survey in which people were asked which institution they found more trustworthy
Lost keys, time and irreversible transactions

Private keys are the codes required to open the safe storing bitcoin and other crypto. Without the private key the " linked" crypto is lost forever... losing access to Bitcoin stored in a wallet because of lost keys is a common phenomenon. 20% of the circulating bitcoin is lost because users have lost their private keys. So, private keys are a sensible topic and pose a great risk to using blockchain and cryptocurrencies.

Sending and receiving Bitcoin can be a hassle. Not only are private keys long alphanumeric codes, but the process leading to the disposition of Bitcoin is confusing and sometimes time consuming. Yes, crypto are meant to be transferred in short time periods, but it all depends on the protocol backing the cryptocurrency in question. Bitcoin is considered to be lengthy when transacting (between 10 - 15 minutes), so other blockchains were created to solve the problem, like Litecoin which takes between 2 - 8 minutes to confirm a transaction.

Figure 38 - Average transaction time on popular cryptocurrencies

However, slower transactions are not a flaw of the system per se. Rather with increasing popularity, the network may become congested as more miners, and computer power is required to confirm transactions. Even though coins are not lost, they patiently await in line to be confirmed, and mined into a block.

Once the transaction is confirmed it becomes irrevocable. Meaning that, if a mistake is made when transacting, it's impossible to "undo" the transaction. For example, if bitcoin is sent to an erroneous address, the lucky holder of the recipient wallet can keep the bitcoin. The only way to recover the funds is by an act of goodwill.

Hacks and scams

2019 was a big year for hackers. Around 4 billion dollars were stolen from crypto-related crimes: hacks and fraudulent scams. Bear in mind that scams and hacks do not occur on the blockchain itself, since manipulating block information is merely impossible because the pre-existing chain would be rendered invalid.

Hacks occur on the top layer of blockchain. Hackers target applications or softwares that run on the blockchain, like exchanges. For example, just because an app that is offered in the app store gets hacked, it doesn't mean that the app store itself was hacked. Well, the same logic applies to Bitcoin. Hackers target exchanges that have custody of a lot of capital, since hacking the blockchain is impossible. Therefore, it's highly recommended to store crypto in cold wallets (wallets that are not connected to the internet).

Figure 39 - Layers in a blockchain ecosystem (simplified)

Fraudulent scams, on the other hand, target naive crypto holders. The most recent Twitter attempt asked Bitcoiners to send bitcoin to a specific wallet to receive double of what was sent. Other types of scams involve ICOs. Initial Coin Offerings are similar to Initial Public Offerings (IPO) in the way that developers seek funding by offering, for the first time, the opportunity to buy the token (cryptoasset) at an early stage before price surges. A research conducted exposed that 80% of the ICOs conducted in 2017 were fraudulent. It's highly recommended to do thorough research before buying new crypto to avoid being a victim of a scam.

Hard and soft forks

One of the best attributes of blockchain is its open source characteristics. Meaning that anyone can interact with the code behind blockchain. It can be accessed, modified or cloned; a great feature if properly used. Some may argue that this feature can enable manipulation that can lead to misappropriation of Bitcoin. A task that is deemed impossible, because the whole community needs to agree on the update consisting of the manipulation.

Updating a blockchain is not limited to misuse, as it can be done to fix a bug or make the blockchain more efficient. When a blockchain is updated, it is called a fork. After a fork, the blockchain's way of validating transactions changes. Now, for the blockchain to be forked, or updated, consensus is required by nodes. If consensus is not reached, the blockchain is split into two different protocols with the same backstory.

Hard fork

Blockchain technology is a chain of blocks that store information. Each block is connected to each other by having the previous block's hash. Therefore, when a hard fork occurs the old blocks are not able to interact with the new modified blocks. So, a new blockchain is created, dividing the old and the new. The good news is that coins held before the fork are incorporated into both blockchains. For example, 10 bitcoin are owned before the hard fork of 2017. After the hard fork, Bitcoin Cash was created in a new updated and separate blockchain.

Considering the shared history between both blockchains, 10 bitcoin would be accounted for on both blockchains. As a result, the user, who is the crypto enthusiast, is left with bitcoin and bitcoin cash.

Ethereum underwent a hard fork after a Decentralised Autonomous Organization (DAO) was hacked. After investors lost around 3.6 million ether ( Ethereum's native cryptocurrency), it was decided that a hard fork was to be done to give investors access to the capital lost because of the hack. The hard fork resulted with two separate systems: Ethereum (ETH) and Ethereum Classic (ETC).

Figure 40 - With the MakerDAO bug, the ETH blockchain forked into Ethereum (ETH) & Ethereum Classic (ETC)
Soft fork

A soft fork is different from a hard fork because the new "rule" is not incompatible with the older rules. Soft forks are common for decreasing the size of blocks. For example, Bitcoin's protocol establishes a limit to how big a block can be, but how small is left open to the community's discretion. Let's say a soft fork is implemented to decrease the size of blocks. The new rule would reject big blocks by filtering out some information. The new smaller blocks do not clash with older big blocks.

Forks can be a risk because a change in the protocol affects the way users transact with one another, so it can have a direct impact on the value perceived of the crypto in question. Be sure to look for new updates or past updates and the reason behind each fork.

Regulation and taxes

Cryptocurrencies are a recent thing. Many have heard of Bitcoin and Ethereum, but little is known about how they work and their potential. It's hard to create efficient regulation on a phenomenon that is still developing. Most countries lack any kind of crypto regulation.

The United States and European countries have the most advanced crypto regulations, but they are limited to taxes. Ever since crypto investors made a lot of money after bitcoin's all-time high ($$19,498.63) in December 2017, governments have rushed to collect taxes from early adopters. The current regime is pretty vague and ambiguous, especially since principles applied to other sorts of investment (property such as stocks). As the crypto market matures, there's little doubt that regulators will begin to enforce new crypto specific policies. Until then, it's highly recommended to keep a tab on the IRS and its policies as most countries will follow their lead.

People who know little about crypto claim that investing in Bitcoin should be avoided, since it can be used to purchase illegal products and services and to launder money. Yes, some may abuse bitcoin's pseudonimity to take part in such transactions, but it doesn't mean that all bitcoiners want to outfox the system. It's a troubling trend, because legislators are encouraged to create policies that limit bitcoin and its potential. Hopefully, sooner or later everyone learns about blockchain and crypto-assets. This way scrutiny and excessive regulations can be avoided. It all depends on the responsibility of the users. At the end, there is always more good than bad in the world.