The meteoric rise in prices for cryptocurrencies — like bitcoin, Ethereum-traded ether, Ripple, Litecoin and others — has attracted lots of attention, from the public, from celebrities and entrepreneurs, and from a rash of scammers pushing everything from phishing emails to “pump and dump” schemes aimed at inflating coin prices before unloading them on casual investors.
Yet, despite the fraud and wild price swings, even Wall Street pros are seeing an opportunity to make money. Bitcoin futures — allowing traders to bet on future price moves, up or down — are now available on major exchanges. Meanwhile, one leading idea for how regular people might be able to invest in cryptocurrencies broadly has been through “exchange-traded funds” or ETFs — low-cost vehicles typically designed for retail investors who want to diversify risk, say by investing in an industry, not just one specific stock or currency.
There’s just one problem. Wall Street’s top regulator, the Securities and Exchange Commission, has now pumped the brakes on the ETF idea. In a new statement, the agency laid out five key risks to cryptocurrency investing that will need to be addressed if Wall Street wants to create these ETFs.
“There are a number of significant investor protection issues that need to be examined before sponsors begin offering these funds to retail investors,” the agency wrote in its letter.
Here are the five big risks and what you need to understand about them before dipping your toes into the cryptocurrency investing waters.
1. It’s too hard to figure out how much a given cryptocurrency should be worth
The first risk outlined in the SEC’s letter is “valuation,” or the imperfect art of trying to figure out what a given investment should be worth.
With cash-generating assets like businesses or publicly-traded stocks, investment pros generally use ratios between a stock’s price and some other metric such as profits, growth, or cash flow. This is especially important if you, like Warren Buffett or his predecessor Benjamin Graham, are a so-called “value investor,” meaning you seek out assets specifically because they are already worth more than people realize.
But even those investors more focused on future growth — the allure of companies like Tesla — can do the math to determine a valuation that makes their investment smart, at least given assumptions.
A major problem, some argue, is that unlike companies that generate cash, cryptocurrencies cannot be valued or assessed in this way — they can only be “priced” and traded like other global currencies. And they are not yet mature or stable — or “liquid” — enough to be traded with much confidence.
What is liquidity?
2. Bitcoin and other cryptos are still tricky to trade
The great irony of bitcoin is that its popularity has arguably robbed it of what was supposed to be an essential function: paying for things digitally. The payments processor Stripe recently ended support for bitcoin, writing that the booms and busts have made the cryptocurrency “less useful for payments.”
It’s not always easy to sell something that might be 30% more or less valuable tomorrow. All the activity is also ramping up transaction times — to an average time of 78 minutes in December, according to CNBC.
One of the SEC’s concerns, according to its letter, is that digital currencies aren’t “liquid” enough to be included into licensed funds, which have to keep a certain percentage of their money in assets that can be sold quickly if investors want their cash back.
3. Cryptocurrency is too easy to misplace
Another downside to storing so much value in mysterious algorithms few people understand is that it’s kind of hard to figure out where to store your money — literally. Take the case of U.K. resident James Howells, who claims to have tens of millions of dollars in bitcoin stored in a hard drive that was accidentally buried at the bottom of a local dump.
Funds that buy stocks, by contrast, are required to have what’s called a “custodian,” someone who holds the stock through a mix of digital or physical records and verifies transactions. As the SEC notes, fund managers are required to use licensed custodians, essentially middlemen, to hold funds as intermediaries to limit the risk of loss or theft. You could also buy stock from the company directly.
Currently, there aren’t any licensed custodians who specialize in ensuring the quality of digital currency transactions. To be sure, this is one of the main problems digital currencies are aiming to solve, particularly through the smart contracts being developed on Ethereum. But according to the SEC, the technology isn’t there yet.
“How would a fund... validate existence, exclusive ownership and software functionality of private cryptocurrency keys and other ownership records?” The SEC wrote. “To what extent would cybersecurity threats or the potential for hacks on digital wallets impact the safekeeping of fund assets...?”
4. Investors in a crypto ETF could be at a disadvantage
The SEC worries that the structure of ETFs is mismatched with the way that cryptocurrencies currently trade — a misalignment that can be taken advantage of (the economic term is “arbitrage”) in a way that might hurt investors who lack the absolute most recent information.
Specifically, regulators fear digital currencies might be even more susceptible to arbitrage because of their relatively low volume (meaning a little bit of buying and selling can change the price a lot) and wild price swings (the price of bitcoin swung 30% or more in a single day six times 2017).
There’s also the fact that some of the biggest bitcoin exchanges have been abruptly shut down. Coinbase, the largest crypto exchange with more than $1 billion in revenues last year, according to Recode, has been plagued by reliability problems: Back in December, the exchange had to shut down twice in one week as eager buyers overwhelmed the site, requiring new maintenance.
To address the problem, the SEC wants to see some kind of mechanism that can account for volatility and more — asking, “How would the shutdown of a cryptocurrency exchange affect the market price or arbitrage mechanism?”
5. Cryptos are susceptible to hacking and other scams
Digital currencies have had lots of problems with hackers over the years, with some of the largest exchanges becoming targets. If you’ve accumulated a lot of bitcoin, you’ve hopefully taken some precautions, like using cold storage through a paper or hardware wallet — though a recent study from researchers at the University of Edinburgh identified a number of security flaws with these hardware methods, too.
Indeed, the SEC’s fifth argument against digital currency funds is sort of a combination of the previous ones: Without addressing these issues regarding valuation, liquidity and custody, digital currencies carry an increased risk for fraud compared to other investments.
Take, for example, the prevalence of “pump and dumps.” As noted in a recent Outline report, social media-enabled schemes — where in-the-know individuals buy a tiny cryptocurrency en masse to raise the price, then immediately sell it for a gain — are increasingly common. This is pretty much exactly how the so-called “wolf of Wall Street” Jordan Belfort made his fortune, buying up tons of super-cheap stock on unregulated exchanges, driving up the price and then dumping them on unsuspecting customers who didn’t know any better.
None of these issues are irresolvable. The SEC’s letter could even be viewed as a vouch of confidence in the underlying project: The commission keeps pretty busy, so if it is making time to outline how digital currencies might be better sold to retail investors, that is arguably a way of saying the technologies have promise.
But still, the SEC’s caution is a reminder: If you’re going to trade digital currencies, you should be doing so with “fun money” you can lose — not your actual savings — at least until these five issues are better dealt with.
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