Watch Out for These Risks Before Investing in Bitcoin or Ether

Twelve years after its creation, regulating bitcoin is still complicated in most countries. That’s just one of the investment risks.

There are a number of risks associated with holding and investing in cryptocurrencies. In the latest CoinDesk Research report, we look at seven different risks, from the regulatory to the technological, that affect bitcoin (BTC, +0.59%) and ether (ETH, -1.43%), and whether you’d want to hold these assets for the long term.

Here is a brief overview of three of those risks, identified in the report “Bitcoin + Ether: An Investor’s Perspective.

1. Regulatory

Twelve years after the creation of the world’s first cryptocurrency, bitcoin, regulating the asset is still complicated in most countries. Officials want to know, are bitcoin and other cryptocurrencies financial assets? Commodities? Property?

As for ether, the questions are on a different level because of the underlying Ethereum blockchain. So regulators in the U.S., for instance, are wrestling with the kind of information decentralized applications (dapps) and proof-of-stake blockchains (where Ethereum is heading with its Eth 2.0 upgrade) do and do not collect about its users.

In December 2020, the U.S. Financial Crimes Enforcement Network (FinCEN), a unit of the Treasury Dept., proposed rules affecting banks and money services companies as well as crypto exchanges. Exchanges would have to collect names and home addresses for the owners of private crypto wallets (also referred to as self-hosted wallets, unhosted wallets or sometimes just “wallets”) receiving more than $3,000 in cryptocurrencies in aggregate in a day.

Such rules, if implemented, could put a big chill on those holding crypto on exchanges, and even on users of Ethereum and its dapp ecosystem. Most of the activity on dapps is as yet untraceable, and the ease of moving value around in a pseudonymous manner through the ether cryptocurrency is still intact. There is the potential for this proposal to be implemented by U.S. regulators in some form but FinCEN is taking public comment and industry feedback until March 29.

2. Technological

The risk of a bug in the Bitcoin protocol’s software is low but not zero. The introduction of upgrades such as “Taproot” brings new code to the bitcoin currency’s underlying protocol that may make its technology open to new attack vectors.

The technological risk for ether is much greater than bitcoin because of the Ethereum blockchain’s ambitious upgrade to a proof-of-stake (PoS) consensus protocol. Ethereum 2.0 will radically change how transactions and dapps are secured on the network.

PoS is a highly experimental technology that has yet to see widespread adoption on the same scale as Ethereum today. Ethereum 2.0 represents the bet that PoS will one day be able to replace Ethereum fully and adopt the network’s existing user base in its entirety.

Due to the ambitious goals of the upgrade, there is a higher probability for code bugs and failures through the implementation of Ethereum 2.0 on Ethereum than Bitcoin’s Taproot upgrade.

In addition to protocol upgrades, there is a different type of technological risk that exists for both the Bitcoin and Ethereum systems because they rely on the activity of “mining” for network security. A hostile actor could launch what is called a “51% attack” and censor blockchain transactions or cancel approved blocks by taking control of the majority of miner hash power.

(Hash power is a measure of the computational energy expended by miners on a blockchain to process and finalize transactions.)

BTC and ETH Mean Hash Rate
Source: Coin Metrics

Given the current size and spread of the crypto industry’s hash power, the cost of a 51% attack on Bitcoin, and to a lesser extent on Ethereum, is prohibitively expensive, but could be within reach of a state actor.

3. Competitive

Another common risk associated with bitcoin and ether is the potential for a more efficient, secure competitor to replace the assets. But while this is possible given that both are based on open-source code that anyone can replicate on GitHub, it is increasingly unlikely.

The main reason is because the size of the Bitcoin and Ethereum networks is becoming an insurmountably high barrier. In Bitcoin’s case, the strength in the network is not just from the number of active addresses, which hit all-time highs in late January 2021. It is also from the number of miners that expend computational power to secure the network.

A competitor would have to steal away bitcoin miners with a more attractive and profitable alternative. Incentivizing miners to switch their machines to a different protocol would require amassing similar levels of user trust and market value.

Ethereum is in a similar position. Network effects matter, even if blockchain interconnectivity becomes seamless because the strength of the developer network and the sprawling web of complementary dapps matter.

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