The Inherent Risks of Capital Markets
Protect your assets by understanding the potential risks of investing in cryptocurrency and traditional markets. Our comprehensive article has all you need to know.
Investing can be a great way to grow your wealth, but it's important to understand that with potential rewards come inherent risks. This is especially true in the world of cryptocurrency markets, where the risks can be even more significant. It's essential to understand the potential dangers of investing and take steps to mitigate those risks.
- Inherent risks are derived directly from the way of functioning of the market and are a natural part of it
- Risk, considering capital markets in general, can be divided into systematic (whole market) and unsystematic (specific business or industry)
- Crypto-specific risks stem mainly from its experimental nature, including security risks, technical and regulatory risks
- The financial risks of Crypto are tied heavily to high volatility and the frequent absence of inherent utility
- Security risks concern mainly hacks, fraud, and unreliable third parties
This article will explore the various risks involved in both the overall capital markets and the crypto market specifically. We'll cover everything from volatility and financial loss to smart contract risks and scams.
- In accounting, the term Inherent risk refers to the possibility of inaccurate information in a financial statement, which could not be prevented by internal control -
Capital markets in general
Capital markets are inherently unpredictable, with various factors such as economic trends, political decisions, and global events impacting their performance. While there is no such thing as a risk-free investment, understanding the potential risks can help investors make more informed decisions.
Market (systematic) risks
Systematic risks are the ones that arise from the overall functioning of the financial system and cannot be completely mitigated by diversification. These risks are generally difficult to predict and can be triggered by factors such as political events, global pandemics, or economic downturns.
Typical examples of systematic risks include:
- Macroeconomic risks - derived from broader economic trends and events, such as changes in interest rates, inflation, or global political instability.
- Interest rate risk - the risk of rising interest rates, which can decrease the value of previously emitted fixed-income securities, such as bonds.
- Geopolitical risks - these arise from events and conflicts around the world, such as trade wars, natural disasters, and political unrest.
Specific (Unsystematic) risks
Unsystematic risks are tied to a specific security or an industry sector. Given the nature of such risks, they can be mitigated by allocating your portfolio to different securities or asset classes. It is somewhat better predictable than systematic risk because it involves fewer conditions to count with and can be assessed by risk management before investing in that particular security.
Unsystematic risks are further divided into the following types:
- Business-specific risk - these risks arise from the nature of the business itself. A company may face increased competition, changes in consumer preferences, or technological disruption, which could negatively impact its financial performance
- Financial risk - These risks stem from a company's financial structure, including its debt levels and credit ratings. If a company has too much debt or a poor credit rating, it may have difficulty securing financing or refinancing existing debt
- Regulatory risks - These risks arise from changes in laws and regulations that affect a company's operations. For example, a company operating in the oil and gas industry may be impacted by changes in environmental regulations
The risks of Crypto markets
As opposed to the traditional financial market, crypto contains many additional risks stemming from its experimental and innovative nature. Understanding these risks is essential for anyone operating in crypto, as it can help mitigate a large number of potential losses just by following basic cautionary techniques.
These are common with any other financial instrument, but with big differences in quantity. Cryptocurrency markets are known to be a high-risk high-reward environment, volatile and speculative. What would be unthinkable in traditional markets is a slice of daily bread in crypto.
This volatility is highly caused by market sentiment with rapid mood swings and excessive use of leverage. Considering projects with lower market capitalization, it is much easier to influence the price with lower capital, adding up to the volatility. The absence of a regulatory framework can also contribute to increased volatility, by enabling more market manipulation and speculation.
Some projects lack real-world applications or intrinsic value, making them highly susceptible to price manipulation and eventual collapse. As a result, investing in these projects carries significant risk, as the value of the asset is based solely on market sentiment and speculation rather than any underlying fundamentals. It is crucial to conduct thorough research before investing in any crypto project to avoid potential losses due to a lack of inherent value.
Lack of liquidity in crypto projects can be caused by various factors, such as low trading volume, limited market depth, and high bid-ask spreads. This lack of liquidity can manifest in the market by making it difficult for traders to buy or sell a particular crypto asset without significantly affecting its price. In other words, low liquidity can result in price volatility, as even a small trade can cause a significant price movement.
Additionally, it can also lead to wider bid-ask spreads, making it more expensive for traders to enter or exit a position. This lack of liquidity can also make it harder for investors to accurately value the asset, which can further contribute to market volatility.
Hacks and scams
Hackers can exploit vulnerabilities in exchanges, wallets, or other infrastructure to steal private keys, gain unauthorized access to user accounts, or manipulate transactions. Once stolen, cryptocurrencies are virtually impossible to recover, and the victims may suffer significant financial losses.
Therefore, it is crucial to follow these common practices:
- Use secure and reputable platforms with audited code
- Keep your private keys in your own custody offline, never share them.
- Always do your own research (DYOR)
Scams are another major risk in the crypto market. The decentralized and often anonymous nature of cryptocurrency transactions can make it difficult to determine the legitimacy of a project or investment opportunity.
Anonymity also plays a big role in enabling various fraudulent activities. When operating on blockchain, it is possible with a few key practices to remain anonymous, in case the fraud was revealed. This anonymity feature further promotes the formation of new scams as it is much harder to connect the scam to a specific group or individual.
One common example of a crypto scam is a "rug pull," in which a project's creators suddenly abandon the project and take all the invested funds with them. Additionally, fake crypto exchanges, pyramid schemes, and Ponzi schemes are prevalent in the crypto market. It is important to thoroughly research any investment opportunity and to be cautious of promises of high returns with little risk.
Exchanges and Custodial Services
Another major security risk in the crypto space is the vulnerability of exchanges and custodial services. These third-party services hold users' funds in digital wallets, which can be a target for hackers. Some risks associated with exchanges and custodial services include:
- Hacks or data breaches - Exchanges and custodial services can be targeted by hackers, resulting in the loss of user funds and sensitive data
- Insolvency or fraud - Exchanges and custodial services may go bankrupt or engage in fraudulent activities, resulting in the loss of user funds
- Centralization risks - By holding users' funds in a centralized way, exchanges and custodial services create a single point of failure that can be targeted by attackers.
Smart contracts often present an opportunity for exploitation points for hackers to steal funds or disrupt the network, as they may be coded poorly. Major financial losses have occurred due to security breaches in smart contracts. Their simultaneous benefit and drawback is that they cannot be modified once placed onto the blockchain. Being a new technology, many things are figured out by a kind of trial-and-error mechanism, often a little error resulting in a major inconvenience.
Blockchain is an experimental and rapidly developing area, meaning it is sometimes quite difficult for common users to operate. Technical challenges often cause users to undergo security breaches or financial loss completely by mistake. Much more responsibility is transferred to the individual, such as the self-custody of private keys and handling transactions.
The learning curve is steep and no technical support is available for users when using blockchain, making it pretty much inaccessible for mass adoption. Mistakes are a common part of crypto and it is expected for newcomers to figure things out without much external help.
Regulatory risks in the crypto market are a major concern. The regulatory landscape for cryptocurrencies and blockchain technology is still developing, and it varies significantly from country to country. Governments may view crypto as a threat to their financial systems or may simply be trying to regulate it to prevent fraud and protect consumers.
This uncertainty can cause significant volatility in crypto markets, as news of increased regulation or outright bans can cause large swings in prices. It is important to stay up to date on regulatory developments and understand the potential impact on your crypto holdings.
Government regulation could put entire crypto projects out of business, simply because they will not be able to fulfill all the requirements. The market sentiment would probably react poorly to such strict regulations, followed by a steep downfall in token prices. This risk is not much predictable and has more of a systematic nature when concerning crypto.
Is crypto riskier than stocks?
Depends on the type of stock and type of crypto. Some stocks of particularly small or innovative companies pose a higher risk for investors than big and verified cryptocurrencies like Bitcoin or Ethereum.
Does crypto have intrinsic value?
As within any field, there are projects that bring more value as well as those with less value. Certain crypto projects are valuable for example because they power a whole self-sustaining ecosystem of applications, such as Ethereum. On the other hand, the majority of emerging projects do not bring much innovation.
How to identify inherent risk?
If the risk is associated directly with how the market or particular industry operates, then it is considered an inherent risk. Derived risks, such as investor psychology and so on are not considered inherent to the market.
How to distinguish between systematic and unsystematic risks?
If the risks involve the whole market and cannot be easily mitigated or predicted, then they could be considered systematic risks. Otherwise, the risks associated with a particular market industry or specific business, stemming from its nature are unsystematic risks.
What is the biggest risk with cryptocurrency?
That is quite relative, as most of the risks are of a different nature and cannot be directly compared to each other. One particularly dangerous risk with a lot of projects is the lack of intrinsic value/utility, as it could easily render them pointless.