Blockchain technology has made crypto an exciting asset class for investing. However, for the first time, we encounter a whole new set of risks with crypto that are unlike any other traditional financial asset.
To be fully informed, we need to consider the technological risks of crypto.
Hacking and Security
Natively digital assets like cryptocurrency are susceptible to hacking. Instead of breaking into a vault, criminals break into our computers or digital wallets. The motives behind the crime aren't always monetarily driven.
Theft / Scams
The decentralized nature of crypto makes tracking down thieves very difficult. The self-sovereignty of a decentralized currency requires us to be responsible for protecting ourselves from fraud and scams. There isn't a governing body to help us recover our lost coins if stolen from us. We have to do our own due diligence to ensure the applications and crypto we use are trustworthy.
We also need to make sure we safeguard our digital wallets. In most cases, people end up losing their coins to scams compared to actual hacks. Anytime prices and popularity surge, we need to be cautious - bad actors have more to gain scamming in this environment. In addition to our computers, exchanges are prime targets. They hold large amounts of the crypto we buy and sell, making them the digital equivalent of bank vaults for thieves. Recently, exchanges have prioritized security and protection; however, hackers have been able to get through in the past.
Savvy hackers who understand the blockchain network can manipulate entries to the ownership ledger to scam merchants or individuals.
Due to strong validation protocols, double-spending is very difficult to do on well-established blockchains like Bitcoin and Ethereum, but it's more likely to occur on smaller blockchains.
For most blockchains, the risk of double-spending requires a 51% attack.
These attacks are especially dangerous because they can give an individual or an entity control over a blockchain.
Mining validates blocks under a proof-of-work system. A 51% attacker needs to amass a majority of mining power, or hash rate, to get control of a blockchain. Once done, they could exclude, modify the ordering of blocks or prevent transactions on the blockchain. While in control, they could also double-spend by reversing transactions they made.
These attacks require enormous amounts of money and computing power (we're talking colossal computer farms). So while they're INCREDIBLY difficult to pull off on major blockchain networks like Bitcoin or Ethereum, they're more likely to happen on smaller networks - especially if done by governments.
Limitations to growth
Some risks are less malicious than hacking and scamming. They stem from continued development efforts on evolving technology.
Networks must be designed to handle large-scale use to be practical. Currently, transactions are processed much slower on blockchain networks than credit card networks, causing transaction costs of some crypto to rise significantly during peak times.
Slower transaction speeds and higher costs are obstacles for crypto to become a dominant global payment system. As blockchain technology evolves, it will need to address these problems.
Forking creates two separate blockchain networks and, therefore, two different versions of the currency.
Monetary incentives can cause more centralization of the technology over time.
Mining pools have begun to pop up because of increasing computing costs to mine Bitcoin. They are a centralized effort that undermines the decentralized intentions of cryptocurrency.
Many positives about crypto rely on an optimistic outlook. You need to understand the risks of the technology that allows crypto to function to invest responsibly.
Here are a few questions to help you consider the risks before buying a cryptocurrency:
- What is the use/utility of this crypto?
- Is it just a currency, or does it also provide a service for any smart contracts?
- How secure is the exchange I'm using?
- How secure is the blockchain?
- Is it widely used? Can I easily trade crypto on it?
- Are there any scalability issues - does it slow down or get expensive during peak times?
- How do blocks get validated; is it by Proof-of-Work or Proof-of-Stake?
- Are there mining pools?
- Is the blockchain likely to fork?