Digital asset suitability

As we’ve explored with the other investment vehicles in this unit, let’s discuss the BRTI of digital assets.

Benefits

While digital assets maintain many benefits related to functionality and usefulness, they provide two primary investment benefits - capital appreciation potential and added diversification.

From 2019-2021, it was difficult to lose money on digital assets. Many cryptocurrencies experienced returns well above 100% (a few above 1,000%), and some NFTs were selling for millions. This Forbes article details 19 billionaires that accumulated their wealth through cryptocurrencies. Although some digital assets had existed for a decade or more (Bitcoin was developed in 2009), their values skyrocketed when the general population became aware of their existence, resulting in significant capital appreciation (buy low, sell high) for many investors.

Digital assets also provide an added layer of diversification. The biggest benefit to maintaining a diversified portfolio is holding assets that perform well when others underperform. For example, in 2020, the S&P 500 was down roughly 4%, while BTC was up over 300%. Having some exposure to digital assets in this period helped balance out the risks experienced in the stock market.

Risks

Unfortunately, digital assets expose investors to many different risks. As some have built incredible wealth on their holdings, many others have experienced significant losses. We’ll discuss the following risks in this section:

• Price volatility
• Fraudulence
• Hacked & lost assets
• Market manipulation
• Digital asset platform disasters

Price volatility

Digital assets are infamous for their price volatility. To demonstrate this, let’s take a look at the annual returns of the top three cryptocurrencies compared to the S&P 500 from 2019-2022:

As you can see, the values of the top three cryptocurrencies fluctuated significantly more than the S&P 500, which is already considered a somewhat volatile stock index. Other digital assets experienced even more volatility. For example, Dogecoin was down 80% in 2019, only to increase 2,300% the following year.

There are several reasons digital assets experience volatility. Some relate directly to the asset itself, while other times, volatility is driven market-wide. Regardless, investors must be aware of the roller coaster ride they’re on. Getting caught on a downward swing could prove to be devastating.

Fraudulence

The world of digital assets is new and complex, which creates an opportunity for sophisticated fraudsters. According to an FTC report, cryptocurrency investors are particularly susceptible:

Since the start of 2021, more than 46,000 people have reported losing over $1 billion in crypto to scams – that’s about one out of every four dollars reported lost, more than any other payment method. The median individual reported loss? A whopping $2,600.

As discussed in the previous chapter, most digital assets are held by a private key. A fraudster obtaining a person’s private key is the equivalent of dropping a traditional wallet in front of a thief. Within seconds, all of the assets can be drained.

Most investors maintain their digital assets in online (digital) wallets. If a scammer gains access to a person’s computer or phone, it becomes very easy to obtain private keys. This can be accomplished by phishing, which involves the creation of fake communications seemingly created by trustworthy sources. For example, assume an investor holds digital assets on a cryptocurrency exchange (e.g., Binance). They receive an email seemingly sent by Binance regarding an issue with their account with a link to contact customer service. The investor clicks the link, which installs malware on their computer. The email was fake, and the malware transmitted personal data stored on the investor’s computer to a scammer, which included login credentials and private keys.

Pig butchering schemes are also a common form of fraud involving digital assets. This form of fraud involves building a (sometimes romantic) relationship with an unsuspecting victim, then soliciting investments in fake digital assets or platforms over time. The North American Securities Administrators Association (NASAA) identified this scheme as the second biggest investor threat in 2023. According to the Department of Justice:

“The victims in Pig Butchering schemes are referred to as ‘pigs’ by the scammers because the scammers will use elaborate storylines to ‘fatten up’ victims into believing they are in a romantic or otherwise close personal relationship. Once the victim places enough trust in the scammer, the scammer brings the victim into a cryptocurrency investment scheme.”

High yield investment programs (HYIPs) are another common form of fraud in the digital asset marketplace. These scams typically involve the promise of incredible returns for little-to-no risk. California’s state administrator provides this example of a fraudulent HYIP::

You see a video on YouTube from someone who looks like they know about investing. The person is talking about a new investment opportunity they recently discovered. In the video, the person is explaining how easy it is to get started and deposit money. The person is also showing off the amazing profits they’ve already made in this investment. It sounds like a great way to invest and make money!

You go to the website, sign up, and select an investment package. Then, the website gives you a crypto wallet address to deposit your funds into. You deposit the crypto asset and over the next few days, weeks, months, or more, you regularly log in to the website and it shows that your account balance is going up and you’re making the high returns as promised! You try withdrawing some of your funds and it works. You deposit more money and now you’re making even higher returns. Then, one day, the website tells you that it is experiencing temporary withdrawal issues. Finally, a few days later, the website is no longer online.

Most fraudulent schemes connected to digital assets are initiated via text messages or social media. Investors must be especially vigilant and skeptical to avoid becoming a victim.

Hacked & lost assets

Any valuable asset held in digital form is subject to hacking. This can occur on an individual or organizational level. For example, a hacker may access an investor’s private keys through a public WiFi system. Or, a cryptocurrency exchange maintaining custody of digital assets is hacked, resulting in enormous losses for the organization and its customers. This actually occurred with the BTC exchange known as Mt. Gox, which resulted in over 650,000 BTC lost (worth over $17 billion as of May 2023).

Investors can also simply lose their digital assets. This especially impacts those that keep their private keys in hardware or paper wallets. If you recall the example we discussed in the previous chapter, a man mistakenly threw away a hard drive holding his private key to 8,000 BTC (worth more than $200 million as of May 2023).

Market manipulation

Market manipulation, which is the act of artificially influencing the price of an asset or commodity, has plagued financial markets. We’ll discuss how this unlawful action impacts the securities markets in a future chapter. For now, let’s discuss the most common forms of market manipulation occurring in the digital asset markets, which include:

• Pump and dump schemes
• Wash trades
• Dissemination of false or misleading information

Pump and dump schemes
A pump and dump scheme typically involves a perpetrator with an investment in a lesser-known digital asset “talking it up” as a fantastic opportunity. If the message is well-publicized, others buy-in and drive up demand. After the asset’s market value rises considerably, the perpetrator sells it and makes a big profit. The infamous John McAfee was charged with fraud connected to this scheme before his death:

McAfee used his verified Twitter account, which currently has around 1 million followers, to recommend a “Coin of the Day” or “Coin of the Week.” The indictment says McAfee claimed to have no stake in these altcoins; in reality, McAfee would allegedly buy large quantities beforehand using bitcoin, then offload them again after his followers had driven up the price.

Wash trades
A wash trade involves trading a digital asset for no legitimate reason other than to entice other investors to execute transactions. For example, a group of fraudsters obtains a large position in a relatively unknown cryptocurrency. Afterward, the group trades the digital asset together only to drive up the reported trading volume (not for any other honest reason). Other investors notice that the lesser-known cryptocurrency is being traded more, and some buy the asset in hopes of getting in before the market price rises “to the moon” (increases considerably). Once the added demand results in a higher market price, the fraudsters sell out of their position for a profit.

Dissemination of false or misleading information
Digital assets are especially prone to market manipulation through the dissemination of false or misleading information. It’s now easier than ever to transmit information to big populations with social media. A fraudster with a large following could effortlessly spread false or misleading information to their communities, potentially resulting in the market being artificially influenced. For example, a group of investors sued Elon Musk and alleged his “trolling,” misleading tweets, public comments caused significant losses in Dogecoin.

Digital asset platform disasters

Several digital asset platforms have seemingly shut down overnight due to poor structures or mismanagement, resulting in significant customer losses. For example:

• FTX collapse results in suspected $8 billion in lost customer assets
• Celsius network, a crypto lending platform, becomes insolvent and owes customers $4.7 billion
• Stablecoin TerraUSD collapses, wiping out $45 billion in market capitalization

Typical investor

If it’s not clear by now, the digital asset marketplace is full of risks and volatility. Of course, with significant risk comes significant return potential. Regardless, most investors should completely avoid or only allocate a small portion of their investment portfolio to digital assets. Most advisers recommend allocating no more than 5% of a portfolio to this type of speculative investment.

Only the most aggressive investors with long time horizons (to make up potential losses) should consider making significant investments in digital assets. Not only must the investor remain savvy and sophisticated technologically to avoid scams, but they must also understand the underlying mechanics and marketability of their chosen assets. The added volatility of most digital assets compounds the risk further.