The 6 Biggest Risks to Bitcoin
What goes up, might come down.
Historically speaking, few, if any, asset classes have outperformed the stock market over the long term. Including dividend reinvestment and inflation, the stock market has returned an average of 7% annually. It has run circles around other assets like gold, bonds, oil, and even home prices.
But 2017 has been a year like no other. It has introduced the world, loud and clear, to cryptocurrencies. When the year began, the aggregate market cap of all digital currencies combined equaled just $17.7 billion. Earlier this month, the aggregate value of these cryptocurrencies soared past $225 billion. This represents almost a 1,200% return in less than 11 months, which the broad-based S&P 500 has taken decades to accomplish.
Leading the charge is the most popular virtual currency, bitcoin. The original cryptocurrency began the year under $970 per coin, and Nov. 16 it topped the $8,000 mark. That's a return of more than 700% year to date, pushing bitcoin's market cap to an astonishing $133 billion. For added context, bitcoin's market cap is now larger than several well-known companies in the Dow Jones Industrial Average.
A happy investor pumping his fist while looking at a rising chart on his computer screen.
Why bitcoin has been unstoppable in 2017
A number of factors have pushed bitcoin higher. At the top of the list is the potential of the blockchain technology that underlies most virtual currencies, including bitcoin. Blockchain is the digital and decentralized ledger that records transactions without the need for a financial intermediary, such as a bank. Because blockchain is usually open-source, it would be nearly impossible to change logged data without someone else noticing, which makes it highly secure. Some pundits suggest it has a bright future in the financial-services industry.
Other factors that have fueled bitcoin's meteoric rise include a weaker U.S. dollar, a growing acceptance of bitcoin as legal tender, and retail investors who simply don't want to miss the boat.
But this isn't to say bitcoin is without risks. In a span of just five months, bitcoin has endured three bear-market-like crashes of 38%, 40%, and 29%, respectively. In no particular order, the following six risks could derail the most popular virtual currency in the world.
Bike chains covered in binary code interconnected to represent blockchain.
- Bitcoin's blockchain loses its appeal
The real value with cryptocurrencies lies with their blockchains. At the beginning of August, following a soft fork that saw bitcoin separate into two separate currencies (bitcoin and bitcoin cash), bitcoin's blockchain was upgraded. This upgrade moved some information off of bitcoin's blockchain in order to boost capacity and transaction settlement times, as well as reduce transaction fees, in an effort to attract enterprises.
But what if bitcoin's blockchain fails to be a go-to option for businesses? Right now, more than 150 organizations are currently testing a version of Ethereum's blockchain, which supports smart contracts. These are protocols that help facilitate, verify, and enforce the negotiation of a contract, and they provide marked distinction from bitcoin's blockchain. If bitcoin's blockchain fails to differentiate itself and attract enterprises, bitcoin's price could suffer.
A businessman putting his hands out as if to say no thanks..
- Brand-name businesses stop accepting bitcoin
Since 2014, a handful of brand-name businesses have accepted bitcoin as a form of payment, with smaller merchants latching on in recent years. Some investors view this growth in bitcoin's payment platform as a good reason to buy.
However, it could also be a source of investor frustration. If bitcoin remains volatile (remember, it's had three declines of at least 29% in a very short period of time over the past five months), there's the real possibility that merchants could bow out of accepting the virtual currency. A potentially lengthy settlement period gives bitcoin time to move against the grain, which could mean converting bitcoin into a lot less cash than when a transaction was completed. If brand-name merchants bail on the virtual currency, bitcoin's price could tumble.
A courtroom with a gavel in the foreground and judge's chair in the background.
- A double-edged sword of regulation
In some ways the regulatory environment for bitcoin has been a positive in 2017. Japan began accepting the currency as legal tender earlier this year, and the CME Group (NASDAQ:CME) -- operator of the world's biggest derivatives marketplace -- recently announced that it would begin carrying bitcoin futures by the end of the year. These moves help to validate bitcoin as an investment and a form of tender.
Then again, the regulatory environment can also keep bitcoin out of lucrative markets. In September, both China and South Korea nixed initial coin offerings, with China going a step further and announcing the eventual closure of domestic cryptocurrency exchanges. Increased regulation could either help or hinder bitcoin.
A cyberattacker with black gloves using a computer keyboard.
- A cyber attack hits Bitfinex (or another cryptocurrency exchange)
Another critical risk for bitcoin -- and all cryptocurrencies, for that matter -- is the potential for a cyberattack. Four years ago, Mt. Gox, which was handling about 70% of bitcoin's trading volume at the time, was hit by a crippling cyberattack. In the bankruptcy filing from Mt. Gox just months later, it cited the theft of 850,000 bitcoin (worth $6.8 billion today) and cash. In the two years following this cyberattack, bitcoin wound up losing more than 80% of its value.
Today, cryptocurrency exchange Bitfinex handles around half of all trading volume for bitcoin. If it were to be hit with a cyber attack, it could destabilize the market and send bitcoin significantly lower.
A frustrated stock trader clasping his head in front of his computer.
- Margin mayhem derived from its CME listing
The recent announcement that the CME Group would begin listing futures for bitcoin by year's end was viewed as a positive by many on Wall Street. The ability for Wall Street firms to take a stake in bitcoin, without having to dabble in decentralized cryptocurrency exchanges, could introduce new money and reduce volatility.
But there's another side to this story.
Futures trading will allow Wall Street to bet against bitcoin for the first time ever. It will also allow all walks of investors to borrow on margin to enter those short positions. If bitcoin's value were to swing violently up or down, it could lead to a flood of margin calls that have the potential to destabilize the market for bitcoin. And because there's no precedent for an asset like bitcoin, setting the margin limits is nothing more than guesswork at this point.
A worried investor looking at a plunging chart on his computer screen.
- Investor emotions sack bitcoin
Last but not least, investor sentiment, which has been a crucial catalyst of bitcoin's growth, could also push this virtual currency downward. Since bitcoin's inception, individual investors have controlled its value. Compared to Wall Street investment firms, retail investors are far more prone to allowing their emotions to influence their investing decisions -- which rarely ends well. Many of bitcoin's wild price swings owe to retail investors' piling into or bailing out of bitcoin based on the latest news. It wouldn't take much for investor sentiment to shift and send bitcoin's value plummeting.
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