Starter Guide to Crypto Investing Risks

Introduction

At Uphold, your security and experience are our top priorities. To ensure a safe and smooth journey, we follow all applicable regulatory requirements, including the financial promotion rules set by the Financial Conduct Authority (FCA). These guidelines aim to empower investors with a better understanding of the risks and responsibilities of crypto investing.

We’ve crafted this guide to explain key terms and concepts, giving you the tools to help make informed decisions as you explore the world of crypto. Let’s dive in and make your crypto journey a confident one!

Crypto Volatility

Crypto asset markets are known for their extreme price swings, where the value of an asset can rise or fall dramatically in a short time. This volatility is driven by various factors, such as regulatory news, adoption rates, technological advancements, market conditions and speculative trading. For instance, a country announcing restrictions on crypto usage could cause sudden price drops, while favourable news, like institutional adoption, could drive prices up.

Before you invest, keep these three things in mind:

• There’s no guarantee that the price of a crypto asset will increase. 
• Past performance is not a reliable indicator of future results.
• You could lose all the money you invest regardless of the asset or how long you own it.

Market Liquidity and Depth

Liquidity is an important concept in crypto. This is how easy it is to buy or sell a crypto asset without changing its price too much. Imagine you're at a lemonade stand. If there is lots of lemonade for sale, and lots of buyers, it's easy to get one for the same price everyone else is paying—that’s high liquidity. But if there’s only a few lemonades left for sale, but the same amount of buyers, someone may offer to pay more to get one of the last ones, and those offering the old prices may have to wait, that’s low liquidity.

When there’s high liquidity, it means you can buy or sell assets quickly without causing big changes in their prices. Low liquidity can cause sudden price swings because there aren’t enough buyers or sellers at a given price. 

Investment Diversification and Risk Management

The FCA classifies crypto assets as high-risk investments. It advises restricted investors to limit high-risk investments like crypto, to under 10% of their net assets.

Crypto assets are high risk partly because they’re complex and can be hard to understand.

Before investing, it’s crucial to do your own research and understand the risks. A key strategy for managing risk is diversification, which means spreading your investments across different asset classes, such as stocks, bonds and crypto assets. This reduces your overall exposure to any single market or asset.

Stablecoins, DeFi Tokens, and Memecoins

The crypto asset market comprises various types of assets, each with distinct functions and risk profiles.

Memecoins

Memecoins are cryptocurrencies inspired by popular trends, which can change quickly. Because they’re tied to what’s popular, their prices can rise or fall suddenly based on shifts in online interest. Memecoins are often backed by enthusiastic online communities but may not have any real-world use or practical value.

Stablecoins

Stablecoins, like USDT or USDC, are designed to track the value of a traditional currency, such as the U.S. dollar. They’re popular in crypto markets because they let you keep funds accessible while helping you avoid the extreme price swings of other crypto assets. However, stablecoins come with risks too. Sometimes, they can ‘depeg,’ meaning their value drops below the currency they’re supposed to track. For example, TerraUSD (UST), a stablecoin linked to the crypto asset Luna, fell from $1 to just a few cents.

Stablecoins can depeg for several reasons including technical or operational issues, market speculation or concerns about the issuer’s transparency and collateral. Sudden market shifts, like a rush to buy or sell stablecoins, could also cause a liquidity crunch, causing their price to drop quickly.

DeFi Tokens

Decentralised Finance (DeFi) tokens are used in blockchain-based financial services that don’t rely on traditional banks or intermediaries. These tokens enable activities like lending and borrowing through smart contracts — automated programs that run on the blockchain. While many DeFi platforms have their code reviewed, tested and audited, smart contracts are still vulnerable to technical issues and hacks. In fact, hacking losses in the DeFi space have been estimated to be in the billions of dollars.

Taxes

If you make a profit from trading crypto assets, you may need to pay Capital Gains Tax in the UK. It’s your responsibility to report your gains and pay any taxes to the proper authorities. We recommend seeking advice from a professional tax advisor to ensure you meet your obligations.

Regulatory Protections

Crypto assets are not regulated in the UK, which means they offer less protection compared to  other investments. For example, unlike bank accounts, there is no Financial Services Compensation Scheme (FSCS) to cover crypto assets. Similarly, the Financial Ombudsman Service (FOS) doesn’t handle complaints related to crypto assets, so they may not be able to help resolve disputes with crypto service providers. This means that if a crypto platform fails, becomes insolvent, or loses your funds, there may be no way to recover your money.

Security Risks with Crypto Exchanges and Wallets

Most crypto assets are powered by blockchain technology, which is a decentralised system, also called a  decentralised ledger, that records all transactions. This means no single entity controls the system. Instead,  it’s maintained by a network of computers, or nodes, making transactions more transparent. However, decentralisation can sometimes result in slower transaction times compared to centralised systems.

Hot and Cold Wallets

Because crypto assets are digital, they're vulnerable to cyber threats. Many exchanges offer hot wallets, which are digital wallets that allow you to easily access and trade your crypto. Hot wallets store your private keys and assets online. While this is convenient, being connected to the internet makes them more vulnerable to hacking.

Cold wallets, such as hardware wallets (physical devices, like thumb drives) aren’t connected to the internet and store assets offline. This offline storage reduces the risk of online attacks, but they’re not risk-free. Cold wallets are still vulnerable to insider threats and operational issues such as losing your private keys, and therefore access to your wallet.

If you store assets at a crypto asset exchange, you don’t hold your own private keys. This adds some risk as you need to trust that your exchange will look after your funds for you.

A well-known example of exchange vulnerability is the 2014 Mt. Gox hack, where 850,000 bitcoins were stolen. While exchanges usually have robust security controls, many people choose to ‘self-custody’ their crypto, meaning they keep their coins in their own wallets that they control with their own private keys rather than in an exchange wallet.

However, if you lose your private keys, you could lose access to your funds forever, so it’s essential to back them up securely. You might also want to explore using multi-signature wallets, which add extra layers of security. For example, Uphold Vault is a hybrid wallet solution that offers assisted key replacement.

Exchanges can also face risks like hacks or outages, which could cause you to miss market opportunities. For example, prices may change while the exchange is offline,  and you might not be able to trade at the prices that were available during the downtime when your exchange comes back online.

If the exchange where you store your funds experiences a hack, theft, insolvency or other technical or operational issue, you could lose your funds.

Due Diligence and Marketing of Crypto Assets

When cryptocurrency trading platforms conduct due diligence, they often look into a crypto project's team, technology, and use case. However, due diligence doesn't guarantee that an asset is safe or will be profitable. Even if an exchange lists an asset, its value can still change unpredictably. It’s important that you do your own research and carefully review the promotional materials for any crypto assets to make sure the information is accurate.

Smart Contracts, Staking and Yield Farming

Smart contracts are self-executing agreements coded directly on the blockchain, commonly used in DeFi. They enable peer-to-peer transactions without intermediaries. For example, in a smart contract you can set predefined conditions, like price and volume, and if these conditions are met, the contract automatically transfers ownership to the buyer. While smart contracts are designed to be secure, they’re still subject to risks, like bugs in their code, which can be exploited.

Staking is the process of delegating your assets on-chain to help validate transactions and operate and secure a crypto network. This is used for crypto assets that rely on Proof of Stake (PoS) as their consensus mechanism. In exchange for staking your crypto assets, you can earn rewards, such as additional crypto assets.

However, there are several risks involved with staking. Examples include: 

• The value of your staked asset and reward can change rapidly in Dollar terms.
• Due to bonding periods that apply to some stakeable assets,  you may not be able to access or sell your crypto during a certain period of time when staked.
• If you’re staking through a third-party service, such as a staking pool, you depend on that service’s security and reliability. If the provider fails or gets hacked, you could lose your staked funds. 
• Reward rates are often variable and may change over a given period.

Yield farming is a practice in DeFi where you can engage in an activity such as lending or staking your assets to earn returns, like interest. Yield farming comes with risks, such as price fluctuations and smart contract vulnerabilities. If you use an asset as collateral to borrow against it, and it suddenly goes down in value, you may lose your collateral.

Understanding these elements is key to navigating the world of crypto. It helps you see how crypto goes beyond traditional investing and highlights the risks tied to emerging technologies.