Bitcoin and other digital currencies have often been perceived by individual investors as a hedge against currency depreciation. However, the recent removal of the stablecoinTerraUSD floor rate and the volatility that has affected several cryptocurrencies have shown the limits of this “impression”.
This proves to us once again that investing in cryptocurrencies can be risky and that investors should only do so under certain conditions. The first is obviously the understanding of the product.
The risks of cryptocurrencies
“In my opinion, one of the major risks is to invest without understanding the product in which you are investing, or the different factors that can influence your short,” warns Laure Fouin, co-head of the Digital Assets and Blockchain group and partner in Osler’s Montreal office.
The expert recalls that the term “cryptocurrency” encompasses several different realities. “A cryptocurrency is a virtual digital asset that relies on blockchain technology and an encrypted computer protocol. This includes both traditional cryptocurrencies such as bitcoin and ether and “stablecoin”, which are backed by an asset whose price is considered stable (such as the dollar),” summarizes Laure Fouin.
The risks of investing thus differ depending on the type of cryptocurrency and in each case, it is important to consider the intrinsic and extrinsic risks. “The major intrinsic risk of investing in bitcoin is the decline in the short of bitcoin while the investor, for one reason or another, wishes to liquidate his position, while the major extrinsic risk remains, as for any other asset, to invest through unsafe channels (such as foreign platforms that have been the subject of warnings from the Canadian Securities Administrators, ” stresses the expert.
Another theoretical intrinsic risk associated with stablecoin is that the value of the asset to which it is backed falls. However, it is important to understand how the stablecoin is “backed” to the asset, and therefore the actual level of correlation.
“Stablecoins can be backed by a currency (FIAT), cryptocurrency or convenience (such as gold) through a real guarantee, often overcollateralized, which is effectively reserved for the repayment of stablecoin holders if need be; but they can also be algorithmic, i.e. not maintaining a reserve of the underlying asset but rather relying on an algorithm that increases or decreases the supply of tokens in the hope of stabilizing the price in a way correlated with the underlying asset. As Terra’s LUNA has proven, the risk of investing in an algorithmic stablecoin is not limited to the price of the underlying, and it is rather necessary to study the functioning of the algorithm and the arbitrage mechanisms underlying it to understand the applicable risks, “summarizes Laure Fouin.