How Safely Are You Trading Cryptocurrencies?
Investors should be aware of the lack of regulation.
Investing in cryptocurrency comes with many risks. While some risks, like extreme price volatility, have become well-known and well-understood by the general public, others remain obscure and leave retail investors potentially vulnerable. From June 2020 to June 2021, 13% of Americans purchased or traded cryptocurrencies, according to a University of Chicago survey. But what percentage of those investors realized that they may not be getting the best price for their crypto investments? How many had any guidance in developing their cryptocurrency investment strategy? Did investors understand that losing their private keys or typing the wrong wallet address could result in the irrecoverable loss of their cryptocurrency?
When you trade a stock through a registered broker, you can take comfort in knowing that you are paying or receiving the best available price. The SEC and Finra's "best execution" regulations and the SEC's "national best bid and offer," or NBBO, regulations ensure that investors receive the best buy or sell price for that security–-no matter which broker you choose to fill the order. The SEC's Order Protection Rule also dictates that an exchange or alternative trading system cannot execute your trade at a worse price than any other exchange or alternative trading system.
When you trade a cryptocurrency through an exchange platform, it is not registered like a securities exchange is, and you lack these (and other) protections. Coinbase (COIN) and Kraken are not registered broker/dealers, and as such are not bound by best execution or NBBO. As such, cryptocurrency prices frequently vary across exchanges, since each exchange determines its prices based on its own internal data regarding supply and demand and trade volumes. For example, at 6:24 p.m. on Oct. 19, 2021, the price of bitcoin quoted on Kraken differed from the price quoted on Robinhood (HOOD) by $116.81.
Since cryptocurrencies are not securities regulated by the SEC, Registered Investment Advisors can only recommend general allocation percentages for cryptocurrencies. RIAs are not able to offer fine-tuned advice regarding specific cryptocurrencies, such as how much Ethereum to own relative to bitcoin. Additionally, crypto is not generally held in managed accounts. Without this advice, investors do not have the benefit of professional services when allocating their portfolio to crypto assets.
Another area where investors are not protected is if they lose information about where their crypto is stored. When you hold or trade cryptocurrency, you do so on a decentralized computer network called a blockchain. Cryptocurrency stored on a blockchain is accessed via a digital wallet that consists of a public key and a private key. The public key generates an address used to facilitate cryptocurrency transactions on the blockchain network. The private key is required to transfer the cryptocurrency from its corresponding public address to another public address, thereby "unlocking" the transaction.
Since a private key is intended to be completely private--a central feature of its design is that no other person or institution has knowledge of another's private key, or the ability to recover it if lost or forgotten--managing one's private key is a very important aspect of investing in cryptocurrencies. If your private key is lost, your access to the cryptocurrency balance linked to that public key is lost as well.
The danger of losing access to one's cryptocurrency holdings is minimal for most retail investors, who typically hold their cryptocurrencies on a hosted wallet provided by an exchange platform like Coinbase. These exchanges confidentially hold your private key for you, and allow you to access your holdings using a user-generated password that can be easily recovered and reset through the exchange's tech support service.
However, the process of transferring cryptocurrency from one wallet to another carries risk. For example, an investor seeking to transfer bitcoin from a Coinbase-hosted wallet to a Kraken-hosted wallet should be extremely careful when entering the address of the receiving wallet, as entering the wrong address could result in a permanent loss of your bitcoin. Although hosted wallets make the process easier by generating QR codes that can be scanned to mechanically copy the recipient wallet's address, problems could also arise if you accidentally select the wrong type of cryptocurrency when generating the recipient wallet address. Since cryptocurrency exchanges are not registered broker/dealers or exchanges, cryptocurrency investments lack the protections of the Securities Investor Protection Corporation, a nonprofit corporation created by Congress that exists to protect investors against the loss of cash or securities in the event that an issuing broker/dealer incurs financial trouble or bankruptcy. Further, cryptocurrency exchanges are not banks, so they also lack FDIC accreditation. Without these protections, your investments are not insured against the collapse or hacking of your chosen crypto exchange.
Despite the recent approval of the first crypto futures exchange-traded fund by the SEC, crypto investing remains an investor-beware zone. On top of price volatility, technological hurdles, regulatory gaps, the absence of government-backed insurance, and the scarcity of professional advice provide additional reasons for investors to exercise caution when considering how much to invest in cryptocurrencies and in selecting an exchange platform on which to trade.
Jasmin Sethi does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.