Bitcoin has proven itself to be one of the most spectacular, speculative, and volatile assets to ever exist in a global environment. While many have doubted Bitcoin, it’s proven many wrong over a long period of time.
However, BTC, like any asset does not come without risk. This article will highlight fundamental risks to cryptocurrency and Bitcoin, and the various severities of those risks.
The algorithm is designed specifically to remove as much tail-risk as possible while capturing the majority of upside to Bitcoin. It does so by implementing hard and variable stops (it never loses more than 1% in a trade). Beyond that, LF has a limit down of 20% of which it will stop all trading for 24 hours upon having a drawdown greater than 20%, a function that served it very well in March 2020 when Bitcoin crashed 60% in two days.
As demonstrated in the past, the largest drawdown the algorithm has ever experienced is 21%, which I like to think of as a “sleep peacefully at night” amount. Bitcoin over that same period has dropped as much as 70% from high to low, exhibited in March 2020. Other instances of recent large drawdowns are:
2021, January 2nd – 20% drop in 12 hours
2020, November 20th – 16% drop in 2 days
2020, August 30th – 20% in 1 day
2019, June 26th – 53% over two months, 30% in the first 2 days
For every drop’s drawdown, the algorithm removed more than half the downside on average. The compromise to the upside is similar, and in total levels out the cumulative returns of BTC over time by essentially compressing its volatility.
Greed, Leveraged Markets
In the crypto space, I saw a lot of ‘new paradigmatic’-like comments and euphoria:
“BTC will never correct more than 10-20%, we’re in a new institutionally backed bull market”
“This market only goes upwards, I just got a HELOC to buy BTC”
“Buy every dip, BTC is going to $300,000”
Bitcoin rapidly ascended above 20k as institutions such as MicroStrategy, Grayscale, PayPal, some insurance firms, and many more began to accumulate Bitcoin, but at the same time, traders and speculators utilizing leverage were market buying on margin and pushing the price into parabolic levels. This is the nature of Bitcoin, and all markets, truly. Greed and fear are the main drivers of human psychology and decision in markets, and they create short and long-term imbalances that are all eventually mean-reverting. We are now reminded that the price can, in fact, go down.
This next phase of the market will likely be a month of consolidation and lower prices while Bitcoin finds supported price levels. If BTC is able to hold above 30k for the next month or so, it’s very likely that BTC will continue to new all time highs.
While I believe short term BTC will recover from these levels, markets search for liquidity. Sellers are constantly looking for buyers, as buyers are looking for sellers. If there are no buyers in the 30k region, the market will likely seek lower levels. The fear and greed index usually gives us a good idea of the sentiment of the Bitcoin market, which undoubtedly was a bit greedy. Traders were heavily margined (borrowed money), and many were liquidated due to the rapid price drop.
Levels not seen since the run from $3,000-$13,000…
Bitcoin is often under scrutiny for being a ‘wild west’ asset, with little regulation that makes it prone to market manipulation, fraud, volatility, and often backlashes from government bodies. While most regulation is ultimately good for Bitcoin adoption, there are regulatory actions that are not only detrimental but even possibly destructive to BTC. Cryptocurrencies aren’t being turned a blind eye to, with the most recent crackdown being on Ripple (XRP).
While Bitcoin is not a security offering (it’s a digital asset), that doesn’t make it immune to aggressive and even harmful regulation. Another reminder of such risk is the CFTC’s charges against Bitmex, which was the largest and most popular exchange for cryptocurrency trading until this year.
Exchange risk is an issue to BTC, although it is much less so than in its early days when Mt. Gox was hacked and BTC came crashing down 90%. Crypto exchanges are less monopolized and there is a lot of diversity in the space, but large exchanges going down or being sued could pose a systemic threat to BTC.
The third, although the least likely; is still worth mentioning. Bitcoin could ultimately become restricted or banned by banks and governments. This is not a likely scenario, but if at any point governments or institutions feel threatened by Bitcoin there may be developments to thwart its existence. The banning of an asset would not be a stranger to history, such as Roosevelt’s ban on gold amidst the great depression.
While SHA-256 (the encryption that Bitcoin wallets are based on) is theoretically quantum-resistant and unlikely (extremely unlikely) to experience a collision; the scalability of computation that quantum computers bring to the show changes how secure the Bitcoin network is. Theoritically if quantum computers can have enough qubits of computing power that are exponentially greater than traditional processing archetecture; they could break into Bitcoin wallets, which would render the network and the currency worthless, as it would be like storing your money on the sidewalk.
On the other hand, there may be a solution to this problem.
Bitcoin has been ‘forked’ in the past, where small changes have been made to its code to improve it upon the consensus of all of the miners. A similar event could happen as Bitcoin adapts to a quantum computed world. If all of the miners agree to a new quantum encrypted Bitcoin, it will be as if the lock is updated for the new key.
Tether is a cryptocurrency meant to replicate the value of the US dollar 1:1 by being backed by USD, however
Tether is a blockchain-based cryptocurrency whose cryptocoins in circulation are backed by an alleged equivalent amount of traditional fiat currencies, like the dollar, the euro or the Japanese yen, which are held in a designated bank account. Tether tokens, the native tokens of the Tether network, trade under the USDT symbol. It was discovered in 2019 that Tether had taken out a loan to back its own stable coin after admitting it was not backed 1:1.
This is particularly relevant as Tether is now apart of the majority of trading volumes, and a large player in the crypto space – while remaining an unaudited organization with no headquarters and MIA officers. Tether is particularly strange in the methods by which it ‘mints’ new tether as new USD is added to the system. Tether creates new coins in large even blocks, over weekends, and at strangely large rates compared to all of its stablecoin peers. Tether is at a minimum, an anomaly. Currently, the New York Attorney general is after Tether and has demanded an audit of their processes.
Ultimately, all asset classes have risks; and these risks are not to be ignored, but understood and protected against. When things seem least likely to go down, its usually when they do. Hopefully, Bitcoin can overcome its problems and continue to be the exceptional and interesting revolution to the financial system that it is.