January 22, 2018 – Although 2017 was a banner year for cryptocurrencies, with numerous digital tokens yielding blockbuster returns, institutional and individual investors alike should exercise caution when investing in cryptocurrencies. The following list details some of the risks that investors should consider when making cryptocurrency investment decisions.
- Cybercrime and Theft Digital hot wallets, such as Coinbase, are at risk of being hacked or going bankrupt. For example, in 2016 Mt. Gox’s hot wallet private keys were stolen resulting in roughly 630,000 Bitcoins stolen from Mt. Gox’s users. Currently, the safest way to store cryptocurrencies is on a cold-storage hardware wallet – which features secure chips that do not require a user to input their private key when transacting on a crypto exchange. This added security layer makes trading on a compromised exchange, or computer, safer.
- Hyper-Volatile Assets Cryptocurrencies are highly speculative assets that not only have the potential to double, triple, etc. in value, but may crash to zero without warning. Prices may shift drastically, often within minutes, raising market dislocation and execution risks when placing trades. Further, increased traffic and denial-of-service (DDoS) cyber-attacks can cripple exchanges, preventing customers from accessing their funds.
- Government Regulation The Securities and Exchange Commission, Commodity Futures Trading Commission, Internal Revenue Service, Department of the Treasury, Congress, and state equivalent agencies are considering if, and how, to regulate crypto-companies and exchanges. Crypto-companies and institutional investors should be wary of the likely emergence of regulatory and compliance hurdles. It is unclear how future regulations will impact cryptocurrency prices.
- Vulnerabilities in Blockchain Consensus Protocols Although some argue that blockchain technology is completely secure, as no one has yet managed to break the encryption and decentralized architecture of a blockchain, technical issues may arise if vulnerabilities in a protocol are discovered. For example, attacks targeting Bitcoin’s blockchain have included: double spending (the coin is spent in more than one transaction); netsplit (when two servers become disconnected); networking attacks; attacks targeting mining; and selfish mining pools.
- Lack of Disclosure Federal law requires companies conducting securities offerings to provide investors with any “material information” concerning the company, its principals, and the investment opportunity that a reasonable person would want to know in order to make an informed investment decision. The deregulated market in which crypto companies operate creates information asymmetries in the market – where the company has information that its investors do not. The greater this information gap, the greater the possibility that the company will act opportunistically, and against the interest of token holders.
- Legal Proceedings, Litigation Class-action lawsuits filed against exchanges have alleged system crashes, lack of access to funds, failure to perform adequate “know your client/anti-money laundering” procedures, and breach of fiduciary duties.
- Social Risk As cryptocurrencies continue to go mainstream there is risk of a market bubble and of unsophisticated investors entering the market without understanding the economic risk.
- Fraud Companies are using Initial Coin Offerings (ICOs) as a mechanism to raise capital and, as no ICOs are registered with the SEC, companies have not always disclosed information that investors need to protect themselves. Information asymmetry stemming from ICOs raises questions of possible pyramid schemes and misstatements regarding the value and potential of the Company’s technology and token. The SEC has halted several ICOs, including:
- REcoin Group Foundation’s REcoin, touted as the “The First Ever Cryptocurrency Backed by Real Estate,” for allegedly misrepresenting that it raised between $2 to $4 million from investors when the actual amount was approximately $300,000.
- PlexCorp’s offering of PlexCoin, which falsely promised a 13-fold profit in less than a month.
- Forgot Your Password? Transacting in cryptocurrencies requires both a public and private key, or password. If the private key is lost or destroyed the user is no longer able to access the tokens housed in their digital wallet. Unfortunately, there are no security questions or a customer service team that can reset a private key – once it is lost, recovery options are limited.
Sherman & Howard has prepared this advisory to provide general information on recent legal developments that may be of interest. This advisory does not provide legal advice for any specific situation and does not create an attorney-client relationship between any reader and the Firm.