The price of cryptocurrency Bitcoin has soared past $50,000 twice in the space of a fortnight, before sliding to nearer the $40,000 mark, proving just how volatile and risky an investment it is.

Bitcoin and other types of cryptocurrency such as Ripple and Ether have proved popular with investors in recent years, despite the significant risks involved. According to research by the financial regulator the Financial Conduct Authority (FCA) an estimated 2.6m UK consumers have bought some form of cryptocurrency, or cryptoassets, at some point. Of the 1.9m that still hold their cryptoassets, half have more than £260.

Here, we explain how cryptocurrencies work, and why they are definitely not for the faint-hearted, or anyone who can’t afford to lose what they put in.

How do cryptocurrencies work?

Cryptocurrencies are essentially a virtual currency.

You can’t see or touch a cryptocurrency, and there’s only a digital record of any transactions, left in what’s known as a blockchain. Cryptocurrencies aren’t supplied by a central bank, as other currencies such as sterling or US dollars are. This is part of its appeal for many investors, as unlike paper money, it is independent of any Government or national authority. Investors in Bitcoin often believe that it is the currency of the future, even more so now that the pandemic has meant many of us are no longer using notes and coins to make purchases.

Cryptocurrencies get their name because information is secured using cryptography, transforming it into a form that unintended recipients aren’t able to understand. New coins are ‘mined’ using computers to solve difficult algorithmic problems. Once these are solved, a token for the relevant cryptocurrency is created, and the computer that found the solution gets this token.

Like any currency, such as pounds or dollars, in order for it to maintain its value as a store of wealth, there needs to be a limited supply of the currency – otherwise if currency can be created out of thin air then the value of that currency collapses and hyperinflation can take place – similar to what was seen in the Weimar republic in the 1920s and Zimbabwe in 2008. To maintain control of supply, most cryptocurrencies are designed to have a maximum limit of the number of coins or tokens that can ever be created – for example Bitcoin is designed to only enable a maximum of 21m Bitcoin that can ever be created and each coin becomes incrementally harder for computers to mine.

Advocates of cryptocurrencies argue that this finite cap, means that they may be more likely to hold their value than Government based currencies such as the dollar or pounds sterling, when Governments continue to create more of their own currencies through quantitative easing to fund the national debt. However, others argue that whilst the supply of any individual cryptocurrency such as Bitcoin is limited, there are so many different cryptocurrencies available that the supply of Cryptocurrencies in general is not so restricted.

Why is there so much interest in cryptocurrencies?

There are a number of factors driving the adoption of Bitcoin and other cryptocurrencies.

Firstly, in an increasingly global world, the idea of a single borderless currency – that can be used anywhere around the globe is attractive as a concept. El Salvador this month became the first country to adopt Bitcoin as official legal tender, although the first day of its rollout was hit by technological glitches and protests. If you add to this, the idea of it being a purely digital currency, where you don’t have to worry about carrying physical cash with you anywhere – and it’s a nod to global integration on a significant scale. Big names such as BNY Mellon, fund manager BlackRock, and global payments leader Mastercard have shown support for cryptocurrencies, whilst Tesla, Square and MicroStrategy have all invested in Bitcoin. However, despite investing in it, Elon Musk, Tesla owner, subsequently announced Bitcoin would no longer be accepted as a payment method.

A second factor is that people like the idea of a currency that is not controlled by Governments and central banks and so is less likely to be manipulated by political forces. Whilst we might think of the British Pound as a relatively safe store of value, those of us who remember the rapid inflation of the 1970s – or who have seen the exchange rate with the dollar and euro swing significantly as a result of recent political outcomes in the UK will appreciate that even something as safe as the pound is subject to the political effects of a single nation.

Finally, in a world where governments are running significant deficits and central banks are pursuing quantitative easing to fund these debts – people are increasingly arguing that cryptocurrencies may hold their value more than any single currency. This same argument is one of the central pillars behind the recent interest in investing in gold. You can read more about investing in gold here.

Whilst the idea of having a currency that transcends any national Government can be a very attractive concept – it’s worth taking a moment to consider whether you think Governments will ultimately allow that to happen? Your guess is as good as ours, but control of the financial system, and the ability to raise taxes through it, is a fundamental part of how Governments operate – so while we like the idea, we are more cautious about whether Governments would ever, truly allow this to happen.

What are the risks?

Although some investors may see recent falls in the value of Bitcoin and other cryptocurrencies as a buying opportunity, it’s vital to remember that they could fall much further in value.

One of the biggest issues with cryptocurrencies is that unlike most investments, it’s not a productive asset – like a company that sells things and makes money – so there is no income on your investment, such as dividends or interest. This means that when you invest in cryptocurrencies, you’re essentially gambling on whether their value will rise as markets expect them to ultimately end up as a credible currency like sterling or the US dollar, or they will become obsolete and worthless. No-one knows what the future holds for digital currencies, as there’s no precedent to go by, so you’re really taking a punt on something that could turn out to be a fad rather than a serious reinvention of money. 

It’s also worth considering that if you want to invest in cryptocurrencies because you believe cash is set to disappear, this trend is already happening with the rise of contactless payments and bank to bank transfers which are far more widely accepted today as a means of payment than cryptocurrency..

The FCA has previously warned that there are few protections for cryptocurrency investors. The transfer, purchase and sale of cryptocurrencies currently fall outside its regulatory remit, leaving customers unable to make complaints to the Financial Ombudsman Service if something goes wrong, or seek protection from the Financial Services Compensation Scheme.

Beware scams

If you’re thinking of buying cryptocurrency, you’ll need to watch out for scams too. More than £27m was lost in 2018/19 by victims of cryptocurrency and forex-related investment scams, according to estimates from the FCA and Action Fraud, the national fraud reporting centre. On average, victims lost £14,600 each. Cryptocurrency theft is also a risk, with high profile accounts having been hacked and currency stolen.

A spokesman for Action Fraud said: “Fraudsters often use social media to promote their ‘get rich quick’ online trading platforms. Posts often use fake celebrity endorsements and images of luxury items like expensive watches and cars. These then link to professional-looking websites where consumers are persuaded to invest.”

Action Fraud advises consumers to steer clear of uninvited investment offers whether made on social media or over the phone, and to check whether the company providing the service is authorised on the FCA’s Register.

If you think you might have fallen victim to a cryptocurrency scam, contact your bank immediately and let them know what’s happened.

If you have been defrauded or experienced a cryptocurrency investment scam you must report it to Action Fraud either online or by calling 0300 123 2040. You should also report what’s happened to the Financial Conduct Authority either online or by telephoning 0800 111 6768 so they can help track down the scam and protect others. 

Complex cryptocurrency based financial products

The FCA recently banned the sale of derivatives and exchange-traded notes that reference certain types of cryptoassets due to the fact consumers could suffer harm from sudden and unexpected losses if they invest in these products. An exchange-traded note is essentially a type of I-O-U issued by a financial institution which promises investors returns based on the movements of certain benchmarks, such as a cryptocurrency index. Derivatives are financial contracts that are based on a specific asset (in this case cryptocurrencies) and are based on its future price, but which have no direct value in themselves. If, for example, you owned an Ether derivative and its value rose, you’d make money but you’d never own the currency itself. In this same example, if the price fell your investment would be worthless – making these types of investment extremely high risk.

Sheldon Mills, interim executive director of strategy and competition at the FCA, said: “This ban reflects how seriously we view the potential harm to retail consumers in these products. Consumer protection is paramount here. Significant price volatility, combined with the inherent difficulties of valuing cryptoassets reliably, places retail consumers at a high risk of suffering losses from trading crypto-derivatives. We have evidence of this happening on a significant scale. The ban provides an appropriate level of protection.”

The ban will come into effect on 6 January 2021. You’ll still be able to buy cryptocurrencies themselves, but you won’t be able to buy complex financial derivative products based on them any more.

How do you invest in cryptocurrencies?

Most people who invest in cryptocurrencies do so through online cryptocurrency exchanges, such as Binance, Bittrex, Kraken and Coinbase. These online exchanges are generally based overseas, so if you’re considering investing in Bitcoin or any other type of cryptocurrency, bear in mind that deposits may only be accepted in either US dollars or euros, although some will accept sterling deposits. This means that depending on which platform you use, you may have to pay foreign exchange fees on top of the fees charged by the exchange to purchase the cryptocurrency.

To set up an account with one of these platforms, you’ll typically be asked to provide a Government-issued photo ID, such as a passport or driving license, and to provide your name, address and date of birth. You’ll usually need a special digital wallet to store and use your cryptocurrency. This will have a unique digital address, so you can send and receive cryptocurrencies.

Seek advice

Please remember that we cannot offer financial advice, so if you’re considering investing in cryptocurrencies, you should seek advice from a qualified independent financial advisor.

If you’re tempted to invest because of recent strong gains, remember that past performance should never be relied on as a guide to what will happen in future. If you do decide to invest in cryptocurrencies, you’ll need to be prepared for a potentially very bumpy ride ahead, with a chance that you could lose some or all of your investment.

You can find a local financial advisor on VouchedFor or Unbiased, or for more information, read our guide on How to find the right financial advisor for you. You can learn more about investing in our article Investing – the basics.

Have you invested in Bitcoin or another type of cryptocurrency, or is it something you’re steering well clear of? We’d be interested in hearing from you. You can join the conversation on the Money section of the Community forum or leave a comment below.

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