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Thinking of buying bitcoin or other cryptocurrencies? What to know before you do

Click to play video: 'What you need to know before investing in cryptocurrency' What you need to know before investing in cryptocurrency
Creators of a flashy new crypto token rode the wave of popularity from Netflix’s hit show “Squid Game” before making off with more than $3.5 million worth of investors’ money. In light of the apparent high-profile scam, Anne Gaviola has more on what you need to know if you’re thinking of investing in cryptocurrency – Nov 4, 2021

Bitcoin is trading around US$62,000 ($76,967) this week, a nearly 70 per cent increase from a year ago. At the same time, SQUID, a new crypto token named after the Netflix sensation Squid Game, saw its value crash to nearly zero — after skyrocketing by thousands of per cent — in an apparent scam.

Read more: The Bitcoin craze is back. Is it different this time?

If you’re wondering, as an investor, whether you should dabble in digital tokens, you’re likely to hear very different opinions from investment advisors. While some remain loath to put any of their clients’ money in crypto, others argue investors who can stomach the risk may want to consider devoting a small share of their portfolio to this new type of asset.

If you don’t know where to start, it helps to look at some of the risks that come with digital coins.

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Fraud

One thing to know about the crypto space: it continues to be rife with scams.

“Why is that? Well, anybody can issue a (digital) token,” says Andreas Park, a professor of finance at the University of Toronto and blockchain expert.

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SQUID, which never had any official affiliation with Netflix, traded for a week before its creators abruptly announced they no longer intended to develop the token. Those who bought in collectively lost US$3.3 million ($4.1 million), according to an estimate by technology website Gizmodo.

Read more: Why the COVID-19 pandemic highlights Canada’s need for a digital currency

Crypto experts have described SQUID as an example of a “rug pull” scam, in which developers draw in unsuspecting investors with the promise of creating a new token, only to quickly walk away with their funds, driving the cryptocurrency’s value to zero.

In the case of SQUID, part of the draw reportedly was the promise to create a play-to-earn platform inspired by the deadly tournament of the Squid Game show, in which adults play a deadly version of children’s games in the hopes of winning a big jackpot.

“Rug pulls usually happen in the decentralized finance (DeFi) ecosystem, especially on decentralized exchanges (DEXs),” reads a post by crypt price-tracking website CoinMarketCap.

Even if you’re investing in established cryptocurrencies, another danger lies in letting crypto exchanges hold onto your digital coins, Park says.

“Exchanges get hacked,” he says.

Canada’s now-defunct crypto exchange QuadrigaCX operated like a Ponzi scheme, according to the Ontario Securities Commission (OSC), which has been leading a push to regulate crypto dealers.

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If you don’t want to rely on intermediaries, a safer alternative is to hold the asset in a so-called “hot wallet,” accessible online, or store it offline in a “cold wallet,” a piece of hardware.

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But that is “a bit of a hassle and it’s a learning curve,” Park says. “It’s not easy for people to do.”

A simple way to gain some exposure to digital tokens while sidestepping the headache of actually holding cryptocurrency is to invest in crypto-holding exchange-traded funds (ETFs), which can be bought or sold like a stock.

“Clearly, an ETF is the easier solution,” Park says.

In February, the OSC cleared the way for the world’s first Bitcoin ETF. Canadians can now buy ETFs tracking Bitcoin, Ether (the token supported by the Ethereum blockchain) or both.

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Volatility

If you’re investing in crypto, get ready for a rough ride. Although cryptocurrencies like Bitcoin and Ether now trade at many multiples of their value just a few years ago, they’re still prone to dizzying highs and stomach-crunching drops.

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Some crypto experts point to signs that at least Bitcoin is no longer quite as volatile as it used to be a decade ago.

Park, however, is skeptical.

“The volatility may temporarily ease off a little bit because it’s traded on so many different places,” he says. “But I would not go that far to say that it’s coming down.”

Read more: Canada’s digital loonie would be greener than Bitcoin, Bank of Canada says

Still, for all their wild ups and downs, what affects the price of cryptos is generally different than what drives fluctuations of other investments like stocks and bonds, notes Darryl Brown, director of portfolio strategies at Spring Planning.

“For many investors, crypto can be a reasonable part of a diversified portfolio,” he says.

Brown says he recommends considering a small allocation — in the range of one to five per cent of a diversified portfolio — to crypto.

“It should not be a substantial part of your portfolio,” he warns.

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Could Bitcoin and other established cryptocurrencies lose all their value?

Worried about whether the value of your crypto holdings could ever go to zero? Even for established tokens like Bitcoin and Ether, experts have very different opinions on the matter.

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“I would say it’s extremely unlikely that the value would go to zero,” Brown says.

Brian Mosoff, CEO of Toronto-based Ether Capital, agrees. He likens Bitcoin and Ether to bluechip stocks, shares of large, well-established companies with a long history of solid financial results.

Read more: Amazon denies reports that it may accept bitcoin as payment by end of 2021

Park offers a different take.

Bitcoin’s existence is “basically based on the idea that people somehow want it. And if people at some point decide that they don’t want it, then the price could go to zero,” he says. The same holds for Ether or any other digital token, he adds.

Still, Park is skeptical of the idea that cryptocurrencies could be regulated out of existence.

Many of the issues surrounding cryptocurrencies stem from the fact that “many of these tokens are effectively securities and they currently don’t abide by the securities regulations,” he says. At the same time, he adds, “it’s going to be very difficult to regulate some of the tokens simply because there is no firm that underlies (them).” 

“It’s just functionally very difficult to go after anybody as a regulator if there is no firm entity that you can actually point your finger to,” he says.

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Still, governments’ attempts to tighten the rules on — or stomp out entirely — cryptocurrencies supported by decentralized networks can dampen the price of digital coins.

Read more: Bitcoin price tops US$60,000, nearing record high

In September, China intensified a crackdown on cryptocurrencies with a blanket ban on all crypto transactions and mining, hitting Bitcoin and other major coins and pressuring crypto and blockchain-related stocks.

The move comes amid a global cryptocurrency crackdown as governments from Asia to the United States fret that privately operated highly volatile digital currencies could undermine their control of the financial and monetary systems, increase systemic risk, promote financial crime and hurt investors.

The U.S. Federal Reserve, though, has said it has no plans to ban Bitcoin and other cryptocurrencies.

“There are different regulatory regimes throughout the world that are taking a look at cryptocurrencies, and they are forming an evolving opinion,” Brown says. “Whether that opinion is supportive or negative towards the future of cryptocurrencies and its inclusion and its availability and its accessibility for investors, that’s going to be a risk that … (is) going to continue to play out for years and years.”

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Other considerations

Another important consideration if you’re pondering investing in cryptocurrencies: while you can hold crypto-backed ETFs in your tax-free savings account (TFSA) and registered retirement savings plan (RRSP) you cannot keep crypto assets themselves in a tax-advantaged account.

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This means that, if you sell cryptocurrency for more than you bought it for, the Canada Revenue Agency may view your profit as taxable capital gain.

It’s also good to know that crypto ETFs in Canada often carry fees of one per cent or more, which are substantially higher than what the lowest-cost ETFs charge.

Read more: Bitcoin price sinks as China cracks down on cryptos, declares all transactions illegal

Mosoff says the higher fees reflect the fact that crypto ETFs are “complex products.” Besides, he adds, the cost of a one per cent fee pales in comparison with the eye-popping gains many coins have delivered.

Investors should also be aware that crypto ETFs may not perfectly track the value of their underlying coins, Brown says.

“Tracking error has to do with in the creation of exchange-traded funds — the way that these entities go about actually mimicking the price movements of the underlying asset,” he says.

For example, you may see that a specific coin has increased by four per cent, while your ETFs tracking that token have only risen by 3.9 per cent in the same time span, Brown explains.

“Those little deviations don’t sound like a lot,” he says, but the gap “could be significant the longer that you hold it.”

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Finally, you may also want to consider the environmental impact of cryptocurrencies, Brown says.

“They may not be an investment that is particularly aligned with someone’s values, especially when it comes to things like energy use.”

— With files from Reuters

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