Cryptocurrency's biggest challenge is just around the corner: Five reasons to be wary of investing

With more than $1 trillion in cryptocurrency value lost since November 2021, many investors may be tempted to buy the dip. After all, previous sharp declines in cryptocurrencies have been followed by explosive growth—all of these fluctuations can be interpreted as bumps in the price discovery process of an important new asset class. CNBC published an article today saying that the most serious risks of cryptocurrency investment may lie ahead. Investors considering long-term allocations to cryptocurrencies should remain vigilant for the following 5 main reasons.

1. Bitcoin ’s risk-adjusted returns are “lackluster”

In the early days of Bitcoin’s development, Bitcoin’s correlation with a broad range of stocks and commodities is almost zero, providing the potential for true portfolio diversification.

However, as cryptocurrency investing has become more mainstream, especially since 2020, Bitcoin’s correlation with U.S. stocks and bonds has risen sharply.

That might be nice if Bitcoin offered decent risk-adjusted returns as compensation. Unfortunately, recent events suggest otherwise: Since 2018, Bitcoin’s risk-adjusted returns have been pretty unimpressive compared to stocks and bonds.

2. Crypto’s “safe haven” attributes remain unproven

Despite the hype about digital gold, cryptocurrencies have failed to demonstrate “safe haven” or inflation-resistant properties in the face of real market volatility or the first round of truly severe inflation in developed markets.

Even during the pandemic-related market sell-off in March 2020, Bitcoin fell far more than traditional asset classes like stocks or bonds.

Likewise, while Bitcoin’s fixed supply could mean resistance to currency debasement, it offers limited protection against inflation amid recent global inflation spikes, with Bitcoin’s price plunging even as inflation soared in the U.S. and U.K.

3. Cryptocurrency conflicts with ESG goals

Cryptocurrencies still have serious problems from an environmental, social and governance perspective, even if Ethereum’s transition from proof-of-work to proof-of-stake reduces the massive energy consumption that underpins crypto mining and validation.

On the environmental front, Bitcoin, which accounts for more than 40% of the current cryptocurrency market cap, will continue to use proof-of-work, a process in which a single transaction requires enough energy to power the average American home for two months.

On the social side, cryptocurrencies’ promise of financial inclusion also appears to be overstated. Crypto wealth is unevenly distributed compared to traditional wealth, and simple mobile-based payment services require no new currency or payment infrastructure.

However, most troubling for investors with ESG goals are the governance issues surrounding cryptocurrencies, whose decentralized frameworks and anonymity make them particularly attractive for illicit activities, money laundering and sanctions evasion.

Increased trading between the ruble and cryptocurrencies following sanctions imposed on Russia following the Ukrainian war suggests that evading financial sanctions is more than a theoretical concern. Market manipulation is another area of ​​governance concern, particularly with celebrity crypto influencers who can cause market prices to surge or plummet with impunity.

4. Stablecoins “will likely become redundant”

Even leaving aside the recent collapse of the Terra stablecoin, surviving stablecoins face a potential existential risk: once central bank digital currencies (CBDCs) become popular, stablecoins are likely to become redundant. This is because a digital dollar, euro, or pound would offer all the features of a stablecoin — but with virtually no liquidity or credit risk.

In other words, even if stablecoins were to transform from currently unregulated money market funds (with limited transparency or auditing of reserves) to regulated digital tokens, they would not offer any additional benefits over CBDCs. Importantly, the prospect of these central bank digital currencies may not be far off. China has already launched an electronic currency called the digital yuan.

The Federal Reserve released a long-awaited study on a digital dollar in early 2022, and the European Central Bank will share its findings on the feasibility of a digital euro in 2023.

5. A patchwork of regulations creates uncertainty

Finally, the lack of clear and unified cryptocurrency regulation creates significant uncertainty for long-term investors.

In fact, in some countries, cryptocurrencies are facing outright bans. China’s sudden ban on all cryptocurrency trading and mining in 2021 is a prominent example, but it is by no means the only one.

Regulators are also concerned about apparent and repeated failures in the infrastructure that supports cryptocurrency mining and trading — another area where significant regulatory uncertainty remains.

Of course, retail speculation and fear of missing out may continue to drive up short-term prices for Bitcoin, Ethereum, and other cryptocurrencies. But there is a lot of uncertainty in the cryptocurrency space, and long-term investors may want to wait on the sidelines to decide how, where, and whether to invest in the crypto ecosystem.