Financial market regulators and central banks around the world regularly warn consumers about the risks related to virtual currencies, or cryptocurrencies, such as Bitcoin.
The Autorité des marchés financiers (the AMF) has already raised awareness among investors about the fact that the anonymity of cryptocurrency, transactions can make it easier for fraudsters to lure investors.
- What are cryptocurrencies?
- How do cryptocurrencies work?
- What risks are associated with cryptocurrency?
- Volatility risk
- Liquidity risk
- Technological and operational risk
- Legal risk
- Risk of participating in criminal, terrorist or fraudulent activities or money laundering
- If you want to speculate on the price of a cryptocurrency or transact business using a cryptocurrency
What are cryptocurrencies?
Cryptocurrency or virtual currency, is similar to money but is not legal tender. In Canada, the only currency that is legal tender is the Canadian dollar, although transactions may in some cases be settled in another currency (e.g., in U.S. dollars) following an agreement between the two parties involved.
Bitcoin is the most widespread and best known cryptocurrency. It is a peer to peer, “decentralized” payment system.
- Contrary to money that is legal tender, Bitcoin is not issued by a central bank or government.
- Bitcoin generally transacts or changes hand by one party registering a transaction, which is called a node, in a ledger-type of software called a distributed ledger or blockchain technology.
- No financial institution is involved in the transaction.
Numerous other cryptocurrencies exist, such as Ethereum, Ripple and Litecoin. None of these cryptocurrencies have legal tender.
How do cryptocurrencies work?
Virtual currencies can be earned or purchased.
They are issued and managed according to predefined rules and/or complex open source code algorithms which are specific to each cryptocurrency. For example, the issuance of new Bitcoins is based on a “mining” algorithm which is run by individuals called “miners” using powerful and sophisticated computers. In exchange for their services, miners are awarded virtual currency units that can be exchanged. Someone who wishes to obtain virtual currency units without participating in these “mining” activities must purchase them.
A cryptocurrency has two keys:
- The first one, called the “public key,” confirms the existence and unique identifier of the virtual currency unit.
- The second one, called the “private key,” is the equivalent of a secret code which the owner stores in a digital wallet.
Once the digital wallet is set up using software or platforms intended for this type of trading, users can buy goods or services, and trade or transfer virtual currency. These types of transactions are done pseudo-anonymously due to the keys used.
When making a payment, owners of a virtual currency unit validate their currency unit with the private key. The transaction is then submitted to a network of miners who confirm the owner of the virtual currency unit, validating the transaction and the transfer to the new owner.
What risks are associated with cryptocurrencies?
The following risks are related to the use of cryptocurrencies:
The value of a cryptocurrency is determined by the public’s interest in it and is based strictly on supply and demand. Media coverage of a cryptocurrency can have a major impact on its value over a short period of time without any official organization or mechanism controlling the volatility. There are also numerous platform or digital exchanges on which digital cryptocurrencies can be negotiated. All such exchanges may offer different prices for the same cryptocurrency.
It can be difficult to trade a cryptocurrency for money that is legal tender. The trading channels such as platforms are not overseen by official regulators or central banks. The bid-ask spread is often very wide due to speculative trading in cryptocurrency.
Technological and operational risk
Cryptocurrencies may be exposed to hacking and theft.
The security of digital wallets and cryptocurrency trading and transaction platforms is not guaranteed. Users may be exposed to theft and total loss of assets.
Cryptocurrencies may not be regulated. There may be no legal framework to protect consumers who buy goods or services using a cryptocurrency and exchanges may operate without being in compliance with applicable laws.
Exchanges may be located outside Canada and the principals may not reside in Canada. It may therefore be difficult to initiate legal action against them.
Risk of participating in criminal, terrorist or fraudulent activities or money laundering
Cryptocurrencies have been associated with fraud, money laundering and criminal or terrorist activities.
If you want to speculate on the price of a cryptocurrency or transact business using cryptocurrency
Make sure you understand the characteristics of these currencies and the risks you will incur.