With a market cap of over $1 trillion and a growing interest from institutional investors, cryptocurrencies are once again becoming a dependable investment product.

As a result of their increased popularity, retail investors are now surging to get their hands on some Bitcoin, as well as other, smaller cap altcoins.

And although the market has undergone several cycles, many still don’t understand the true importance of crypto risk management. There are several pitfalls you need to look out for, which is why crypto risk management is so important.

In this article, you will learn about the common dangers that come with using cryptocurrencies, as well as what you can do to avoid them.

Note that we will not discuss risk management strategies in terms of short-term trading, but rather on an industry-wide level. At the end of this article, however, we will share some trading-related risk management tips.

Why is crypto risk management important

Risk management is a vital element for traders and investors, all markets included. However, its importance becomes even more prevalent in highly volatile investment products, like cryptocurrencies.

Bull markets like the one we are currently experiencing can be treacherous. With prices soaring, every market entry can look like a potential winner. To the untrained eye, it may seem that nothing can go wrong.

However, like any industry are some underlying risks that can affect the safety of your funds. For instance, price rallies motivate fraudulent actors to ramp up their game and try to scam investors out of their money.

Furthermore, increased media attention and price increases can trigger unwanted attention from regulating bodies, resulting in a severe impact on the market.

Learning about risk management and knowing how to stay ahead of potential problems will help you to limit losses and maximize gains, while keeping your funds safe.

Common problems and risks of cryptocurrencies

It’s undeniable that crypto provides considerable advantages compared to traditional payment and investment vehicles. However, these perks sometimes come at a cost. Understanding the caveats will allow you to set up an efficient crypto risk management plan.

1. Custodial risks

Becoming your own bank and enjoying the financial freedom provided by cryptocurrencies requires a fair deal of cautiousness. There are several reasons for this.

  • All transactions are final – blockchain transactions are, in most cases, irreversible. Once you send coins over the network, they are gone forever. While this feature eliminates chargeback frauds, it also means that you need to be extra careful when sending funds. A small error in the destination address can result in a total loss of funds.
  • Loss of private keys – cryptocurrency users are the sole custodian of their funds. There’s no central entity that could ever prevent you from spending or using your crypto. At the same time, misplacing your private key also means that the contents of your wallet might become inaccessible. Studies estimate that 20% of all bitcoins have been irrevocably lost due to user error.
  • Personal risks – Few retail investors have the means to secure their crypto wallets efficiently. Holding your private keys can expose you to risks of theft or natural disasters like fires, floods, etc.

2. Crypto exchange hacks

Because of its appreciating value, the cryptocurrency market has been a target of choice for cyberattacks in the past decade.

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While private wallets remain unhackable, centralized exchange-based wallets are much weaker. Trading platforms are targeted by hackers continuously as they keep large amounts of sensitive user data on their servers.

When hackers successfully breach the security of a cryptocurrency exchange, the losses are immense. Due to the broadly unregulated state of the market, government agencies such as the FDIC cannot guarantee the safety of funds deposited on centralized exchanges. As a result, crypto exchanges rarely offer any kind of compensation to the affected individuals.

3. ICOs, scams, pump-and-dump schemes

The lack of regulations regarding the issuing of cryptocurrencies means that anyone can get their coin listed on an exchange. Their decentralized nature doesn’t offer a reliable assessment mechanism or an equivalent to the SEC to scrutinize project viability.

A clear consequence was the crypto bubble of 2017. At the time, thousands of new cryptos were issued. New projects were raising funds in the hundreds of millions of dollars through ICOs, with little-to-no regard for investor safety.

However, many of these projects turned out to be either dead-on-arrival or blatant exit scams. Some, like the infamous Bitconnect, were simple Ponzi schemes created with the single purpose to take off with investors’ money.

And while the popularity of ICOs has died off, fraudsters still exploit gullible investors with impossible profit-making promises. Some popular online crypto scams include:

  • Fraudulent social media posts – impersonating media personalities that promote various projects or giveaways. Sometimes, these can be quite elaborate and dupe even more careful investors.
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  • Coin mining Ponzi schemes, which usually request an initial investment promising regular returns.
  • Pump and dump trading schemes, where entire trader groups coordinate to artificially inflate the value of a coin. Just recently, XRP investors faced such an orchestrated attack.
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  • Phishing scams, which can be of various nature, such as impostor websites or phishing emails. These resemble legit sources, with the goal to collect sensitive information such as your crypto addresses or payment data.
  • DeFi Scams – the popularity of decentralized finance has increased the number of fraudulent projects in this niche. Founders can launch their tokens on decentralized exchanges such as Uniswap. First, they attempt to rally their price with some good marketing. Once they succeed, they unload their holdings on unsuspecting investors, only to disappear with the profits. Projects backed by anonymous teams can often be the target of such “rug-pull” scams.

The following video should give you a good idea of how to detect these red flags and enhance your crypto risk management skills.

4. Crypto legality and regulations

Since the cryptocurrency ecosystem is fairly recent, its legality varies wildly from one country to another. With the increasing popularity of bitcoin, governments are scrambling to come up with proper regulative measures that apply to this type of asset.

Additionally, there’s a widespread misconception that cryptocurrencies are massively used for criminal activities, money laundering schemes, and tax evasion. Because of this, governments have partaken various steps towards regulating cryptocurrencies to enforce taxation and reduce cryptocurrency AML risks.

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The workflow of a KYC procedure (Source: Lemonway)

That being said, these regulations are not set in stone and can change drastically within short periods of time. In some countries, common misunderstandings of the crypto space can quickly turn the absence of regulation into a blanket ban or vice versa. This could leave investors holding funds that they cannot legally convert into FIAT.

A recent example is the cryptocurrency trading ban that was lifted in India in March 2020, after 2 years of enforcement. However, the latest developments show that the Indian government is once again on the brink of imposing a blanket ban on bitcoin. This makes the future of crypto uncertain for more than a billion potential users.

Finally, as cryptocurrencies are not considered legal tender in most countries, they do not allow for legal ownership. This makes it very hard for users to access legal mechanisms to recover lost funds in case they are defrauded.

5. Volatility and price fluctuations

Crypto risk management is also important when it comes to volatility. Because of the nascent nature and low volumes of the markets, cryptocurrencies are subject to drastic price movements, often causing large losses and emotional distress.

For the average investor, these price swings might seem like an unnecessary risk. On the other hand, they can be effectively countered by sticking to a sound crypto investment strategy.

How to protect yourself from blockchain risks

Most of the aforementioned risks can be successfully avoided if you have a clear crypto risk management strategy in place. Below we go through some of the best tips that will help you stay on the safe side when handling your cryptocurrency investments.

Tip #1 – Take essential safety precautions

Try to apply the following best practices to increase the safety of your funds at all times:

  • Use cold storage (and non-custodial) solutions when storing your cryptocurrency. . 
  • Write down your private keys on a piece of paper and store it safely. 
  • Don’t leave your funds on exchanges for extended periods of time. 
  • Never share your private keys with anyone other than your close ones. 
  • Use a separate email address for all your crypto-related business. 
  • Keep the existence of your crypto holdings private.
  • Make sure that the destination address is correct before sending funds. 
  • Make sure you are using a secure connection when accessing cryptocurrency exchanges. Usually, the website should present a padlock icon in the address bar or start with “https”.
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Tip #2 – Research before you invest

In addition to common safety measures, you should always do research on the project before you spend money on it.

Don’t blindly trust anyone on the internet about the opportunity a project presents. Instead, do some due diligence by going through this simple checklist:

  • Check the team credibility – verify the background of the people behind the project and if they were involved in other successful or unsuccessful launches. 
  • Realistic goals – ensure the goals set by the team are achievable and not just a PR stunt to attract investors. Extravagant ROI projections should be an instant red flag. Compare the project to the competition and assess its long-term viability. 
  • Read the white paper – confirm that there’s a real, working project behind the coin and that it’s not just smoke and mirrors. 

Remember to use trustworthy sources and do not take anything at face value. For a more complete take on how to do this, check out our ultimate guide on how to research cryptocurrency.

Tip #3 – Keep track of regulations and pay your taxes

As we previously saw, keeping track of the legal developments in your country regarding cryptocurrencies is essential to staying on the right side of the law.

Furthermore, always pay your crypto taxes if required by your government. Failure of complying is considered tax fraud and the consequences can range from harsh fines to prison sentences.

On this account, keep track of the details of all of your cryptocurrency transactions to provide a thorough tax filing and avoid legal liability.

Below are some handy guides on how to declare your taxes in the EU, US, and the UK.

  • EU tax guide on cryptocurrencies.
  • US tax guide on cryptocurrencies.
  • UK tax guide on cryptocurrencies.

Bonus tip – Learn about crypto risk management in trading

Finally, keeping the following notions in mind when trading cryptocurrencies will help you consolidate your crypto risk management even further:

  • Learn about position sizing – assess your risk profile and invest and trade accordingly. Consider the risk/reward ratio that you are comfortable with and never invest more than you can afford to lose.
  • Don’t succumb to FOMO or FUD – try to develop emotional intelligence and don’t get dragged into panic selling or buying.
  • Use stop-loss orders to limit your exposure to risky trades.

Wrapping up

In this article, we talked about the potential risks investors might encounter when entering the exciting market of cryptocurrencies. With the goal of helping you draw out an effective crypto risk management plan, we talked about:

  • The importance of crypto risk management. 
  • The common risks of handling, investing, and trading cryptocurrencies. 
  • The best practices and tips on how to avoid these risks. 

To conclude, we can say that most of the risks of using cryptocurrencies can be linked to the lack of regulations of the market.

Understandably, the cryptocurrency community often views regulations as an infringement to their initial purpose of financial freedom and privacy. However, the benefits of regulations should outweigh the negatives in the long run.

Clear regulations would bring more legitimacy to a market that has previously been marred with fraud and money laundering scandals. This would attract businesses and financial institutions into the ecosystem, pushing towards mass adoption.