The challenges of cryptocurrencies

There is no guarantee of a refund

People are always making mistakes: writing down numbers incorrectly, failing to save important information. Some errors are detected immediately, while others are not. If a cryptocurrency user enters an incorrect wallet address during the exchange, he is guaranteed to lose his funds.

Digital assets do not have a central regulatory body, but operate in distributed systems on blockchain technology. The problem with cryptocurrencies is that no one will give the investor guarantees of compensation for losses in case of errors in transactions with digital assets.

Malware and hacker attacks

Cryptocurrencies are prone to security breaches. Hackers break into exchanges, empty wallets, and infect computers with malware that steals digital assets. Since transactions are conducted online, attackers misappropriate users’ funds through phishing and viruses. To protect purchased cryptocurrency from theft, investors should be confident in their security system and the counterparty whose services they use.

Software needs to be updated regularly. There are very few ways to recover lost coins and tokens. If a user’s wallet keys are stolen, the thief can impersonate the original account holder. He will gain access to the funds just like the user. Once the bitcoins are transferred out of the account and the transaction has been recorded on the blockchain, the investor will lose his money forever.

Cryptocurrency exchanges shutting down

Digital assets rely heavily on unregulated companies that are often susceptible to hacking. Any exchange deals with financial transactions, so it must maintain security as well as comply with KYC (customer verification) and AML (anti-money laundering) regulations. Cryptocurrency trading platforms are not responsible for volatility and other market risks. However, exchanges do have their own specifics:

• Data loss. There is always a risk that servers will fail, information may be irretrievably lost. Data leakage is also possible when stored in cloud services.
• Loss of user funds. A serious risk for any coin and token exchange is hacking or unauthorized access to traders’ capital. It is possible to lose money as a result of a system error.
• Infrastructure failure. The number of clients is growing, and the system is not ready for such loads. As a result, there are failures, problems with withdrawal and trading, vulnerabilities that create the risk of theft or loss of money. There are user security issues, increased risks of hacking, long-term failure of the exchange and serious reputational losses.
• Inability to meet regulatory requirements. Regulatory restrictions, as well as non-compliance with AML and KYC terms and conditions, can lead to site blocking and problems with fiat currency exchanges.

Exchanges that encounter such situations are more likely to subsequently shut down and users lose their funds.

Technical problems

The risks associated with digital assets are becoming increasingly apparent alongside their potential benefits, which emphasizes the need to properly understand the technical challenges.

Peer-to-peer interactions during virtual currency trading are governed by specific protocols. If there is disagreement over consensus rules, this could lead to the separation of cryptocurrency. For example, in 2016, two versions of the Efirium currency appeared: Ethereum and Ethereum Classic. Although both projects were originally a single blockchain, they are traded differently. This is called a fork. In most cases, forks create confusion and technical difficulties. This is a serious problem with cryptocurrencies.

Protocol vulnerabilities

The biggest challenge faced by digital currency is the lack of proof that users didn’t spend the same money twice. Traditional financial systems solve this problem by adding a superstructure of banks and other institutions. They account for each payment and ensure that funds are not spent twice. Bitcoin was the first digital currency to offer an alternative solution that didn’t require a third-party intermediary. This was done through a decentralized network of nodes that follow the same protocol to achieve consensus and store transactional data. In order to spend bitcoins or any other coins and tokens twice, the user must either gain control of a significant portion of the network or find a way to simulate that the transaction has been validated. Among the popular hacks in the world of blockchain technology, the following are technically performed:

Means that attackers gain control of 51% of all nodes in the blockchain, allowing them to control the network by taking advantage of a majority-based consensus protocol. Attackers can spend cryptocurrency twice and cancel transactions.

Such schemes only apply to coins and tokens based on the Proof-of-Work consensus algorithm, such as Bitcoin and its derivatives. The more concentrated a part of the network is in the same hands, the higher the risk.

Hackers quickly send coins to the seller and into their wallet: one right after the other. If an attacker controls a node, they can reject the first transaction, prioritize the second transaction, and pass this action to other nodes for confirmation, tricking users.

Aimed at merchants who do not wait for transaction confirmation before sending an item. For this hack, attackers must run their own node. They include transactions between their wallets in new blocks that they create themselves. The deceived merchant, without seeing this, ships the ordered goods. The new blocks are then released into the network. Transactions against these blockchain items have a higher priority and therefore only they are recorded on the chain.

Was invented long before blockchain technology. Creates a threat to any online system where a single device can try to control the network with multiple identities. In blockchain, an attacker can run multiple nodes and outmaneuver legitimate participants in the network. In fact, Sybil is a clone of the 51% attack.

To prevent hacking, blockchains implement various consensus algorithms. Proof of work or ownership shares increase the cost of misconduct and make it disadvantageous for attackers.

Unreliable ICOs

In 2017, investing in blockchain and cryptocurrency related projects has become very popular. This type of fundraising is called Initial Coin Offering (ICO). Projects have started to easily raise large amounts of investment with nothing more than an internet connection. In 2017, more than $1.7 billion was raised through ICOs. There were few successful projects and many investors lost their money. The cryptocurrency market is still unregulated, there are no risk assessment mechanisms and there is no guarantee of return on investment other than the honest word of the people who came up with the project.

Just because someone has an idea doesn’t mean it’s good and feasible. There is no guarantee that the final product will make a profit, or that the project creator won’t spend the money on himself. He or she may simply abscond with the money, knowing that it is virtually impossible to trace the recipient in the cryptocurrency market.

Fraud

Since the introduction of cryptocurrencies to the market, their value has proven to be unstable. The potential for very high returns on a new type of asset attracts fraudsters. This poses risks to coin and token holders. Beginner investors are more susceptible to situations with fraudsters than professionals.

In addition, cryptocurrency is unregulated, so it is easier for criminals to exploit it than traditional regulated bank accounts and other authorized investment schemes. The combination of these factors has led to an increase in cryptoasset fraud.

Attackers typically target individuals rather than companies. Victims are chosen at random. They are usually incentivized to make investments by promising high returns. Often, however, the scammers take the investors’ money and disappear.

In other cases, people hand over funds for a crypto asset and either lose control over it or don’t realize what they bought at all. Scammers create a fictitious cryptocurrency exchange and sell people digital money, claiming that its price will increase as the trading platform grows. When the holder tries to withdraw assets from the exchange, they find that they cannot access the funds. Therefore, anyone planning to invest in cryptocurrency should only use well-known platforms that can be easily verified by conducting a simple internet research.

The possibility of a digital currency market crash

Proponents of bitcoin say that it is an investment opportunity. However, there is a cash flow associated with the financial asset. Coins and tokens generally have no source of income or practical application. Speculation is their raison d’être. Coin and token prices are subject to sudden and random movement and can be managed. This raises another problem: savings.

For an asset to serve as a means of capital accumulation, it must be liquid, applicable, and have a stable value. Cryptocurrencies have none of these characteristics.

Bitcoin trading suffers from illiquidity and manipulation due to the existence of whales (wallets containing large quantities of BTC coins).

At the end of 2020, the top 100 Bitcoin addresses accounted for 13% of the total number of bitcoins, with the identities of most owners unknown. Thus, all it takes is a few whale wallets to manipulate the market, causing dramatic price fluctuations. The volatility has made cryptoassets a risky instrument to save.

There is a possibility that the prices of coins and tokens will eventually collapse. This could be caused by a shift in monetary policy or after regulations are passed.

Recommendations for asset holders

The following measures can help avoid problems:

Summary

For all the possible obstacles to mass adoption, cryptocurrencies (and blockchain technology) will evolve. They offer many of the benefits consumers are looking for in the current system of finance: decentralization, transparency, and flexibility.

But some problems of the cryptocurrency market remain unresolved. These primarily concern price stability, investment security and the fight against digital fraud.

Frequently Asked Questions