Bitcoin for Everyone

Lesson 5 – Understanding the Risks

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Welcome back to Bitcoin for Everyone. A Coin Academy original course. This course is designed to introduce to you to the worlds most popular alternative currency, Bitcoin.

We’ve divided this course into a series of eight lessons. This is the 5th lesson entitled Understanding the Risks, when we take a hard look at the different risks that are associated with Bitcoins and Digital Currencies in general.

Now really what we want to advocate in the course of this lesson is the development of a realistic view towards risks in this environment. There are lots of potential risks, but we feel that there are a manageable number of realistic risks. Now that’s a personal decision you have to make it for yourself but that’s our take on this.

We do advise you, find a balance: What level of risk are you comfortable with? An approach to personal digital security, which is a key element of risk management from a cost/benefit perspective. And you know for those of you who are extremely risk averse, this is probably not the time for you to be involved in this market. Hopefully that’s changing but a point in the time if you’re that kind of caution person just take a pass.

This is the scary slide. We call it the scary slide because what we’ve done is we’ve looked at a July 2014 paper produce by the European Banking Association and we’ve extracted from it the list of risks they found to exist with Digital Currencies. Now there were 33 items that were listed as potential risks to users of digital currency and they rated those from Low Risk to High Risk. There are actually more then 33 items in total on the list, but the other items dealt with institutional risks, risks to nations etc, they didn’t deal with risks to users so that’s why they’re not included here.

Of that list of 33, 17 were deemed High Risk, a very high percentage. Only 3 were considered as Low Risk, and of the list of 33 however 7 items were only applicable to investors. So if you’re not looking in investing in digital currency there’s some items that don’t apply to you. The risks vary in likelihood and moreover some of them are common to all electronic transactions. I mean this is from a banking association, it is going to be conservative and that’s actually part of the reason why we used it as the base line for this discussion, as we wanted to put forward the most conservative viewpoint of this so everybody goes in with their eyes open.

Lets take a look at the high-risk items and this is a fairly long slide so bear with me. First, rate fluctuation, as we’ve seen there’s a significant fluctuation in Bitcoin valuations. Fraudulent exchanges, and here when we say exchange, we mean the currency exchange. Note this item was listed twice there are two variations. Once situation the entire exchange was fraudulent, it has been created only for that purpose and another scenario is a particular transaction was fraudulent though the exchange as whole was not.

Next would loss due to changes in protocol. What they mean here is the change in the underlying digital currency protocol. Say for an example reversion of the protocol that causes previous units of the currency to decrease in value or to be of lower utility value. Next would be digital wallet theft or hacking. Next would be hacking of the currency exchange itself, next would be identity theft. Next up was the inability to find an exchange that’s liquid this is listed twice, again two different scenarios – one the exchange is essential bankrupt it doesn’t have sufficient assets to cover its obligations and two, at the time you wish use the exchange to move in or out of the digital currency it is not liquid, in other words temporary liquidity problem that causes you to lose value.

Next would be loss of value due to market manipulation. This would be the intentional attempt to inflate or deflate the market for the benefit of someone. Next would be freezing of your digital currency assets, for example a government seizure by law enforcement. Next up, is failure of the counter party to settle, again listed twice, one of them is complete failure to settle the other one is failure to settle in a timely fashion.

Next up was the possibility that merchants may cease to accept the currency, leaving you holding currency you cannot spend as you wish. Next up would be transactions transfer errors, in other words problems with the transactions in itself. Next was the conversion to fiat currency, so you have money invested in this digital currency and now you can’t get the money out. And finally on this list of high-risk items was the loss of access to the digital wallet. Meaning, you’ve lost your password, your password and you can no longer get into your digital wallet. Since you cannot get into your digital wallet you cannot access your digital currency.

So that is the list of high risk items I want to break that down a little bit now and look at it in another context. First, when we talk about this list basically there are some items here that are not unique to digital currencies and I’ve highlighted those in the orange color on the screen. Things like rate fluctuation, identity theft, loss of value due to market manipulation, transaction transfer errors, freezing of digital currency assets: these could happen in any kind of market in any kind of asset. These are basically background noise particularly when we talk about identity theft and electronic transactions environment.

Next there are certain items that can be mitigated through due diligence and through good practices of personal security, for example digital wallet theft or hacking, identity theft and loss of access to the digital wallet. If you haven’t placed sufficient security protocols you have good adherence to best practices you can certainly minimize the risk in these areas.

So what does this leave us with in terms of unique risks to digital currencies? Well it does leave us with a number of items. So then we need to ask ourselves, how many of those items are actually high potential items, what’s likelihood of those things occurring? How many times in the past even have they occurred? Fraudulent exchanges, loss due to changes in protocol, hacking of a currency exchange, inability to find exchange that is liquid, failure of counterparty to settle, merchants may cease to accept and inability to convert to fiat currency.

Well obviously the Mt Gox fiasco would be an example of an exchange that cease to be liquid. Mt. Gox would also provide us with an example hacking of a currency exchange; there have been other hacking of currency exchange events as well. Again Mt. Gox could also provide with a situation where we were unable to convert to a fiat currency, though that really isn’t on point because you could have converted to a fiat currency using a different exchange assuming you still had access to your Bitcoins from Mt. Gox. The possibility of merchants ceasing to accept currency will certainly with the mainstream market player like Bitcoin that seems rather remote, and certainly we would have some sort of indication that this was coming given this time to dispose of our digital assets. Failure of counterparty to settle this is definitely a risk, fraudulent exchanges, definitely a risk, loss due to change in protocol seems awfully remote.

So there you have it that’s a realistic look at these in terms of things that unique to digital currency and their various likelihood of occurring. Of course this is a personal opinion you may have different approach to these.

Lets go ahead and look at the rest of the items on the list. What were the medium risk items? First, unexpected tax liabilities, next buying a currency that lacks the features you require, violations of laws or regulations, unexpected application of laws, loss of currency by custodian and losses due to information inequality with the trading partner.

A lot of these items are due diligence items. Your tax liabilities, you should be able to diagnose this, have you bought a currency that lack the features you require again, due diligence should have detected that for you. Violations of laws and regulations, virtually everything here is really a due diligence issue. Obviously loss of currency by a custodian – someone who’s holding the currency for you is an issue that’s difficult to deal with. Losses due to information inequality with the trading partner, again you need to do your due diligence, educate yourself before you get into the market so that you aren’t taken advantage of.

And the final item on this list is ATM Fraud. But then again, talk about the background noise in other words; this is an existing risk in any kind of ATM transaction whatsoever. So I look at this medium risk list and I think a lot of these items are items that should be discharged through due diligence by you as a user.

So finally we go to the low risk items, and this is an even more particular list. Virtually everything here, at least the first two major items relate to Bitcoin mining. If you are a member of the mining pool you may not get your fair share, if you are a member of a mining pool, computer capacity may be diverted for the benefit of others. Ok yeah that’s true. Mining we consider to be fairly a high-risk activity. Then the final item, lack of ability to identify risks, hopefully this presentations has gone some ways to eliminating some of that. But again, you need to do your due diligence and you need to educate yourself.

So what is a healthy response to all this? And again this is a personal question. Bottom line – a number of the items are risks common to electronic transactions, and in those areas Bitcoin introduces no unique risk elements. Next several of the times can be managed through due diligence. Next, some of the items can be marginalized through development of – and adherence to – best practices for personal digital security. Still other items are rather less likely.

At the end of the day, it all comes down to this – you have to decide what’s gonna let you sleep at night.

Join us for Lesson Six – Before you Buy your First Bitcoin.