Rewards can be great with cryptocurrency investing but so can the risks

The growing frenzy around bitcoin and other cryptocurrency offerings has prompted warnings from a range of financial heavyweights on the risks that current and potential investors should keep in mind.

Bank of Canada governor Stephen Poloz sounded the alarm last week, saying that buying into the trend is "closer to gambling than investing", while Canada's securities regulators association issued a special warning on Monday about the high level of risk associated with digital currency-linked products.

Top of mind for many is the question of just how big a bubble bitcoin is in. Virtually worthless in early 2009, the cryptocurrency hit $1,000 US by early 2017 and then soared to its current price of just under $17,000 US, a 12-month gain of more than 1,900 per cent.

The disruptive potential of bitcoin and its underlying blockchain technology is only helping fuel the speculation and could lead it to go higher still, said BMO Financial Group chief economist Doug Porter.

"Bubbles start off with a very compelling story, a fundamental change that triggers a lot of enthusiasm and attracts a lot of investment, and often what we see happen is a good thing goes crazy."

"These sorts of things, whenever you get into the speculative mania, they can go a lot further and higher than many people believe is possible," he said.

Even those who fully believe bitcoin will keep growing and help to disrupt financial systems expect the price volatility to continue.

"Even if there are corrections along the way, it will come back even stronger than before, so I'm not too worried about corrections. But for sure there is going to be volatility," said William Mougayar, a cryptocurrency investor and author of The Business Blockchain.

But with such an astounding run-up already this year, investors are turning to the debut of other coin launches in the hopes of repeating the astounding profits that have come to early bitcoin speculators.

The rise of initial coin offerings (ICOs) or token offerings used by blockchain start-ups to raise money has, however, led to other risks for the casual investor.

With little regulation and more than $3.6 billion US raised in 234 offerings this year according to CoinSchedule, a cryptocurrency and ICO website, the area has been ripe for abuse, said University of Waterloo associate professor Jean-Paul Lam.

"There has been quite a lot of fraud already, with companies taking advantage of the frenzy in ICOs and investors thinking they can make a quick return on their investment and they would invest in a lot of these projects without doing any due diligence."

"What has surprised me is the frenzy with people not assessing risk," said Lam.

The SEC has already cracked down on two such offerings this month, including one by Quebec-based PlexCorps that it said raised up to $15 million US from thousands of investors since August by promising a 13-fold profit in less than a month.

Another seldom-mentioned risk is as old as money itself: taxes.

While some believe their offshore wallets and decentralized ledger will allow them to hide their gains, Toronto tax lawyer Evan Kwok said the Canada Revenue Agency is actively looking into the issue and could begin a crackdown at any time.

Active traders of digital currencies will likely have their profits taxed as business income, while those who have sat on their holdings would be taxed under capital gains, said Kwok.

However, keeping track of gains can become complicated, since the digital exchanges don't always provide complete transaction history, while those who actually use bitcoin to buy real-world items have to keep track of those transactions as well.

"Once you transact away from that currency, let's say you buy a coffee using bitcoin, that triggers a capital gain, you actually used it and liquidated your position."

Investors also have to understand the basics of the technology, including the public wallet, private key, and how to secure your private key, said Jean-Philippe Vergne, co-director of the Scotiabank Digital Banking Lab at Western University.

He said investors also have to be wary of the cryptocurrency exchanges, as there have been numerous hacks, including a South Korean exchange that shut down Tuesday after a cyberattack.

But despite the risks, Vergne said it could still be a way to diversify holdings for certain investors.

"I think for investors who are interested in adding maybe five to 10 per cent of their savings in cryptocurrency, which is a nice way to diversify and gain exposure to an up-and-coming sector of the economy, why not, it may be a good idea."