What is the risk associated with crypto currency
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The interest of investors in investing in payment tokens such as Bitcoin - also called "virtual currencies" or "crypto currencies" in non-technical terms among investors - remains unbroken. This is also shown by the figures: The total market capitalization of all existing payment tokens increased by around 60 times between 2015 and 2020 (see Figure 1). The number of different payment tokens has also grown rapidly in recent years. According to publicly available sources, there are currently more than 6,000 such tokens. The downside of the hype: Most of them have a very short lifespan or are largely unknown and therefore worthless.
Figure 1: Development of the total market capitalization of payment tokens
The increasing interest of small investors does not stop at a direct investment in payment tokens. There is also growing demand for financial instruments that track the performance of payment tokens.
The number of securities issued with payment tokens as an underlying increased from 12 to 2018 to currently around 6,500. The trading volume of small investors in Germany was more than 700 million euros over the past two years. The certificates industry assumes that the demand for such financial instruments will continue to grow.
However, the products are not suitable for every investor. They contain considerable risks, especially for small investors.
What are derivatives with payment tokens as an underlying?
Derivatives are financial instruments, the price of which depends on how the price of an underlying asset develops. Two categories of derivatives are particularly relevant for retail investors: financial contracts for difference (CFDs) and certificates.
In CFD, two parties bet by contract on how the price of a certain underlying asset will develop. Due to significant investor protection concerns, the BaFin issued a product intervention measure with its general decree of July 23, 2019 and thus restricted the marketing, distribution and sale of CFDs to small investors in Germany (see message "CFD trading"). Due to the high volatility of crypto values, a tightened leverage limit applies to these CFDs. Small investors in Germany are only allowed to trade CFDs with such underlyings with a leverage of up to two (initial margin protection).
Certificates and Exchange Traded Notes are bearer bonds. They certify for the holder a claim against the issuer for payment or repayment of a sum of money or delivery of an underlying asset (see BaFinJournal May 2019).
What are payment tokens?
Payment tokens denote investments in digital form that are not financial instruments according to Section 2 (4) of the Securities Trading Act (WpHG), do not represent legal tender and do not represent any rights. With these virtual currencies, there is no responsible central institution such as a central bank that monitors them or issues the units. The high relevance of information technology is typical: encryption technologies secure the payment tokens, decentralized networks manage them (see BaFinPerspektiven 1/2018).
Participation tokens (security tokens) that have security-like properties do not fall under the definition of payment tokens. They are classified as securities. Your issuers are therefore subject to regulatory requirements such as the obligation to prepare a securities prospectus. It is currently not known that security tokens or stablecoins act as underlying assets for derivatives.
Well-known payment tokens include Bitcoin, Ether, Litecoin, Ripple, Tether and Bitcoin Cash. Bitcoin accounts for more than 60 percent of the global total market capitalization of payment tokens amounting to 235 billion euros. It is not surprising that it is also most commonly used as an underlying asset for derivatives.
What options do payment tokens offer as an investment object?
How the value of a payment token develops does not usually depend on other macroeconomic factors. Often there is no correlation between payment tokens and traditional asset classes such as stock indices and commodities. Due to this lack of correlation, investors try to diversify their portfolio with payment tokens and thus reduce their overall risk. As a rule, however, experienced investors use payment tokens primarily as an object of speculation.
What risks are associated with payment tokens as an investment object?
Investors can hardly make reliable forecasts about the performance of payment tokens - virtual currencies are too complex for that. This is particularly due to the fact that payment tokens are not based on any real economic value. They have no intrinsic value and are therefore open to speculation. For the stability of a payment token, its reputation and acceptance are extremely important - especially in light of the fact that payment tokens are not issued by central banks and are not a legal tender.
Another risk posed by payment tokens: their extreme volatility (see info box). It is usually six to 13 times higher for known payment tokens than for other base values. Compared to the US S&P 500 stock index, Bitcoin, for example, shows a 26 times higher range of fluctuation - not on the basis of changes in contractual claims, but primarily on the basis of speculation.
Volatility describes the range of fluctuations in returns. It is a measure of the frequency and intensity of fluctuations in the value or price of an underlying asset. This means that volatility is also a measure of the uncertainty of an investment and its price risk. The higher the volatility, the more the price fluctuates and the riskier an investment is.
The extreme fluctuation range of Bitcoin also stands out when compared to currencies: Between July 2017 and July 2019, its average volatility was more than 4 percent (see Figure 2). During the same period, the exchange rate between the US dollar and the euro showed a volatility of 0.36 percent (see Figure 3). The Bitcoin fluctuated twelve times more.
Figure 2: Bitcoin volatility
Figure 3: Volatility of the exchange rate between the US dollar and the euro
The exchange rate between the US dollar and the euro fluctuated during the observation period between two consecutive closing rates by a maximum of 1.88 percent, while the value of Bitcoin changed several times by over 10 percent. On December 7, 2017, the closing price was 22.44 percent above the closing price on the previous day. These short-term, strong price fluctuations (flash crashes) are still typical for payment tokens today.
Ledger splits are also typical. This is what the split of a payment token is called. Two blockchains with a common history are continued. This is usually followed by higher volatility and uncertainty about the future price of both the remaining and the newly created payment token. There is also the risk that a payment token will no longer exist, which means that the base value for the derivative is no longer applicable and the derivative becomes worthless. In addition, payment tokens are not regulated. There is no independent body that monitors trading and pricing. Since payment tokens do not represent financial instruments under securities law, they are not subject to any back office and transparency obligations under capital market law - in contrast to most other base values such as shares.
Wallets are one way for investors to manage their crypto assets themselves. This means the storage location of the private key for full access to the crypto values stored. This storage location can be software, hardware such as a USB stick or the sheet of paper on which the key was written down. If investors lose their private key, they can no longer access their crypto assets. If hackers crack the password, there is also a risk of total loss. In order to reduce the technical risks, investors can use service providers who offer crypto custody business. The management of your crypto values is then based on a securities account.
The European Supervisory Authorities (ESAs) and BaFin have already warned of the risks of crypto assets.
What options do derivatives with payment tokens as an underlying offer?
In the best case scenario, investors can use derivatives to benefit from the rising prices of payment tokens - or, if they have bet on the opposite, from falling prices. You can speculate with a payment token, but avoid specific operational or technical risks because you do not purchase it directly. This basically makes your investment easier and less error-prone. If investors opt for derivatives, for example, the payment token does not have to be kept in a wallet with a private key.
Overall, trading in derivatives whose underlying is a payment token is more transparent than a direct investment. This is due to the legal requirements, especially for certificates. Certificate issuers not only have to prepare a securities prospectus, but also a key information sheet. These documents describe the risks of the investment and also contain information on the tradability of the certificate as well as a risk rating, information on the costs associated with the product and a recommended holding period. In addition, the issuer carries out a target market classification. However, this higher level of transparency only relates to the certificate structure; the underlying asset itself remains intransparent.
What are the disadvantages of derivatives with payment tokens as an underlying?
In contrast to the direct purchase of payment tokens, it should be noted that investors not only bear the price risk of the underlying, but also, as with all certificates, the risk of an issuer default and, in the case of CFDs, the counterparty default risk.
In addition, the market risks of the tokens are transferred to the respective derivative. Continuous trading on the basis of supply and demand is not guaranteed for certificates on payment tokens either. Since there is often insufficient liquidity or market breadth, market makers set the prices - at their own discretion and with the option of suspending or even ending the price determination at any time (see BaFinJournal January 2019). In addition, the issuer factors into the certificate the costs that it incurs as a result of the fact that it carries out hedging transactions or acts as a market maker itself. Such costs do not arise with a direct investment in payment tokens.
The leverage effect in the case of knock-out certificates or the possibility of short-term termination by the issuer in the case of investment certificates are risks inherent in the product that investors must also consider - depending on which derivative design they choose.
At a glance: Excursus: Empirical study on investor losses
Certificates with payment tokens as an underlying regularly generate losses for more than half of their investors. A BaFin analysis of the transaction data of small investors between January 2018 and April 2020 showed that the majority of investors invested in non-leveraged investment certificates and only a fifth of these investors speculated with leverage certificates - in both cases a negative deal.
When trading leverage certificates with payment tokens as an underlying, around 60 percent of these small investors suffered a loss and only around 40 percent made a profit. In the case of non-leveraged investment certificates, however, the ratio is more balanced with a loss rate of around 52 percent. On average, small investors lose around 250 euros when trading certificates with payment tokens as the base value.
When trading financial contracts for difference (CFDs) with payment tokens as an underlying asset, more than 80 percent of small investors regularly suffer losses.
What should investors consider?
Payment tokens have no intrinsic value and are not subject to any securities law supervision. A high level of volatility and thus uncertainty about future performance are typical for them.
Certificates in particular are more transparent overall and make it possible to participate in the performance of payment tokens without having to invest in them directly. However, the high level of uncertainty due to the volatility also affects the derivatives. In addition, the general lack of transparency with regard to payment tokens also remains with certificates and CFDs.
Therefore, derivatives with payment tokens as an underlying are not suitable for a long-term investment strategy, but rather for short-term speculation. Since the prognosis of the future price development of payment tokens is particularly complex, only experienced investors should consider derivatives with these underlying values.
Regardless of this, BaFin monitors the market for certificates with payment tokens as an underlying and checks in individual cases whether supervisory measures, including a product ban, are necessary.
BaFin department for operational abuse monitoring and product intervention
BaFinJournal 09/2020 (Download)
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