Top threats to bitcoin and cryptocurrencies in 2018

Cryptocurrency hacking risks

The fundamental reasons behind the creation of bitcoin and the blockchain can be easily forgotten. It was not a coincidence that Satoshi Nakamoto released his whitepaper for bitcoin only weeks after the collapse of Lehman Brothers in 2008 (it was even referenced to in the Genesis block). It is not a coincidence that a decentralised electronic payment system was created as the centralised system on both sides of the Atlantic fell to its knees.

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There are two elements that form the backbone of cryptocurrencies – anonymity and the ability to operate without any central authority or single point of control. Both of these are under threat.

One of the biggest strengths of bitcoin and its blockchain is that it is a run on a consensus-based model that sees user’s computers maintaining the network to replace the traditional role that banks and financial institutions usually play. This is one of the reasons why the blockchain is immune to hacking – attacking a worldwide network of computers is almost impossible compared to trying to attack the network of just one business, even if that business is one of the biggest in the world.

But the rise (and fall) of cryptocurrency exchanges has undermined that strength – it places the control back into the hands of a third party, ones that are prone to being hacked. When you use an exchange it is responsible for your data, your cryptocurrency and your fiat currency.

Exchanges have become the biggest kink in the armour just as the regulators are about to strike.

Mt. Gox exchange issues

The story of Mt. Gox highlights the problems that exchanges pose, but also demonstrates why they exist in the first place. They were only created because of bitcoin’s inability to scale up. Without exchanges, transaction times would still take days to complete – and amid the volatility in prices, this is just not feasible.

Back in 2010 when bitcoin was trading for cents rather than thousands of dollars, Jed McCaleb became frustrated at not being able to buy bitcoin as quickly as he wanted. That prompted him to turn a website he originally set up to trade playing cards into one of the first bitcoin exchanges to arrive on the market: Mt. Gox.

The Japanese-based exchange quickly went on to become the biggest in the world. But, scared by the scrutiny he could come under (particularly from US authorities), he offloaded the exchange in 2011 to an inexperienced Frenchman living in Tokyo at the time, Mark Karpeles. The site’s growth accelerated after Karpeles took over, but more than he was prepared for.

Mt. Gox famously collapsed in early 2014 after 750,000 bitcoin – about 6% of the total circulation at the time – worth about $500 million went missing. Surprisingly, despite causing an 80% dive in the price of bitcoin, people kept putting their money into Mt. Gox after the hack (a recurring theme for other exchanges that have been hacked since), and the exchange managed to cling on because the price of bitcoin began rising again. But as the price began to tumble later in 2014, Mt. Gox and its owner lost the ability to survive.

While the industry has tried to learn from Mt. Gox’s mistake (it is now spread much more evenly across multiple exchanges even if there are still a few dominant players), the introduction of third parties in the cryptocurrency world has continued to expose its users to hacks and theft. It is not bitcoin’s blockchain being hacked, it’s the exchanges because of their lack of infrastructure.

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If anything, exchanges have experienced more hacks as time has gone on. In recent weeks and months, Slovenian exchange NiceHash had $64 million of bitcoin stolen. South Korea’s YouBit filed for insolvency after a large chunk of its assets were hacked. And in the US, authorities have decried BitConnect as a Ponzi scheme and frozen its assets, as well as stopped a major initial coin offering (ICO) launched by AriseBank, which was claiming to be the world’s first ‘decentralised bank’. The likes of DAO having lost $50 million of ether in 2016 also shows the problem has spread beyond bitcoin.

However, it is the recent hack of Japan’s second largest exchange, Coincheck (losing $500 million of XEM), that has brought back memories of Mt. Gox. Japan’s Financial Services Agency has ordered Coincheck to report full details of the incident and the company has vowed to reimburse customers, claiming it is capitalised enough to do so.

Japan is a major hub for cryptocurrency trading and the country has been a leader in terms of both embracing and regulating the market, but Coincheck is making the government re-evaluate its attitude toward cryptocurrencies, and any apparent success is more reflective of the lack of acceptance of its Asian neighbours.

The severity of thefts, especially from the larger exchanges, and their ability to cover losses and prevent such events is the number one reason regulators worldwide are increasingly being forced to take action.

Another vulnerability that is hampering the market is storage. Users have three choices of where to store their cryptocurrencies – in an exchange, in a software wallet or a hardware wallet. Anything but the latter is insecure, because the wallet providers are also third parties offering hackers a loop hole into the system.

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Tether and Bitfinex Exchange affecting the price of bitcoin

One of the biggest scandals to have hit the market, if proven true, has been sparked by cryptocurrency Tether, and the exchange Bitfinex, both of which share a chief executive and are heavily intertwined. The attraction of the cryptocurrency is that every tether created is backed by a US dollar, providing some guarantee to investors by keeping the price relatively stable while other coins violently fluctuate in price. But questions have been raised about whether the company has the $2.3 billion worth of reserves to cover the 2.3 billion of tether currently outstanding.

People trading tethers for bitcoin on Bitfinex have driven the price of bitcoin up, but if it is true that the dollars underpinning the tether do not exist, then the value of tether could crash, and if it has inflated the price of bitcoin as claimed, then the price of the original cryptocurrency will follow suit.

The market is still awaiting clarity but the situation does not look good. After agreeing to an audit, Tether’s relationship with its auditor ‘dissolved’, the company’s website has been down since the claims emerged and US authorities have now subpoenaed both Tether and Bitfinex looking for answers. It could lead to a domino effect. Or it could not. Watch this space.

Cryptocurrency regulation is on the horizon

While many involved in cryptocurrencies want regulators to stay clear and let the innovators continue the work they started, it would be naïve to think an industry failing to protect its consumers and linked to illicit activity can avoid regulation.

There is no consensus between any countries or blocs on how to regulate cryptocurrencies, which has turned out to be one of the biggest drivers behind the volatility in cryptocurrency prices.

It doesn’t look like there will be a widely recognised regulatory framework anytime soon. European Central Bank (ECB) executive, Benoit Coeure, recently suggested for countries to come together to form a regulatory framework for the industry at the G20 meeting in Buenos Aires in March this year. It isn’t even off the starting block yet.

Individual countries are therefore taking an independent approach and trying to regulate something designed not to be regulated, and almost all of them have dithered. The mixed messages make the situation extremely confusing for everyone involved.

The regulation that has come through can also be seen as hasty in some circumstances. New York, for example, made virtual currency companies in the city require a BitLicense from the middle of 2014, but that was introduced at least a year earlier than planned, after it was rushed through following the collapse of Mt. Gox.

Different countries, different attitudes to cryptocurrencies

‘The lesson from the internet is – anything that China bans, it invests in. That’s a joke, but the US allows Google to operate here, allows Twitter to operate here, allows bitcoin to operate here, allows Facebook to operate here. The Chinese government doesn’t allow any of those companies to operate in their country as they operate in this country, or at all. This is about freedom, ultimately.’ – Fred Wilson, partner at Union Square Ventures speaking at the Bitcoin Hearing in New York, 2014.

There is an abundance of irony in the way cryptocurrencies are being tackled by authorities at present. China has taken the most extreme measures against cryptocurrencies, banning ICOs and cracking down on exchanges, but the country has by far the largest amount of cryptocurrency traders and homes the majority of the miners that keep the entire blockchain and ecosystem running.

Read more on China's ban on ICOs and what it means for the crypto market.

The US can’t make its mind up, having halted numerous ICOs, shutdown virtual currency firms and made an example of several of the early entrepreneurs by sending them to prison, while at the same time allowing cryptocurrency derivatives to trade publicly. The country also auctioned off $13.5 million worth of bitcoin it seized when it shutdown dark marketplace Silk Road, at a time when it didn’t endorse virtual currency. No wonder there is confusion.

South Korea is equally undecided. Some days it has threatened to shutdown the entire industry, other days it has said it is only unhappy about the anonymity of payments, apparently forgetting that anonymous payments is one of the two fundamental purposes of cryptocurrencies.

Meanwhile, the European Union has failed to do more than warn investors of the potential risks of investing in cryptocurrencies, and the UK has been even slower to react.

Credit, tax and fraud

Governments may be nowhere near deciding how they will regulate cryptocurrencies, but they are making much more progress on how they want to tax them. Tax authorities in both the US and the UK published guidance on how cryptocurrencies should be treated about four years ago, making investors liable to capital gains tax (and possibly income tax for those who have turned to investing cryptocurrency trading full-time).

The price surge that pushed bitcoin to its peak in late 2017 is thought to have pushed more and more people to cash in. It seems there is enough money being made that the tax authorities are no longer willing to miss out.

The liquidity of the market is also in question as reports have emerged that credit is being increasingly used to fund people’s cryptocurrency investments. An investor may have seen their investment in bitcoin rise, but the credit used to make the investment still needs to be paid back – in fiat – and those who used credit and bought bitcoin at the wrong time have an even bigger headache.

In the UK, Lloyds Banking Group has now become one of the first to ban customers from using credit cards to buy bitcoin and other cryptocurrencies, following US banks who started addressing the problem earlier.

If investors have used a significant enough amount of credit to make their investments, the liquidity in the market and trading volumes could see a correlating drop if that credit is no longer available.

There has also been issues with cashing in cryptocurrency, with many finding it much easier to convert their fiat currency into cryptocurrency than the other way round. The Chief Executive of the Coinfloor exchange, Mark Lamb, recently said UK investors have had a particularly hard time converting their cryptocurrencies into pounds (GBP). This is because there is a lack of relationship between exchanges and UK banks, forcing investors to convert into euros or dollars and then into sterling, incurring the high transaction fees that bitcoin was invented to avoid.

Fraud is also a growing problem. The level of fraud being committed varies wildly, from fake ICOs and corrupt exchanges, to impersonators on social media convincing unsuspecting people to send them their cryptocurrencies. Ethereum creator, Vitalik Buterin, recently tweeted there is 827 ways to slightly adjust his name and handle on the site, amidst rising amounts of fake accounts using his reputation to swindle individuals out of their coins.

The founder of Ethereum: Vitalik Buterin.

The love-hate relationship with cryptocurrencies and the world

Everyone involved in cryptocurrencies is learning, even the most experienced. An entirely new market is evolving and finding its feet, and that means there is still a lot to work out. That includes deciding where, or even if, cryptocurrencies can lie within the traditional financial and regulatory system.

The industry has always suffered from a ‘chicken or egg’ problem, whereby it needs more people to adopt cryptocurrencies for merchants to adopt them, while businesses need more people to use virtual currencies before they are incentivised to facilitate cryptocurrency payments.

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Similarly, the market needs help from those it is trying to circumnavigate. It needs fiat currency and funding from big banks, exchanges need the ability of big business to take infrastructure and security to the next level, the market needs regulation to stop the Wild West attitude that keeps attracting the cowboys. Equally, big business wants the blockchain technology and regulators want to encourage entrepreneurship if cryptocurrencies are to take off.

It may be a hard pill to swallow for many, but collaborating with the traditional financial and regulatory system can go a long way to securing the future of cryptocurrencies. Without their assistance, it could all be lost.

And, if nothing else, one of the biggest possible weaknesses that could bring down cryptocurrencies is pure sentiment. The hype may have peaked in late 2017, but what will the attitude be a year later?

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