The risks of different cryptoasset types

Estimated time to read: 5min

Before buying cryptoassets, please take time to understand the different risks associated with the different types of cryptoassets and the steps you can take to mitigate certain risks.

1. Stablecoins
2. Defi tokens
3. Wrapped tokens
4. Meme coins
5. Staked assets

1. ‘Stablecoin’ (e.g. USDT) means that the manufacturers claim their value is linked to certain assets, such as US Dollars. Stablecoins use a different strategy to maintain stability, each with their own risks.

• Counterparty risk: If an asset is backed by collateral (e.g. cash) you are relying on a third party to maintain that collateral which introduces risk if the party becomes insolvent or otherwise fails.
• Redemption risk: During periods of market volatility, uncertainty, or distress. If the asset claims to be redeemable for underlying collateral, there is risk that the redemption process will not work as expected.
• Collateral risk: The value of the collateral may fluctuate, affecting the stability of the asset (especially if is another cryptoasset).
• FX risk: Lots of stablecoins are denominated in US Dollars, thereby exposing you to movements in the USD:GBP exchange rate
• Algorithmic risk: If an algorithm is used to maintain stability (e.g. by adjusting supply based on demand) it may fail or fluctuate, which may cause instability or even total loss.

2. Decentralised Finance (or ‘DeFi’) tokens are crypto-assets linked to financial applications and protocols built on decentralised blockchain technology.

• Smart contract risk: DeFi relies on smart contracts. A coding error or oversight can lead to a contract being exploited, potentially resulting in significant losses.
• Regulatory risk: DeFi operates in a decentralised manner, often without intermediaries or financial crime controls. Regulators may impose rules impacting the use, value, or legality of certain DeFi protocols or assets. Where multiple jurisdictions are used, this risk increases significantly.
• Rug-pulls / Exit scams: Some DeFi projects might be launched by anonymous or pseudonymous teams, increasing the risk of "rug pulls" where developers withdraw funds before abandoning the project, as investors panic to sell, the price crashes, often to zero.
• Data/oracle risk: DeFi protocols often rely on external data sources or ‘oracles’. Manipulation or inaccuracies in these data sources can lead to unintended financial outcomes within the protocols.
• Protocol complexity: The complexity of some DeFi protocols make it difficult for average users to fully understand the mechanisms and associated risks.
• Whale movement risk: Large account holders can flood the market causing prices to drop suddenly. This is another form of volatility risk.

3. Wrapped crypto-assets (e.g. cbETH) (aka ‘wrapped tokens’) are tokenised representations of other crypto-assets. They are typically created to facilitate compatibility and interaction across different blockchain protocols.

• Smart contract risk: Wrapped tokens rely on smart contracts to link their value to an underlying asset. These contracts could have vulnerabilities or flaws that can be exploited, potentially leading to a loss of funds.
• Collateral risk: The value of a wrapped token is typically backed by an equivalent amount of the underlying asset. If the mechanisms ensuring this collateralisation fail, the wrapped token's value might decline.
• Counterparty risk: The underlying assets for wrapped tokens may be held in custody by a third party. If this party becomes insolvent, mismanages the assets, or defrauded or hacked, the value of the wrapped token is undermined.
• Bridging risk: Wrapped tokens may be used to bridge assets between different blockchain ecosystems. These bridges may suffer technical issues, hampering the ability to transfer or use the tokens as intended.
• Pricing disparity: The price of the wrapped asset and any underlying asset might diverge due to market inefficiencies or liquidity issues.

4. ‘Meme coins’ (e.g. DOGE) are crypto-assets whose value is driven primarily by demand led by community interest and online trends.

• Volatility risk: Meme coins can be fashion fads that come and go, making them highly volatile. The value of meme coins can be influenced by social media trends, celebrity endorsements, and other factors unrelated to traditional investment fundamentals.
• Lack of utility: Meme coins often lack intrinsic value or utility, being primarily driven by community interest, online trends, and speculative trading.
• Market manipulation: Meme coins may be susceptible to increased risk of market manipulation including ‘pump-and-dump’ schemes, where promoters drive demand then sell up before anyone else.
• Lack of transparency: Typically, there’s limited information available about their development teams, goals, and financials. This lack of transparency can make it challenging to assess the credibility and the potential of a meme coin accurately.
• Lack of interest: Fashions come and go. As new coins are created, people may lose interest in old ones.
• Emotional investing: Don’t invest impulsively - Meme coins provoke emotional investment decisions, leading to impulsive decisions.

Staked cryptoassets (e.g. staked ETH, staked ATOM) are locked on the relevant blockchain protocol in order to secure the network and earn rewards.

• Slashing risk: By staking your assets, you risk potential loss if the network penalises your validator.
• Liquidity risk: Some protocols require staked assets to be held for a period of time, which prevents you from accessing or selling your assets quickly.
• Performance risk: The yield or reward is determined by the relevant protocol, not guaranteed, and varies over time.
• Protocol risks: Changes or updates to the consensus mechanism may introduce bugs, vulnerabilities, or unforeseen outcomes.

We’ve prepared some information that may help you to mitigate some of these risks.

Counterparty risk, where possible it is helpful maintain an up-to-date portfolio tracker. In the event of the failure of a 3^rd party, administrators may require a detailed record of your holdings, including the coins owned, the quantity, and the purchase dates.

Cybersecurity risk, we strongly recommend the following best practices to enhance security:

• Implement Two-Factor Authentication (2FA) to add an additional layer of security.
• Refrain from disclosing usernames and passwords.
• Utilise secure offline storage solutions, such as hardware wallets or paper wallets, for safeguarding your digital assets.
• Ensure that your offline storage mediums, i.e. hardware wallets or paper wallets, are stored in waterproof and fireproof containers to protect against environmental damage.
• Archive data using at least two different storage mediums (e.g., multiple encrypted USB drives) and store them in separate physical locations to mitigate risks associated with localised disasters.
• Under no circumstances should private keys or seed phrases be shared with unauthorised individuals.
• Utilise Virtual Private Networks (VPNs) and incognito browsing modes when accessing exchange platforms.
• Ensure that your computing devices are equipped with up-to-date antivirus software and firewall protections.

Adherence to these best practice guidelines will significantly improve the security of your digital assets, though it may not completely protect you.