This article explains the biggest risks in crypto, and what you can do to protect yourself from them.
In 2021, crypto experienced a historic rise in market cap, and the entire industry seemed poised to deliver on its potential. Unfortunately, that trend ended abruptly in 2022, a year full of catastrophic events, highlighting some of the biggest risks in crypto.
While some say crypto is dead, setbacks like this are nothing new to this nascent industry. The builders and investors in this space have just learned a valuable lesson. We will dust ourselves off and continue on our journey of building a better financial system and internet.
While 2022 may just be a bump on the road, it's clear that this industry needs to better educate and protect new users. At Outlet, we pride ourselves on teaching our customers how to safely store their tokens and avoid the biggest risks in crypto.
This article explains those risks and teaches you what you can do to mitigate them. Let's dive in!
Sam Bankman-Fried and FTX highlighted the biggest risk in crypto very clearly in 2022: centralized exchange risk. If you store your funds with a centralized entity, whether it is an exchange like FTX or a lender like BlockFi or Celsius, you have to trust that company to handle your funds appropriately. Unfortunately, multiple centralized entities did not do that in 2022. As a result, millions of customers wound up having their assets frozen, possibly lost forever.
Centralized entities that went bust in 2022 and left their customers high and dry include FTX, Celsius, BlockFi, Voyager Digital, Donut, Alice Finance, and many more.
How to Protect Yourself From Centralized Exchange Risk
Ironically, this is the very risk that the blockchain is designed to solve by allowing users to self-custody their assets. Users who store their tokens in private wallets avoid centralized exchange risk altogether. Self-custody does require a bit more work, but the security is well worth it.
However, self-custody is not risk-free.
The second biggest risk in crypto is the flipside of centralized exchange risk: self-custody risk. Although storing crypto assets in a private wallet is the most secure way to safeguard them, it is not 100% risk-free.
Instead of needing to trust a third party, when you store your funds in self-custody, you need to trust yourself. That means you need to have a backup of your private key stored somewhere safe from fires, theft, and anything else that could cause it to get lost or damaged.
If you lose your private key or someone manages to steal it, your crypto will be gone permanently. So while we do recommend self-custody, it's critical to be responsible and make sure your backup remains safe.
How to Protect Yourself From Self-custody Risk
To protect yourself from the second biggest risk in crypto, you need to get creative with your private key storage. The best thing to do is buy a hardware device like a Ledger Nano or a Trezor directly from the manufacturer (i.e., not from a third-party retailer like Amazon).
However, even with a hardware device, you will need to store a backup of your private key in a separate location, such as a safe deposit box or a fireproof box in your house.
For the highest level of security, you can even create a multi-sig wallet with three or more private keys, but only requires 2 of the keys in order to restore a backup. You can then store the keys separately, so your crypto will still be safe if one backup gets damaged or stolen.
Hot wallets are crypto wallets that are connected to the internet and accessible via browser extensions and software applications. Because they are connected to the internet, they are vulnerable to phishing attacks.
Phishing attacks are when a hacker attempts to get unsuspecting users to click on malicious links designed to search the user's computer for a hot wallet and steal funds from it.
How to Protect Yourself from Phishing Attacks
You should always be vigilant to protect your computer from hackers, but if you store funds in a hot wallet, you must be even more careful. To protect yourself from hacks, a good rule of thumb is to never click on any link that a stranger sends you. You even need to be vigilant with links sent from friends.
Many hackers pose as trustworthy people who are there to help you. For example, they may pretend to be customer service reps or even friends, so never click on suspicious links and never share your private keys or seed phrases with anyone.
Malicious links can also be on websites and even Google ads, so the best practice is to only click on links you are 100% sure can be trusted. If you do that, your funds will be safe from phishing attacks.
The fourth biggest risk in crypto is still one that we still see far too frequently: scams and rug pulls.
Unfortunately, not every project in crypto is what it appears to be. Sometimes founders pitch a token or an NFT that will never be able to deliver on their promises. Other times, the founders may lose conviction in their vision and sell all of their tokens before abandoning the project. Either way, investors are often left holding bags that have dropped in value almost to 0.
How To Protect Yourself from Scams and Rug Pulls
To avoid getting suckered into a scam, you need to be vigilant. Doing your own research is essential if you invest in this space, and it's wise to avoid projects with anonymous founders or people with cult-like followings (think Do Kwon and Richard Heart). If the crowd is drinking the Kool-Aid too enthusiastically, it's probably time to leave the party.
For people who are uncomfortable doing their own research, it's best to stick to the most reputable blockchains like Bitcoin and Ethereum. However, even the honest players in this industry could go to 0 someday, so it's essential to remember crypto's golden rule: never invest more than you can afford to lose.
The fifth biggest risk in crypto is one that we can do little to prevent: the threat of incoming regulations from the United States government.
After the fallout with FTX, it is becoming more and more likely that the government will hand down regulations in the near future, but we still don't know what those regulations will look like.
While it would be difficult for a government to regulate decentralized protocols, they could shut down onramps and centralized exchanges. If they make it impossible for people to buy crypto, they could force crypto and all of its innovation outside US borders.
That wouldn't necessarily be the end of crypto, but it would be a huge setback, and it's unclear if the industry could recover. Unfortunately, there is little we can do as individuals to protect crypto from short-sighted regulations outside of calling your representatives.
However, there is a caveat to the threat of regulation: if done well, regulations could be a good thing for crypto.
Let's face it: crypto can't continue functioning like the wild west. We need safeguards to protect us from scammers, rug pullers, and outright fraudsters like Sam Bankman-Fried. If the government gets regulations right, it will design laws that empower consumers and hinder criminals. If they do that effectively, incoming regulations could lay the groundwork for a better future in crypto and ultimately lead to the next bull market.
The sixth biggest risk in crypto, and the last on our list, is smart contract risk. Smart contract risk refers to the possibility of faulty smart contracts locking up assets accidentally or making them vulnerable to attack by hackers.
The most famous example of smart contract risk was the DAO hack in 2016. The DAO was a project built on Ethereum. It was designed to allow users to deposit their ETH and pool it together to make larger investments.
However, a hacker noticed a bug in the smart contract's code and drained almost 31% of the ETH deposited into it. This hack led to a highly controversial hard fork when the chain split into Ethereum and Ethereum Classic.
How to Protect Yourself From Smart Contract Risk
Smart contract risk only applies to users who invest with blockchain-based applications like lending protocols, liquidity pools, or other financial instruments. If you want to avoid it entirely, you can easily do so by not investing with these protocols.
If you want to invest in blockchain-based protocols, you can protect yourself by only investing in protocols that have published audits of their code. Even better, only invest in protocols that have existed for multiple years without ever being hacked.
The longer a decentralized app exists without a hack, the less likely it is that a bug in the code could lead to a hack in the future.
Some of the risks on this list are entirely avoidable, like smart contract risk. Others, like centralized exchange risk, are not avoidable but can be mitigated by limiting your exposure to centralized entities. Others, like the threat of regulation, can't be controlled or avoided at all.
Investing in crypto and using blockchain-based products always involves some level of risk. Therefore, the most important thing you can do in this space is to keep your exposure to an amount you can afford to lose.
If you have too much invested in crypto, and the markets or specific projects go to 0, it could be devastating. But if you view this as a speculative investment because you believe in the power of the blockchain, there is also a tremendous potential upside that you may be able to realize in the next decade.
Be careful, be wary of unproven projects and braggadocious, arrogant, and anonymous founders, and always do your own research! However, if you do your best to mitigate your risks, crypto is still one of the most exciting industries you can invest in.