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Why is it so risky to invest my money into crypto?

Author: LB 2021-01-06 95

It is not only about volatility. But what is volatility by the way? In order to see clearly, we have to define a few technical terms. Bitcoin and Ethereum are both rallying on the charts, but where does this all lead to? When prices are increasing at a breakneck rate, something else must also happen in the background. There are not many experts in the field who would do the necessary whistleblowing, but there are more and more financial gurus speaking of wise crypto investments and the Internet is flooded with ads promoting crypto investment platforms. The American currency has been overwhelmed by its excessive printing, which is part of the Quantitative Easing project to bail out failing economies. Self-proclaimed financial experts tell us that this is the reason why we should put our hard earned capital into cryptos. I think reality is much more complex than this and BTC or Ethereum investments are not as safe as some experts with mala fide intention would tell us. While it is a challenge to separate the wheat from the chaff in the world of cryptos, a detailed analysis on the problem can be useful, so without further ado, let's dive into the topic!


I am always taken aback, when ordinary citizens come to me and start their eulogium on cryptos. They are telling me that they invest all their money into crypto assets, because the time has come. Zcash, LiteCoin, SmartCash, Handshake, Pirate and others are mentioned. We witness new ICOs on a daily basis and many believe that all these new coins are developed based on a very novel idea. I am not trying to underrate the innovation in this field, but the pace they reach a $1M market capitalization is alarming. Mostly because this single sign is usually enough for beginners to think that if others have invested into this new coin, then nothing can go wrong, so many of us are happy to give them a try. There is not much to lose anyway. Why not invest a few hundred USD and see how things evolve? That is the people around me think.


1. So how do you invest as a pro?


Every book on investment starts with a simple idea. Invest your money into things you understand. Make sure you understand how it works and how much ROI you can expect. So do you happen to know the ROI of LiteCoin? Are you familiar with the mathematical background of this ICOs? How do they work? How do the crypto derivatives pay dividends? Do you know the answer to these questions or it was your neighbour who told you to buy a few coins? Yes, you might have watched a few videos on YouTube, where nobody guarantees that the person you are watching is a sincere person and not a charlatan. Well, if it was a new ICO, the price of the coin will eventually go up, because if enough people are brainwashed enough, the increasing demand will push the price upwards. But then it might go down. So this is basically what we call "volatility". More rigorously speaking, volatility is related to the standard deviation of the price. Volatility can be used as an input parameter to generate positive revenue streams. And then the Fibonacci series come into play, and some believe in Bollinger Bands. Trading platforms and brokerage firms have deceived millions of users with these mirages and still people entrust their hard earned money to these virtual charlatans. The financial world has another sort of participants, who are not content reading a few articles on the topic and start investing based on shallow knowledge. They usually solve the Black-Scholes model using numerical methods in order to minimize the risk of their investment portfolio. Their portfolio contains financial derivatives, zero-risk bonds, stocks, cash and other delicate assets. In order to understand the behaviour of these things, you need at least 2-3 semesters of advanced mathematics, a few years in college and some infield experience. Whoever is willing to go through this process, equips himself with enough knowledge to generate millions of dollars of revenue for a hedge fund. They are called traders and the companies are usually called Morgan Stanley or Goldman Sachs. Their story is somewhat different.


2. A few thoughts on cryptos


Bitcoin and Ethereum are in a certain sense more sophisticated assets than brand new ICOs, but still there is a concomittant risk with one purchases these coins in order to invest his money. Recently, I found a site called a crypto51.app, which tells us the cost of a possible 51 percent attack on a crypto network. But what is a 51 percent attack in this case?


Some of the readers might be familiar with the concept, but for those who are not, let me explain the 51 percent attack in details.


So whenever you are a participant in a cryptocurrency network and you want to transfer some money from A to B, this transaction has to be validated. The process of validation is done by cryptocurrency miners and the process is called cryptocurrency mining. A very similar thing happens, when you are trying to wire funds from your bank account to your neighbour. Your bank has to check whether you have enough money on your account. In order to do this, your bank has to keep track of your account's history. So for example, initially you had no money in your account. Then you deposited $1000 into the account. And then you withdrew $200 in cash. And somebody wired you $500. And so on. The bank keeps track of this data, therefore they can always tell you your balance and also the bank can tell you whether you are allowed to transfer a certain amount of money to someone else. It is simple, isn't it?


So the bank has to know your entire transaction history and based on this they can form a decision. They have to form a decision, because if your balance is bellow zero, you are not allowed to withdraw anything nor transfer money. Or in other words you are not allowed to double-spend your money. We expect this kind of operation from a financial system, otherwise there would be nothing else but chaos on Earth.


3. The almighty crypto miner


Well, but the world of crypto is a little bit more chaotic. Or it can be chaotic. In an ideal situation, when miners posses almost the same amount of mining power, the probability of mining a block by one user is almost the same as the probability of the other one succeeding. So the blocks are accepted from each user with equal probability. However, if someone gets hold of more than 50 percent of the hashing power of the network, then the situation is altered. This user will always be faster than the others, or in other words this user will monopolize the system and he will have the ability to produce longer blocks than the other users. The consensus in these crypto networks is that whoever mines the longer block, gets accepted. This means that a user, in possession of 51 percent or more of the hashing power of the network becomes almighty in the crypto sense.


Such an almighty user can start mining his block stealthily and he can also perform malicious modifications on the corrupted chain. He can double-spend, block transactions or certain wallet addresses and he can return the tampered chain to the rest of the users. Since such a chain is always longer than the chain mined by the others, his will be accepted and he will grow crypto rich.


The previously mentioned crypto51.app tells you the theoretical cost of such an attack on each crypto network:


Cost of a potential 51% attack.

If you use Nicehash, you can even rent this hash capacity. You do not even have to buy the hardware. Luckily enough, if there are many participants in the crypto network, then getting hold of that amount of hashing power is almost impossible, but the probability of this is never zero. Here are two examples of 51% attacks from recent years:


A 51% attack.

A 51% attack.

So the problem is given. When you invest in crypto, you not only have to consider the risk caused by volatility, but there is a non zero chance of someone stealing your coins. Well, the same is true for a bank account, or when you carry around large amount of cash. But non-experts tend to neglect this risk and the situation is even worse, when someone puts his money into a new ICO. New coins with not many miners are extremely vulnerable to 51% attacks, because almost anyone with sufficient cash is able to rent a larger portion of hash power for a few hours and attack the newly born network.


4. Problems with Ethereum


Ethereum, unlike Bitcoin is mined using GPUs. Ethereum has been invented to overcome the problem of ASIC based mining. Hardware manufacturers started producing mining machines and this caused an unexpected mess in the Bitcoin ecosystem, because whoever got hold of these machines quicker than other could mine Bitcoin and the network started to tend towards centralization, instead of decentralization. Mining Bitcoin with an ASIC minier is not a grandiose feat, because these ASIC only calculte a simple hash value of the transaction data and it can also be performed in a parallel fashion.


However, when one wants to mine Ethereum, he has to prepare his miner for memory intesive processes. During these calculations large directed acyclic graphs (DAG) are stored on memory and this makes the mining process unfeasible on ASIC miners. If you want to learn more on how to mine Ethereum on a GPU, click here: How to mine Ethereum on GPU for beginners - a step-by-step guide


This concept of mining makes the Ethereum network somewhat more fair, because if you have a CUDA capable video card, you can start mining Ethereum in a few minutes and even if mining turns out to be less profitable you still have your GPU to use it for other meaningful purposes, such as building deep learning libraries or training machine learning models. You do not have this option with the ASIC miners.


In a very simple scenario, you just have to connect to a mining pool and you can start mining Ethereum. But this brings us two problems. First of all, the mining pool usually have a mining fee. Most of them operate with a 1% fee. And also, there is an issue with decentralization again. If these mining pools concentrate a lot of miners together, does not it imply that they could eventually take hold of more than 51% of the network's hashing power? So this is an issue to be solved.


So what shall we do if we do not want to connect to a mining pool? Is it still possible to mine Ethereum? Yes, it is. But you will have to initialize a full node. The current size of a full node, based on the data provided by etherscan.io is 614 Gb and this number keeps growing. Expert say that if the Ethereum infrastructure wants to handle as many transactions as VISA does, there will be an explosive growth in the size of the full nodes. This brings us new apprehensions, because the implication of this is that those who have a small SDD are not able to mine anymore. Or in other words, we bought our expensive GPU in vain, because we cannot even download the full blockchain onto our computer. Whoever invested more money into SDD space, stays in the game. But how long will this go on? Do these problems exist in the system intrinsically? So what if the hard drive require of the entire blockchain grows so severe that only a few participants remain in the system? Would not this imply that some might have the possibility to conquer 51% of the computational power? What if they have mala fide intentions? Or how was this? I am already losing track of this. Anyway, let us see what the future brings us.



The size of full nodes in the Ethereum network.

Obviously, if you are a newcomer and this is one of the first articles you read on cryptos you might be only focusing on the Bitcoin or Ethereum price rally. But are not you missing out something? I guess there are more less experienced investors than experienced investors. If the price is going up, then let us buy some! And then sell some, and then buy more. So this means that as Ethereum and other currencies become more and more attractive investment assets, the number of transactions will also grow. If there are more transactions, the size of the full nodes will also grow. And we already understand the issue with 51% attacks. So is it risky to invest your money into cryptos? Yes. Definitely!



Illustration: pixabay


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