Understanding currency risk in cryptocurrency investing

The Oxford English Dictionary describes risk as “A situation involving exposure to danger”. While this is certainly true of all financial markets, it is particularly true of cryptocurrencies.

If you find yourself asking “What could possibly go wrong?” you’re acknowledging the very clear exposure to risk.

It is possible to group risks together and qualify them, which is an important aspect when it comes to investing. Humans are notoriously bad at judging risk, either being too risk-averse or taking too many risks. But the balance must be struck because it’s up to an individual investor to determine their own level of risk.

Day to day lives have an enormous impact on this. A professional poker player, for instance, will likely hold a very different view of acceptable levels of risk to, say, a paramedic. For the former, losses are expected as part of the larger game. To the latter, losses are often considered fatal.

For that reason it’s a good idea to qualify risk as objectively as possible. But this is extremely difficult. It’s also worth trying to find ways to compare risk, and this is much easier.

Ultimately decisions about risk are largely driven by personal feelings about an investment, but there are ways to try and remove emotions from the process. In this series, The No Bull Investor attempts to make the process slightly less daunting, and examines risks every investor should consider before investing in cryptocurrencies.

(There are of course other risks not covered here, and as always, prospective investors should do their own research before investing as there’s significant risk of financial loss involved.)

What is “currency risk”?

In its broadest terms, “currency risk” is the potential loss an investor faces owing to the inevitable and constant fluctuations in foreign currency values. It is associated with all currencies, but it is particularly applicable to cryptocurrencies because of the multiple levels of transaction often demanded to trade.

British readers generally use pounds sterling (GBP) for day-to-day use, but most exchanges prefer euros (EUR) or dollars (USD) when dealing in cryptocurrencies. There is risk here for British investors straight away: by transferring GBP into EUR or USD, the value may change before you even buy any cryptocurrencies.

For example: if an investor converts £1,000 into €1,135, that money is going to have to go into an exchange before being converted into a cryptocurrency. If the pound goes up in the interim, you will know you could have got €1,150 by waiting a few minutes.

The only way to reduce exposure to this risk is to remove the GBP to EUR conversion by using an exchange that supports pounds. However, the most popular exchanges all use EUR or USD, and you might find you get a worse price, have a smaller choice of cryptocurrencies or have to wait longer for orders to be fulfilled on a British exchange.

At the exchange

Currency risk also happens at the exchange. If you buy or sell bitcoins based on fiat-to-bitcoin price movement, you are taking advantage (or disadvantage) of currency risk. An additional layer of risk applies when the dollar is used as a fiat base pair.

If a UK-based investor converts GBP to EUR, buys bitcoin but tracks the value of bitcoin in USD, they are setting themselves up for substantial currency risk. As bitcoin in particular tends to be paired with USD, investors looking to use the dollar pairing should keep a note of the price paid at the point of purchase in dollars and use that as a reference.

Altcoin currency risk

Another form of currency risk occurs with the altcoin market. Bitcoin dominates price action across the whole cryptocurrency market. When bitcoin rises, altcoins tend to drop. When bitcoin is stable, money tends to flow into altcoins. When bitcoin crashes, money tends to flow back into bitcoin.

It’s tempting to measure an altcoin’s performance against the US dollar. However, unless you bought the altcoin directly in dollars, or are selling the altcoin for dollars then the dollar price is largely irrelevant.

Let’s take a worked example:

In week one, 1 bitcoin is worth $10,000. You buy 0.1 bitcoin for $1,000 after loading your account with EUR from your Revolut account, which is loaded with GBP.

Along the way you have paid SEPA fees, transferred multiple currencies and, if you’re lucky, you might have avoided exchange fees.

You transfer your 0.1 bitcoin (worth $1,000) to your binance account, and proceed to buy just under 0.1 bitcoin’s worth of Cardano after fees. After working your way back to USD (having never used USD anywhere in the transaction) you have approximately $985 worth of Cardano at 25 cents (or 3,000 satoshi) each.

In week two, 1 bitcoin is now worth $15,000 and Cardano has gone up by a just under a third against the dollar to $1280.50. It’s now worth 2,800 satoshi but 32.5 cents against the dollar. Are you up, or are you down? In terms of the currency you never used anywhere along your investment, you’re up. In terms of the currency you bought and will sell the Cardano in, you’re slightly down.

To make matters worse, if you sell your Cardano now, you’ll need to convert the value into GBP for capital gains tax (CTG) purposes. Even though you have lost money against bitcoin if you sell, you may have made a profit in sterling, and the tax man will want his cut.

Of course currency risk is less of an issue for buy-and-hold investors, but it’s one of the more complex parts of cryptocurrency tax planning as HMRC’s guidance on how tax should be calculated is based on GBP conversions at the point of asset acquisition and disposal.

Token currency risk

A final form of currency risk is specific to tokens built on another platform. An ERC-20 token is an example of a token that is based on the ethereum blockchain. ERC-20 tokens are most commonly used in ICOs as it allows them to easily distribute a token without having to build an entire blockchain. When using an ERC20 token, there is an additional invisible tie to ethereum that has the ability to affect the price of the token, and vice versa.

Managing Currency Risk in Cryptocurrency Markets

It’s easy to look at these different forms of currency risk and consider cryptocurrencies high risk, but to do so would be to judge it without understanding the risks themselves.

Most of these risks occur in the physical world. For example, commodities such as gold and oil are mainly traded in USD. UK-issued gold bullion coins, such as sovereigns, are essentially tax free in the UK, a position that could only be wished for with cryptocurrencies.

Like cryptocurrencies, gold sovereigns incur exchange risks when bought from foreign gold exchanges and base pair risk as they are a UK-issued gold coin, but the value is based on weight valued in US dollars.

Financial derivatives have similar exchange risks, base pair risks and in some cases risks similar to the ERC20 token ethereum base risk.

By comparing these cryptocurrency risks to those in other financial markets it is possible to recognise which risks are better or worse from a position of relative knowledge instead of relying on gut feeling alone.

There are a few ways to reduce exposure to cryptocurrency risk without reducing opportunity for profit.

To manage base-pair exchange risk, it’s generally better to shop around. Buying your bitcoin in EUR can be a headache, but if it’s cheaper than buying in GBP then you’ll get more bitcoin for your money regardless.

Don’t forget to factor currency exchange fees and any charges you may encounter along the way.

For British investors, a common route is to use the Revolut app to convert to EUR and a SEPA transfer to a EUR-denominated exchange such as Coinbase. Coinbase has the ability to trade some cryptocurrencies in GBP, but doesn’t make it easy to use.

As always, another risk worth considering is Brexit, and its impact on charges around EUR payments. At the time of writing, as with much about Brexit, little is known about what will happen. It may be prudent to hope for the best but plan for the worst.

Choose a base currency

When looking at altcoins, it makes sense to choose a base cryptocurrency in advance. This has the advantage of providing a standard baseline upon which performance can be measured without having to consider fluctuations external to the broader market.

The No Bull Investor uses bitcoin as a base pair for all altcoin purchases regardless of the currency used to purchase it. You might wish to use ethereum instead, particularly if you’re not a fan of bitcoin or you are heavily invested in ERC-20 tokens.

That internal base pair can then be used to measure performance of the portfolio as a whole in a local currency.

Should a flippening occur (i.e., the moment at which bitcoin loses its preeminence) between bitcoin and ethereum, this will be unlikely to affect your portfolio in the short term. If you consider changing for any reason, your accountant will thank you for doing this on a tax year boundary.