Back

Technological risks of crypto

Lesson in Course: Crypto (advanced, 9min)

Cryptocurrencies are a completely digital asset class. What are the technological risks we need to consider?

Eureka!

What it's about: Crypto has unique technological risks and we could be targeted by hackers committing thefts and scams.

Why it's important: Decentralization means we are more responsible for the security of our assets.

Key takeaway: Before buying crypto, ask questions about the potential blockchain weaknesses to consider the technical risks and invest responsibly.

Blockchain technology has made crypto an exciting asset class for investing. However, for the first time, we encounter a whole new set of risks with crypto that are unlike any other traditional financial asset.

To be fully informed, we need to consider the technological risks of crypto.

Hacking and Security

Natively digital assets like cryptocurrency are susceptible to hacking. Instead of breaking into a vault, criminals break into our computers or digital wallets. The motives behind the crime aren't always monetarily driven.

Theft / Scams

The decentralized nature of crypto makes tracking down thieves very difficult. The self-sovereignty of a decentralized currency requires us to be responsible for protecting ourselves from fraud and scams. There isn't a governing body to help us recover our lost coins if stolen from us. We have to do our own due diligence to ensure the applications and crypto we use are trustworthy. 

Decentralization makes identifying thieves difficult

We also need to make sure we safeguard our digital wallets. In most cases, people end up losing their coins to scams compared to actual hacks. Anytime prices and popularity surge, we need to be cautious - bad actors have more to gain scamming in this environment. In addition to our computers, exchanges are prime targets. They hold large amounts of the crypto we buy and sell, making them the digital equivalent of bank vaults for thieves. Recently, exchanges have prioritized security and protection; however, hackers have been able to get through in the past. 

 

Double Spending

Savvy hackers who understand the blockchain network can manipulate entries to the ownership ledger to scam merchants or individuals.

What is Double-spending?

The risk that a digital currency is spent twice by a scammer or hacker 

What double-spending might look like

A double-spender may offer to buy a TV from us with crypto, and upon seeing the crypto transacted, we deliver the TV to them. Afterward, we find out that the crypto is no longer in our account because it wasn't theirs to spend, and they've made off with our TV.

Due to strong validation protocols, double-spending is very difficult to do on well-established blockchains like Bitcoin and Ethereum, but it's more likely to occur on smaller blockchains. 

Double spending results in multiple recipients of the same coins

For most blockchains, the risk of double-spending requires a 51% attack.

51% attack

These attacks are especially dangerous because they can give an individual or an entity control over a blockchain.

What is 51% attack?

When an entity owns more than 51% of the mining power, giving them control of a blockchain network.

Mining validates blocks under a proof-of-work system. A 51% attacker needs to amass a majority of mining power, or hash rate, to get control of a blockchain. Once done, they could exclude, modify the ordering of blocks or prevent transactions on the blockchain. While in control, they could also double-spend by reversing transactions they made.

A 51% attack gives full control to the attacker

These attacks require enormous amounts of money and computing power (we're talking colossal computer farms). So while they're INCREDIBLY difficult to pull off on major blockchain networks like Bitcoin or Ethereum, they're more likely to happen on smaller networks - especially if done by governments.

 

Limitations to growth

Some risks are less malicious than hacking and scamming. They stem from continued development efforts on evolving technology.

Scalability

Networks must be designed to handle large-scale use to be practical. Currently, transactions are processed much slower on blockchain networks than credit card networks, causing transaction costs of some crypto to rise significantly during peak times.

Not all blockchains can grow and keep up with demand

Slower transaction speeds and higher costs are obstacles for crypto to become a dominant global payment system. As blockchain technology evolves, it will need to address these problems.

Forking

Forking creates two separate blockchain networks and, therefore, two different versions of the currency. 

What is Forking ?

When a major change occurs to the underlying protocol of a blockchain, creating two separate blockchain networks.

The Ethereum fork

Ethereum classic forked, creating the current Ethereum protocol where ETH is purchased and sold. In 2016, the Ethereum blockchain was hacked, and $50 million worth of crypto was stolen. Developers updated the protocol to prevent future hacks and forked — Ethereum was born, and the old protocol was named Ethereum classic. The two versions often trade very differently, and we have to watch for future forks in the crypto we own.

Unintentional Centralization 

Monetary incentives can cause more centralization of the technology over time. 

Groups of people gather to benefit and decide over network outcomes

Mining pools have begun to pop up because of increasing computing costs to mine Bitcoin. They are a centralized effort that undermines the decentralized intentions of cryptocurrency.

What is Mining pools?

Miners who share their processing power over a network to increase the likelihood they will mine the next block and earn the rewards.

Actionable ideas

Many positives about crypto rely on an optimistic outlook. You need to understand the risks of the technology that allows crypto to function to invest responsibly.

Here are a few questions to help you consider the risks before buying a cryptocurrency:

  • What is the use/utility of this crypto? 
    • Is it just a currency, or does it also provide a service for any smart contracts?
  • How secure is the exchange I'm using?
  • How secure is the blockchain? 
    • Is it widely used? Can I easily trade crypto on it?
    • Are there any scalability issues - does it slow down or get expensive during peak times?
  • How do blocks get validated; is it by Proof-of-Work or Proof-of-Stake?
    • Are there mining pools?
  • Is the blockchain likely to fork?
 

Supplementary materials

The story of Mt. Gox - losing over 740,000 Bitcoin

As of April 30, 2021, the stolen Bitcoin is worth over $41 billion!!

Read the whole storyhttps://thenextweb.com/news/a-brief-history-of-mt-gox-the-3b-bitcoin-tragedy-that-just-wont-end
A deeper dive into a 51% attack
https://www.youtube.com/watch?v=BuTj9raHQOU&ab_channel=BinanceAcademy

Glossary

What is Double-spending?

The risk that a digital currency can be spent twice. 

What is 51% attack?

When an entity owns more than 51% of the mining power, giving them control of a blockchain network.

What is Forking ?

When a major change occurs to the underlying protocol of a blockchain, creating two separate blockchain networks.

What is Mining pools?

Miners who share their processing power over a network to increase the likelihood they will mine the next block and earn the rewards.