Crypto assets encompass a wide range of digital assets, each with distinct features, purposes, and risk profiles. From stablecoins aiming to maintain a steady value to highly speculative meme coins, the landscape offers various investment options, each carrying unique benefits and risks. This guide provides an overview of the main categories of crypto assets, highlighting their characteristics and the associated risks to help investors make informed decisions
1. Stablecoins
Stablecoins are cryptoassets designed to maintain a stable value, typically pegged to a reserve asset like fiat currency (e.g., US Dollars). These assets are intended to reduce the volatility associated with cryptocurrencies. There are two primary types of stablecoins: asset-backed and algorithmic.
- Asset-backed stablecoins are supported by collateral such as fiat currency, commodities, or other cryptocurrencies. Examples include USD Coin (USDC) and Tether (USDT), which are pegged to the US dollar.
- Algorithmic stablecoins rely on algorithms and smart contracts to manage the supply and maintain stability without actual reserves. A notable example is TerraUSD (UST), which collapsed in 2022 when its algorithmic mechanisms failed.
Key Risks:
- Counterparty Risk: For asset-backed stablecoins, there is reliance on a third party to maintain reserves. If the party becomes insolvent or mismanages the reserves, the stablecoin’s value could collapse.
- Redemption Risk: During market volatility, redeeming stablecoins for their underlying collateral may become difficult, causing delays or losses.
- Collateral Risk: The value of the collateral backing the stablecoin can fluctuate, especially in commodity- or crypto-backed stablecoins, affecting stability.
- Foreign Exchange (FX) Risk: Many stablecoins are pegged to the US dollar, meaning non-US investors face exposure to foreign exchange fluctuations.
- Algorithm Risk: Algorithmic stablecoins can experience price instability if the underlying mechanisms fail, as seen in the collapse of TerraUSD (UST).
2. DeFi Tokens
Decentralized Finance (DeFi) tokens are linked to decentralised applications (dApps) that offer financial services such as lending, borrowing, and trading, without intermediaries like banks. These tokens enable users to interact with DeFi platforms in exchange for governance rights, rewards, or transaction fees.
Examples of popular DeFi tokens include Uniswap (UNI), a token used on the decentralised exchange Uniswap, and Aave (AAVE), which is used in the Aave lending platform. Another example is Compound (COMP), the governance token of the Compound Finance protocol.
Key Risks:
- Smart Contract Risk: DeFi platforms rely on smart contracts to execute transactions. Any coding errors or security flaws can lead to financial losses if they are exploited.
- Regulatory Risk: DeFi operates in a largely unregulated space, making the sector vulnerable to changes in regulation that could affect the legality or value of these platforms.
- Rug-Pulls/Exit Scams: Some DeFi projects are led by anonymous teams, increasing the risk of scams where developers abandon the project, leaving investors with worthless tokens.
- Oracle/Data Risk: DeFi protocols rely on external data sources (oracles). If oracles provide incorrect or manipulated data, it can lead to significant financial losses.
3. Wrapped Tokens
Wrapped tokens are digital representations of another cryptoasset, allowing the asset to be used on different blockchain networks. For example, Wrapped Bitcoin (WBTC) is a tokenised version of Bitcoin that allows Bitcoin to be used on the Ethereum blockchain. Similarly, Wrapped Ethereum (WETH) allows Ethereum to be used across multiple DeFi platforms and blockchain ecosystems.
Key Risks:
- Smart Contract Risk: Wrapped tokens rely on smart contracts to manage and secure the underlying assets. If the smart contract contains flaws or is hacked, the value of the wrapped token could be at risk.
- Custodial Risk: The underlying assets backing wrapped tokens are typically held by third-party custodians. If the custodian becomes insolvent or fails, the wrapped tokens could lose their value.
- Bridging Risk: The technology that facilitates asset transfers between blockchains (bridging) can experience technical difficulties, leading to delays or even the loss of assets during transfers.
4. Meme Coins
Meme coins are highly speculative cryptoassets that derive their value mainly from community interest, social media hype, and internet culture. These coins typically have little to no intrinsic utility or underlying technology but can gain rapid popularity due to viral trends.
Prominent examples include Dogecoin (DOGE), which started as a joke but gained massive attention from online communities, and Shiba Inu (SHIB), which was inspired by Dogecoin’s success. Pepe Coin (PEPE) is another meme coin that has recently seen similar attention.
Key Risks:
- Volatility Risk: Meme coins are highly speculative and can experience extreme price fluctuations due to hype-driven trading.
- Lack of Utility: Many meme coins have no real-world use cases or intrinsic value, making them more prone to sudden price crashes once the initial hype fades.
- Market Manipulation: Meme coins are often targets for pump-and-dump schemes, where prices are artificially inflated before crashing, leaving investors with significant losses.
- Emotional Investing: Investors are often influenced by social media trends and community hype, leading to impulsive and emotional investment decisions.
5. Staked Crypto-assets
Staked cryptoassets are tokens locked into blockchain networks to support the security and operation of those networks. Investors who stake their tokens can earn rewards, but these assets are typically locked for a set period, during which they cannot be easily accessed or sold.
Examples of staked assets include Staked Ethereum (stETH), which is used in Ethereum’s Proof-of-Stake network.
Key Risks:
- Slashing Risk: Validators in Proof-of-Stake networks may be penalised (slashed) for misbehaviour or technical issues, leading to a reduction of staked assets.
- Liquidity Risk: Staked assets are often locked for a specific period, meaning they cannot be sold or transferred quickly if market conditions change.
- APY Variability: The annual percentage yield (APY) from staking rewards is not fixed and may fluctuate based on network conditions, validator performance, or changes in the protocol’s rules.
6. Cryptocurrencies
Cryptocurrencies are decentralised digital currencies designed to act as a medium of exchange, a store of value, or both. Cryptocurrencies are some of the most well-known and widely traded cryptoassets, but they are also extremely volatile.
Examples include Bitcoin (BTC), the first and most prominent cryptocurrency, Ethereum (ETH), which powers smart contracts and decentralised applications, and Litecoin (LTC), a faster alternative to Bitcoin.
Key Risks:
- Volatility: Cryptocurrencies are known for their dramatic price swings, leading to both rapid gains and significant losses.
- Lack of Regulation: Cryptocurrencies operate in largely unregulated markets, making them vulnerable to fraud, market manipulation, and cyberattacks.
- Technology Risk: The infrastructure supporting cryptocurrencies, such as exchanges and wallets, is prone to operational failures, outages, and cyberattacks, potentially preventing access to funds.
Diversification of Investments
Concentrating your investments in a single asset class can be highly risky. Diversifying across multiple asset types can help reduce your dependence on the performance of any single investment.
A widely accepted guideline is to limit your exposure to high-risk assets, such as cryptoassets, to no more than 10% of your total investment portfolio. Learn more here.
For more comprehensive guidance on safeguarding yourself in the cryptoasset space, the FCA's website offers valuable resources.
Investors can explore the FCA's website for further information on cryptoassets, to learn more about cryptoassets and understand the evolving landscape of digital assets and regulatory measures. As the crypto market evolves, staying informed is paramount to making sound investment decisions.