This Hidden Cryptocurrency Risk Is Beginning To Take Shape

What investors witnessed with cryptocurrencies in 2017 may never be duplicated again across any asset class. In just 12 months' time, the aggregate value of all virtual currencies soared by more than 3,300%, or almost $600 billion on a nominal basis. This is a return that would have taken the stock market decades to deliver.

A Rundown Of Why Virtual Currencies Were Unstoppable Last Year

Behind the rapid rise in cryptocurrencies was a confluence of factors. And at the top of that list is very likely blockchain technology.

This article originally appeared in the Motley Fool. ​

For those unfamiliar with blockchain, we're talking about the digital, distributed, and decentralized ledger underpinning most cryptocurrencies that's responsible for logging all transactions in a transparent and unchanging manner. For financial institutions, blockchain offers the ability to transfer funds in real-time, or at worst within a matter of seconds. That would be preferable to current banking networks that can sometimes take up to five business days to validate and settle cross-border transactions. Blockchain also simplifies transactions to simply a sender and receiver of funds, eliminating banks from enjoying third-party transaction fees.

Aside from blockchain, cryptocurrencies also benefited from a weaker dollar in 2017. A falling dollar entices investors to move away from holding cash, which for some meant buying into bitcoin and other cryptocurrencies that could seemingly do no wrong.

We also can't forget that as a result of cryptocurrency trading occurring on decentralized exchanges, and financial institutions not wanting any part of those exchanges, the vast majority of crypto investing is the result of retail investors. These investors usually have limited means to bet against cryptocurrencies, meaning there's a natural incentive to push valuations higher.

This "Hidden Risk" Isn't So Hidden Anymore

As I said, 2017 was a picture-perfect year for cryptocurrencies. However, they entered 2018 with a list of risks that was a mile long. A potential increase in regulation surrounding digital currencies, as well as growing access by institutional investors who have a less than optimistic view on their valuation, has weighed on the market. In fact, from peak to trough, cryptocurrencies have shed 70% of their market cap since Jan. 7, 2018.

But it's not necessarily a step up in regulation that's most concerning for virtual currency investors. Instead, it's a hidden risk that I alluded to back in early January: class action lawsuits.

You see, lawsuits are pretty common in the stock market. Practically anytime one company buys another, or a company falls off a cliff and loses, say, 30% or more of its value, specialized law firms examine the circumstances surrounding these events to determine if a class action lawsuit can be filed against the company in question in an attempt to win money for shareholders (and the law firm). Just because the cryptocurrency market is largely unregulated doesn't preclude it from class action lawsuits. Over the past two months, this hidden risk has begun to rear its head, with numerous lawsuits having been filed.

Court Is Now In Session

In early March, lawyers in the Northern District of California sought class-action status for a lawsuit filed against Coinbase, the most popular cryptocurrency exchange, for its handling of the Bitcoin Cash launch. Following the hard fork of bitcoin into bitcoin and Bitcoin Cash during the summer of 2017, Coinbase had promised to make Bitcoin Cash trading accessible to its members by Jan. 1, 2018. However, it attempted (and failed) to open up trading on Dec. 19, a bit earlier than anticipated. The lawsuit alleges that Coinbase insiders knew this and bid up the price of Bitcoin Cash. In total, it's alleged that Coinbase investors lost out on more than $5 million.

Even more recently -- as in this week -- a class action lawsuit was filed by crypto law firm Silver Miller against Nano (formerly RaiBlocks) and its development team for allegedly violating securities laws. The lawsuit stems from a February 2018 hack that saw $170 million worth of Nano's tokens (XRB) stolen from BitGrail, an Italian cryptocurrency exchange. Prior to this theft, it's alleged that Nano's team steered investors to deposit money with the oft-troubled BitGrail, despite knowing of issues with the exchange.

Even the purported creator of bitcoin, Craig Wright, is facing a monumental lawsuit, albeit not of the class action variety. The suit asserts that Wright stole more than 1.1 million bitcoin that rightfully belonged to the now-deceased Dave Kleiman. According to Vice News, Kleiman's estate claims that Wright, "unlawfully, willfully, and maliciously misappropriated trade secrets belong to Dave's estate relating to blockchain-based technologies."

Now What?

These mounting lawsuits bring two concerns to the forefront.

First, there is no precedent to cryptocurrency lawsuits. Even though the aforementioned Silver Miller law firm specializes in bringing lawsuits against virtual currencies on behalf of investors, there's no particular history of cases we can look back on to see how these might turn out or what the final settlement(s) could look like, relatively to what the plaintiffs are asking for. It's possible that some of these lawsuits could prove financially burdensome, especially to unprepared crypto teams.

The second issue is that these lawsuits add another level of uncertainty to a market that's easily perturbed by uncertainty. Remember, cryptocurrency trading is still dominated by retail investors, and retail investors have a penchant for allowing their emotions to get the best of them from time to time. A drawn-out lawsuit is the exact opposite of what flailing virtual currencies need right now.

I've already stated my case for keeping away from cryptocurrencies until significantly more regulation is introduced, and would add these lawsuits as the icing on the cake as to why virtual currencies aren't worth your money.

Sean Williams has no position in any of the stocks or cryptocurrencies mentioned. The Motley Fool has no position in any of the stocks or cryptocurrencies mentioned. The Motley Fool has a disclosure policy.