Are virtual asset "deposits" or "staking" of high risk?

Virtual assets/Crypto assets
Risks

 

Can virtual assets (also known as crypto assets) generate interest/reward? And at high rates too? Is it really that good? There are many virtual asset service platforms in the market which offer high interest/reward via virtual asset "deposits", "savings", "earnings" or "staking" services. However, it is worth thinking twice whether they are as good as they seem.

One commonly-termed virtual asset arrangement is "staking", a term that is used very loosely in the virtual asset market to represent a wide range of arrangements from virtual asset "deposits", "lending", "savings", "earnings" to locking up certain "proof of stake" virtual assets to perform validation services for the corresponding blockchain network and being rewarded for such validation services. The rights and obligations of the users and the platform under each "staking" service arrangement may vary. In most cases, users deposit their virtual assets onto the platforms which offer “staking” services and the platforms promise to, in return, pay each user "staking" rewards after a period of time. This is akin to lending whereby the platforms would pay crypto depositors high rates of interest for lending out their crypto.

Popular interest/reward-earning virtual assets in the market include stablecoins, Bitcoin and Ethereum, and also many other tokens with annual interest/reward rates of up to 10%-20% or even more. Some may think that they are not speculating but just making deposits for interest or otherwise "staking" for reward, so the risk should not be high. And thus, the high interest/reward rates offered by virtual asset platforms may appear to be very attractive.

Risks behind high interest rates

First of all, investors should understand that whilst some virtual asset arrangements are commonly labelled or marketed as "deposits" or "savings" products, they are not regulated and are not the same as bank deposits. Investors are not afforded with any form of protection.

There is no such thing as a free lunch, and interest/reward from virtual assets is no exception. Generally speaking, the higher the potential returns, the higher the risks. The interest/reward from virtual assets is subject to the following major risks:

1. Interest/reward earned is not enough to cover for price drops

The price of virtual assets often fluctuates, therefore using virtual assets for interest/reward purposes may turn into earning interest/reward but ultimately losing from  drops in the prices of the virtual assets. For example, Bitcoin is the most popular virtual asset but it has experienced two massive plunges in the past few years, dropping over 80% between December 2017 and December 2018; and 70% between November 2021 and November 2022 respectively. Even high interest/reward are not enough to make up for losses in the prices. Some think that such risk can be avoided by earning interest/reward via stablecoins, but the fact is that some stablecoins may not be what their name suggests. In May 2022, “Terra UST”, an algorithm-based stablecoin collapsed, causing its price to plunge by 90% in just a few days.

2. Changes of interest/reward rates

The interest/reward rates offered by virtual asset platforms may change at any time, as such the high interest/reward rates may not last forever. If a platform offers very attractive interest/reward rates, investors should understand why it can afford to do so and whether such business model is sustainable. For example, some platforms earn revenue by lending the deposited virtual assets to support their high interest/reward payouts. However, if the market demand for these lending services drops, this would significantly bring down their revenue, and the high interest/reward rates may become unsustainable.

3. Risk of “bank run”

After platforms accept virtual assets from investors for “deposits” or “staking” services, they may use such assets to generate revenue, via means such as lending the deposited virtual assets to earn interest spread. In the event of a sharp fall in the virtual asset market or issues with the platform itself, many investors may rush to make withdrawals at the same time. If the platform does not have sufficient liquidity, it may cause panic and "bank runs". In June 2022, one of the major virtual asset interest/reward-generating platforms suspended all withdrawal services due to "extreme market conditions". The question remains whether investors can eventually get back their "deposited coins".

4. Platform risk

Most virtual asset platforms are currently not regulated and there may be a lack of transparency in their operations. Many platforms may have disclaimers to discharge responsibility even if they lose all virtual assets of the investors. If disputes arise between investors and the platforms, there may not be any channels to handle complaints. In the event of platform failures, cessation of operations, frauds, breach of contract, thefts or cyberattacks etc., all virtual assets deposited with the platforms may be wiped out completely. If such platforms do not have a nexus with Hong Kong, Hong Kong regulators and law enforcing agencies may not have jurisdictions over them. In case of disputes, seeking recourse is likely to be difficult, while seeking compensations through legal means may simply not be feasible.

5. May constitute unauthorised collective investment schemes

Some virtual asset arrangements could amount to a collective investment scheme (CIS) as defined under the Securities and Futures Ordinance (SFO) if the participating investors do not have day-to-day control over the management of their virtual assets and the virtual assets are pooled and/or managed as a whole by the operator to generate returns for investors. Such virtual asset arrangements may be unauthorised CIS and may be highly risky. The product will not have been vetted nor its offer and marketing materials reviewed by the SFC. Investors will have no protection under the SFO.

Virtual assets are high-risk products, and their related transactions or investments are also of high-risk nature. Earning virtual asset interest/reward is not as safe as it seems. We should not be so consumed by returns that we overlook the risks involved. The public should have a clear understanding of the nature and risks of virtual asset trading or investment beforehand, otherwise it is best not to engage in related activities.

16 June 2023