I think owning cryptocurrencies is a very interesting proposition. Unlike stocks and bonds and other financial assets which mainly derive their value from their discounted future cash flows, the value of crypto is still largely speculation-driven.
Critics will tell you that buying crypto is like the equivalent to gambling. It’s just about speculating that the price of the asset will rise in the future. They will tell you that it’s going to zero and you will lose all your money if you invest in them.
At the same time, there are a lot of true-blue believers who truly appreciate the value of these networks and decentralized economies, and they are resolute in the fact that crypto is not going away, despite all the naysayers.
Before we dive too deep into this discussion, it’s also good to briefly introduce the concepts of crypto and the blockchain – which is the technology that most cryptocurrencies are built on.
The blockchain is a decentralized and distributed ledger with a single source of truth. Entities – humans or machines – can transact on the blockchain and one of the use cases is to transfer value securely in a manner where there’s no single source of dependency and no single clearing party.
Cryptocurrencies usually originate as a reward for participating in the blockchain network, perhaps through validating a transaction or doing some form of work like solving a mathematical hash puzzle using compute resources. They can also be minted, where the blockchain network creates these tokens out of thin air. Whatever the method used, individual blockchains usually issue their own native tokens based on their own economic model.
Why would anyone own crypto?
Now that I’ve gotten the basic concepts out of the way, There are some reasons why people might want to own crypto aside from speculation.
1) Participation in a decentralised economy
Most blockchain networks require transacting in their own native tokens. For example, the Ethereum network requires Ether to transact, and the Harmony network requires Harmony One tokens to transact. The Bitcoin network requires you to transact in Bitcoins, which is merely just one representation of a blockchain network.
Ethereum’s use case goes beyond transfer of value as in the case of Bitcoin – it extends to even things like decentralised applications and smart contracts using the Ethereum Virtual Machine.
The Ethereum blockchain is also currently used to tokenize the US Dollar through stablecoins. For example, the USDC stablecoin allows digital dollars to be moved over the Internet. USDC is issued by regulated financial institutions, and backed by fully reserved assets, and redeemable on a 1:1 basis for US dollars.
Some popular dApps include decentralised exchanges, which can be used to swap tokens from one person to another. The industry is still nascent, so there aren’t much high value use cases to begin with, but as the industry matures, more developers will be building new use cases on blockchain networks – and that might potentially be revolutionary.
However, not all cryptocurrencies that are currently being traded and listed on exchanges play a part in the future blockchain ecosystem – some of which may be privately controlled by enterprises as part of a private blockchain network.
Hence, investing in cryptocurrencies is not directly an investment in the potential of blockchain technology, depending on how the adoption of blockchain technology in the future takes place.
2) Hedge against real world assets
The second reason I can think of is really as a hedge to real world financial assets. A hedge works if the correlation of asset returns are negatively correlated – meaning they don’t move together.
Take for example the prices of REITs and stocks – while both might not be directly equivalent assets, their prices move roughly in-line with each other. They have a relatively high correlation of between 0.68 and 0.78. If the prices of stocks go down, REITs tend to follow, and you might end up wiping your entire portfolio if both crash at the same time.
Instead, if you hold assets such as gold, a traditional hedge to stocks, then when stock prices are falling, the price of gold might even go up because people are looking for safe assets. The net effects of the two is that your portfolio wouldn’t as volatile and you wouldn’t be completely wiped out.
Cryptocurrencies can be viewed similarly as a hedge to real world financial assets, whose prices have been artificially inflated by the Fed’s easy money policies which have no where to go other than buying financial assets. If you believe that the system is broken, or if you want to take a counter-position in case this is a bubble that might burst, you’d want an uncorrelated asset to hedge your positions.
This Decrypt article (potential bias) says that the correlation of Bitcoin – a popular cryptocurrency – to the S&P 500 is 0.16. Coindesk research (also potential bias) puts the 60-day rolling average correlation floating around 0.30 for the month of June 2020.
Where I see crypto in my portfolio
Personally, I have a 5% to 8% weight in cryptocurrencies in my overall asset allocation and I plan to keep it that way for the foreseeable future.
I also won’t go into specifics about which crypto I own, because it’s not in anyone’s interest if you end up losing money, but I do want to share some of my perspectives on the strategy behind owning crypto.
I see that the crypto boom and subsequent crash in 2017-2018 being very similar to the dot com tech bubble in 2001. There was a lot of hype, speculative mania and relentless purchase of crypto (remember people even sold their houses to buy crypto?) which eventually came crashing down. Markets work in cycles, and it’s always the case that history repeats itself.
At the same time, during this relatively lull period, the industry is slowly seeing increased regulatory clarity. There is also a slow but steady adoption in some areas of crypto, especially in a period where people are locked down and tend to interact in the digital realm.
There are blockchain projects that are particularly interesting, especially in the decentralised finance space, which are areas of optimism when it comes to adoption in the coming years.
When we look at the people in the space, those crazy speculators who lost a lot of money during the boom have mostly given up and left the industry for good, potentially paving the way for a more sustainable and organic growth of the industry that’s led by believers, long-term investors and those who are ‘in for the tech’.
Although it’s still in the early stages, regulators have not fully caught up on its implications and potential, which makes it interesting for risk takers who dare to make bold investment bets that may payoff with a huge potential upside.
For example, there are platform like Republic Crypto that allows startups to raise capital through public and private sales and tokenise their platforms. There are solutions like Unstoppable Domains that provide domain name services on the blockchain which makes them resilient to censorship.
I also don’t deny the risks that exist in the whole space. There’s toxicity in some blockchain communities where people just talk about price speculation or exchange listings, there’s a lot of fake and black money flowing around the system, tokens with manipulated prices and all sorts of distorted reality that makes it difficult for people to regain trust in the space.
There’s also not a lot of regulatory protection in your investments, and if you make a wrong transaction, you’re unlikely to ever recover your tokens/coins – which makes crypto rather out of reach for the common man at this time.
At the same time, crypto can be some sort of doomsday insurance, as Social Capital Billionaire Chamath Palihapitiya puts it for Bitcoin –
“I just think that if people have been hard-working, with their heads down, they should have an opportunity to make sure that they don’t get wiped out if the government itself just continues to make a string of bad decisions that then have rising consequences. And Bitcoin, to me, is the only thing that I’ve seen so far that is really fundamentally uncorrelated to that decision-making process and to that decision-making body. Because at the end of the day, any other asset class – equities, debt, real estate, commodities – they’re all tightly, tightly coupled to a legislative framework and an interconnectedness in the financial markets that brings together many of the governments that are sort of behaving this way. And so it’s almost like a bet against the ruling class in some ways, and making sure that you have a small amount of insurance… Insurance is something that pays off 1,000 bucks to a buck. You want these massive, massive asymmetric payoffs, because you want to be sure that a small amount of insurance can basically make you whole. And that’s why I think that you should just take 1% of your portfolio, put it in Bitcoin, never look at it… and hope that that 1% goes to zero.”
So yeah, I see crypto like buying term insurance, the value of your premiums can go to zero, but if sh*t hits the fan then at least you have some form of participation in the upside of that asset class.
Disclaimer: This is not financial advice.