Cryptocurrency: Still Worth Investing?

Investing in cryptocurrency has become an increasingly popular topic of discussion, with some investors experiencing jaw-dropping returns and others losing it all. Cryptocurrency is a decentralised and secure digital currency, based on blockchain technology, that offers new investment opportunities. It is not immune to risk, however, and investors need to be aware of the potential downsides.

Diversification of portfolios

Cryptocurrency portfolio diversification is important for investors to broaden their exposure to this emerging asset class. Diversification can also help capture potential gains from different industries and underlying asset classes. By spreading investments across multiple coins with different use cases, market segments, and technological advancements, crypto investors can benefit from the growth potential of various sectors of the crypto market.

• Diversify by coins and tokens: You can diversify your direct ownership of digital coins by choosing from many types of crypto coins, including payment tokens, security tokens, utility tokens, governance tokens, basic attention tokens, gaming tokens, and non-fungible tokens (NFTs).
• Diversify by industry focus: Invest in cryptocurrency projects that focus on different industries. Blockchain technology is being applied to and disrupting many sectors, including healthcare, supply chain, transportation, entertainment, and climate change.
• Diversify by asset class: Crypto and blockchain investors have many options across asset classes, including stocks, bonds, and real estate.
• Diversify by investment vehicle: If portfolio security is a concern, investors can diversify their crypto holdings across various investment vehicles and account types, such as digital wallets, taxable brokerage accounts, cryptocurrency IRAs, and decentralized financial products.

It is important to note that diversification can help mitigate risks, but it cannot guarantee profits or completely protect against losses. Crypto is considered a high-risk investment, and investors are advised to conduct their own research and only risk the amount of money they can afford to lose.

Potential for astronomically high returns

Cryptocurrency can provide extremely high returns in a short period of time. For example, from May 2016 to September 2024, Bitcoin's price skyrocketed from $500 to around $59,125, a growth of 11,725%. Similarly, Ethereum's price increased by 22,675% from April 2016 to September 2024. These types of returns are not limited to the two largest cryptocurrencies by market capitalization, as Binance Coin (BNB) saw a gain of 535,028% from 2017 to September 2024.

The high return potential of cryptocurrencies is further demonstrated by their ability to provide positive diversification effects, specifically against rising inflation. This makes them attractive to institutional investors who seek to diversify their risks by investing in assets that behave differently under the same economic conditions.

Additionally, the development of more investment instruments, such as options and futures on Bitcoin and Ethereum, allows investors to capture the upside potential of cryptocurrencies while potentially mitigating some of the risks.

The newness of the cryptocurrency sector also means that there is room for future developments and regulatory changes that could make investing in cryptocurrencies even more attractive. For instance, stablecoins, which are cryptocurrencies linked to the value of a fiat currency, have emerged as a way to potentially reduce the volatility associated with cryptocurrencies.

While the potential for high returns exists, it is important to remember that cryptocurrencies are a highly volatile asset class, and investors need to be comfortable with the associated risks before investing.

The emergence of crypto as a new asset class

The crypto market has experienced tremendous highs and lows since the launch of Bitcoin in 2009. Despite the risks and volatility, the crypto market has a market cap of over USD 1.7 trillion, making it too big to ignore. As crypto assets continue to develop and mature, they are increasingly being recognised as a new and distinct asset class.

An asset class is defined as "a set of assets that bear some fundamental similarities to each other and that have characteristics that make them distinct from other assets that are not part of the class." There are three broad asset classes: capital assets, consumable/transformable assets, and store-of-value assets.

Crypto has unique characteristics that set it apart from traditional asset classes. Here are some reasons why crypto is considered a new asset class:

• Investability: While cryptocurrencies have historically low liquidity, their liquidity has improved, and they remain accessible independent of regulation and capital controls.
• Politico-economic profile: Crypto's innovative technology, including public, permissionless, distributed ledgers/blockchains, incentive design, and decentralised governance, sets it apart from traditional asset classes.
• Correlation of returns: Similar to gold, there is a historically weak correlation between the price development of cryptocurrencies and other assets such as equities and bonds. However, recent market events have strengthened this correlation, indicating that investors may consider crypto a short-term risk-on asset.
• Risk-return trade-off profile: Adding cryptocurrencies to traditional investment portfolios can improve their risk-return profile. Crypto introduces new technological, reputational, regulatory, and political risks, influencing risk budgets and due diligence.

The benefits of investing in crypto as a new asset class

• Massive returns: Crypto has the potential for astronomically high returns, making it attractive to investors despite the associated risks.
• Uncorrelated assets: Crypto assets have little to no correlation with other asset classes, making them a valuable addition to a diversified portfolio.
• Limited supply: Many crypto assets, such as Bitcoin, have a limited number of tokens, which can drive up their value over time.
• Inefficient market: The crypto market is still relatively inefficient, with vast price differences across exchanges and a time lag in absorbing news. This creates opportunities for market makers and informed investors.

Challenges and risks

Investing in crypto as a new asset class also comes with challenges and risks, including custody issues, the lack of digital asset custodians, retail-focused exchanges, and regulatory compliance, particularly regarding anti-money laundering (AML) and know-your-customer (KYC) requirements.

Positive inflation-hedging effects

Investing in cryptocurrency carries risks, but it can be a good way to hedge against inflation. Here are some reasons why cryptocurrency can be a good inflation hedge:

• Limited Supply: Most cryptocurrencies, including Bitcoin, have a limited supply. This means that only a certain amount of coins will ever be produced, unlike traditional fiat currencies, which can be printed endlessly, leading to inflation. The limited supply of cryptocurrencies reduces the chances of inflation and makes them a good hedge against the devaluation of fiat currencies.
• Decentralized System: Cryptocurrency operates on a decentralized system, meaning it is not controlled by any central authority or government. This decentralization eliminates the risk of governments manipulating the money supply and printing more money, which can lead to inflation.
• High Returns: Cryptocurrency has the potential to provide high returns, outpacing the rate of inflation. While there are risks due to volatility, the high returns can help preserve and even increase purchasing power.
• Alternative Investment: Cryptocurrency offers an alternative investment option to traditional assets. By diversifying into cryptocurrency, investors can hedge against inflation, especially when traditional inflation hedges like gold may not perform well during certain periods.
• Technological Advancements: Cryptocurrency is a relatively new technology that is constantly evolving. Advancements in blockchain technology, such as increased speed and efficiency of transactions, can drive up the demand for cryptocurrency, making it a more attractive investment option during inflationary periods.

Potential for stablecoins to reduce volatility

Stablecoins are cryptocurrencies that aim to reduce the volatility associated with popular cryptocurrencies like Bitcoin. They do so by pegging their market value to an external reference, such as a fiat currency like the US dollar, the price of a commodity like gold, or an algorithm that controls supply. This helps to stabilise their value and makes them more useful as a medium of exchange for everyday transactions.

There are three main types of stablecoin:

• Fiat-collateralized stablecoins: These maintain a reserve of fiat currency, such as the US dollar, as collateral. Tether (USDT) and TrueUSD (TUSD) are popular examples, with Tether being the third-largest cryptocurrency by market capitalization as of June 2024.
• Commodity-backed stablecoins: These are pegged to the market value of commodities such as gold, silver, or oil. Tether Gold (XAUt) is an example of this type, with its gold reserves held in Switzerland.
• Crypto-collateralized stablecoins: These are backed by other cryptocurrencies and are generally over-collateralized to account for the volatility of the reserve cryptocurrency. MakerDAO's Dai (DAI) is an example, pegged to the US dollar but backed by Ethereum (ETH) and other cryptocurrencies.
• Algorithmic stablecoins: These may or may not hold reserve assets. They focus on controlling supply through an algorithm to maintain price stability. TerraUSD (UST) is an example of an algorithmic stablecoin that plunged in value in May 2022, highlighting the risks associated with this type of stablecoin.

While stablecoins offer the potential for reduced volatility, it is important to approach them with caution. They require independent auditors to verify collateral or reserves, and there have been concerns about the transparency and accuracy of such audits. Additionally, stablecoins are subject to regulatory scrutiny due to their rapid growth and potential impact on the broader financial system.

In summary, stablecoins offer a potential solution to the high volatility of popular cryptocurrencies, making them more suitable for everyday transactions. However, it is essential to carefully consider the risks and regulatory environment before investing in stablecoins or any other type of cryptocurrency.

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