February 23, 2023
The cryptocurrency ecosystem continues to grow and attract more interest across the globe. It is becoming progressively intertwined with traditional financial markets, evidenced by a steady increase in the number of managed funds holding cryptocurrency assets on their balance sheets.
These funds accept that cryptocurrency has several risk and return characteristics, which need to be considered when adding cryptocurrency to an investment portfolio.
Cryptocurrency products can be technically complex, highly price volatile and difficult to hold securely. As the cryptocurrency industry continues to develop and grow, these assets are still commonly associated with speculative investments and thus pose significant financial risks.
Risks and vulnerabilities
Many supporters of cryptocurrency use exchanges which are particularly vulnerable to hacking and targets of criminal activity. These security breaches have led to sizable losses for investors who have had their digital currencies stolen. As a response, many exchanges and third-party insurers now offer protection against hacks. While centralised exchanges make it easier to buy and sell, the risks of allowing a third party to control access to assets and the potential threat of an exchange facing bankruptcy sees some investors avoid this approach.
Safely storing cryptocurrencies is more difficult than owning other assets, such as stocks or bonds. There are trade-offs between holding cryptocurrency assets on centralised exchanges, such as Coinbase and Binance, and holding them offline in cold storage hardware wallets. Cold storage is not risk free, with assets taking longer to access which risks missing buy/sell target prices. Access is also via private keys, which if lost, makes it impossible for an investor to access their investments.
Many cryptocurrencies are launched with positive intentions and whilst success is not assured, early investors in successful cryptocurrency projects receive healthy returns. However, competition is fierce amongst the large quantum of blockchain projects of which some are no more than scams. Statistically speaking, only a small percentage of cryptocurrency projects ultimately prosper.
Key to the industry’s continued success is the widespread adoption of cryptocurrency, known as the “The Network Effect”. The principle is simple; more investors want to own cryptocurrency because cryptocurrency is owned by more investors. Bitcoin, viewed by many as ‘digital gold’, is a good example of a cryptocurrency that has gained huge value due to its fixed supply. This is unlike that of fiat currencies, such as AUD, USD, EUR, and GBP which can see their value depreciate where supply is controlled by central reserve banks aimed at controlling the economy.
"Many cryptocurrencies are launched with positive intentions and whilst success is not assured, early investors in successful cryptocurrency projects receive healthy returns."
Rewards and growth
For at least the past decade there has been steady growth in developer activity, social media activity and a quantum of start-ups in and around the cryptocurrency industry. These have led to a growth in cryptocurrency derived long-term and short-term investments. A long-term investment strategy of buying and holding digital assets, is suited to those assets of a more stable nature, such as stable coins. The value of these coins is derived from a reference asset, such as fiat money (e.g. Tether ‘USDT’), exchange-traded commodities (e.g. Paxos Gold ‘PAXG’), or other cryptocurrencies (e.g. Wrapped Bitcoin ‘WBTC’). However, cryptocurrency is inherently extremely volatile, both short-term and long-term, and therefore any investment in this asset class attracts large risks, in addition to the enormous potential in capital growth and returns.
Other returns can be made from other unique investment strategies specific to the cryptocurrency industry. Mining is a popular approach and involves “Miners” (or auditors) solving exceptionally difficult computational math problems with advanced computer algorithms, in exchange for cryptocurrency as a fee. As cryptocurrency is run on decentralised blockchain technology, there is no single entity like a bank responsible for verifying its authenticity. This “Proof of Work” is critical, as it tests and authenticates the validity of new transactions on the blockchain, updates the general ledger and adds news blocks to the blockchain whilst preserving its integrity.
Staking is another popular investment opportunity and another method to validate the blockchain. Investors buy and hold, or ‘lock up’, their cryptocurrency for a fixed period. This cryptocurrency is then used in a “Proof of Stake” network to validate transactions. Once a new block is validated and added to the blockchain, the investor receives a reward for essentially lending their cryptocurrency to the network. This could be compared to receiving interest from a bank deposit.
Investors can also take a more traditional approach and lend their cryptocurrency to other investors, receiving interest on the loan. Those borrowing the cryptocurrency may then stake it to receive a net return.
As the cryptocurrency industry becomes more regulated and matures it is likely to incite more capital and drive mainstream participation, thus boosting the pace of cryptocurrency adoption. Encouraged by a better understanding of the risks and clearer evidence of the returns, this will continue to increase and further validate the industry resulting in new investors wanting to gain direct exposure.
Will Banks is an Adjunct Industry Fellow in Griffith Business School. Will has had a successful career in senior financial and board level executive positions, which have spanned across Australia, Europe, and the United Kingdom. With an expertise in leading businesses through financial regulatory authorisations, mobilisations, or crisis management, he has dedicated over two decades to building, advising, and managing global financial service institutions and start-ups.
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