The Risks & Benefits of Investing in Cryptocurrencies & Digital Assets

Note: This post should not be considered professional investment advice. If you want to invest in digital assets, assess your own personal and financial situation, risk tolerance and consult a financial professional.

Digital assets or crypto assets have become a significant topic of interest for investors. For those new to this emerging asset class, check out this introductory post that explains what a digital asset is and the different types that exist. As a quick reference, digital assets can split into three broad areas.

Cryptocurrencies: used as a means of payment for goods and services

Crypto-tokens: provide digital access to an application/ service.

Crypto-commodities: allow for the creation and provision of new, independent digital assets that can represent an entirely unique set of values.

As with any hot topic, there are polarising opinions and lots of noise, making it difficult to get a clear picture. The truth is, digital assets are in their infancy and have several significant risks and benefits that demand an investor’s attention. Over time, these risks and benefits will change, new risks and benefits will emerge and vice versa.

It’s also important to point out that it’s difficult to predict what the future holds for this new asset class. There are too many external contributing factors (like regulations) that are yet to be clarified, all which can have a significant impact on future viability.

If you’re considering whether to add digital assets to your traditional portfolio, here are a few risks and benefits to examine.

Risks

Price volatility & manipulation

Digital assets have been on a wild ride. Epic booms, busts, wild swings, and scams have amazed and baffled investors who have witnessed unexplainable and unprecedented gains and losses over the last decade.

For example, here’s a coinmetrics chart on the volatility of daily returns (14-day average) comparing BTC (Red) to S&P 500 (Teal). Volatility swings in BTC and other crypto assets makes it hard for investors (especially retail investors) to build confidence and secure gains.

BTC (Red) Vs S&P 500 (Teal)

Price volatility is common and generally stems from three main sources; sentiment, speculation and market manipulation. It’s the unregulated and anonymous nature of digital asset markets combined with the susceptibility of cryptocurrencies and other crypto assets to sentiment, emotion, and publicity that make prices volatile.

Crypto exchanges, media owners, and powerful investors can manipulate prices. This manipulation seems to be widespread — albeit not widely proven yet. The most used manipulation strategies include wash trading, dark pool trading, pump and dumps, and shilling.

Lack of regulations

A lack of regulatory frameworks means there is a high degree of uncertainty like price volatility and manipulation. Investors and entrepreneurs are also concerned about the possibility of future restrictions which may have a significant impact on the value of digital assets or completely ban them altogether.

For the large part, crypto regulations are complex, disorganised and haphazard. One area of particular concern for investors is tax treatment. A lack of regulation or what some term as regulatory greyness means some investors are scared off investing in digital assets because they don’t have a clear understanding of what tax obligations need consideration or what actions must be taken and what records need to be kept.

The good news is that regulators are catching up. Authorities in many jurisdictions are taking steps, producing research papers, standards and introducing new regulations. One of the first countries to begin building a robust regulatory framework is Switzerland. The country has proposed an idea for minimising rules while still keeping companies in line with legislation through ‘sandboxes’ allowing startups to experiment and innovate within controlled conditions.

Britain and Singapore have been exploring their blockchain and crypto regulatory environment as well, providing platforms which enable companies to experiment under relaxed regulation and licensing requirements. In the US, the New York Attorney General’s Office recently launched the most comprehensive study on exchanges.

Market adoption

Thanks to a market downturn, the entire digital asset market is worth less than McDonald’s. But even before the 2018 slump, the market for digital assets relative to other markets like currency, gold, stock markets was vastly smaller.
 
Market adoption remains low for a host of reasons from regulatory concerns and technology shortfalls to market volatility, public misunderstandings and the fact that digital assets and the underlying blockchain technology that powers them are still emerging and in their infancy. This means there’s a chance that this new asset class, impeded by many different factors, regulations being one of them, will never be broadly adopted, leading to a complete loss of value. There is a clear need for more regulations, technology improvements and institutionalisation to help drive trust and scale in digital assets.

Security, custody & consumer rights

Storing digital assets can be risky business. There have been significant incidents of theft on personal wallets but also on exchanges. Hacking remains a constant threat if digital assets are not correctly stored and protected. To make things worse, assets that get lost or stolen cannot be recovered, and mistaken transactions cannot be reversed. Also, unlike traditional investing through a bank or brokerage, digital assets don’t have official safeguards or insurances. Rebates on lost investments depend on the whim of the organisation you’re dealing with.
 
The good news. Custody solutions which give financial institutions the ability to hold cryptocurrencies on behalf of trading clients are beginning to emerge. This is expected to catalyse the entry of institutional capital into the industry and in-turn provide a trusted stamp of approval for retail investors as well.

Coinbase has announced its custody product upon completion of their first successful deposit. The multinational investment bank, Citigroup, has announced that it will offer crypto custody solutions to institutional investors. Citigroup launched a product called Digital Asset Receipt, intended for institutional investors to securely invest in cryptocurrencies in a regulated and secure manner. There is also Fidelity, which has announced a new and separate company called Fidelity Digital Asset Services. The Wall Street incumbent will handle custody for major cryptocurrencies such as bitcoin and execute trades for investors such as hedge funds and family offices.

Exiting the market

The crypto market’s off-ramps are a real problem for many investors. Many exchanges only allow withdrawals in USD, some also allow EUR, GBP, and JPY, but the choice is minimal, and exchanges frequently require high minimum withdrawals when withdrawing to fiat. Lots of exchanges that support fiat withdrawals also only accept a few leading crypto assets and to withdraw fiat money, investors need to go through a tedious verification process that can take months.

Some exchanges have also been accused of withholding funds for unclear reasons, and many banks are still very wary of accepting money from the sale of cryptocurrency. All this exposes investors to exchange rates, fees, and risks associated with dealing with opaque exchanges. The situation is improving, but it’s far from ideal.

Benefits

Diversification & changing asset correlations

Correlation analysis is essential when designing and implementing investment portfolios. The problem for investors today is that the evolving economic landscape is changing correlations across assets and this is resulting in some assets not providing the diversification benefits they once did. This makes having alternative assets that perform in a non-correlated way to traditional investments critical to help hedge against market downturns, a safe haven of sorts.

“One of the key breakthroughs of modern portfolio theory was to show that a riskier asset can be added to a portfolio, and if its behavior differs significantly from the preexisting assets in that portfolio, it can actually decrease the overall risk of the portfolio” — Chris Burniske

So far, the correlation of major asset classes like real estate, stocks, bonds and currencies to digital assets have shown little or no correlation. Although it’s a new asset class, this makes digital assets an effective way of diversifying traditional portfolios. According to Matt Hougan, VP Research & Development at Bitwise Asset Management Inc.

“Over the long term, we think the fundamental drivers of crypto are different from the fundamental driver of equities and other assets, and we would expect the low correlation to persist.”

A few critical notes in this point. It remains unknown how crypto assets will perform during periods of extreme market stresses. Furthermore, non-correlation is not the same as inverse correlation, so if the market goes down, there is no guarantee that crypto will go up. Finally, within the crypto asset class, cryptocurrencies, for the most part, appear to be closely correlated. This means that there are no or very few diversification benefits of investing in a variety of different cryptocurrencies within the same portfolio at this time.

A changing investment landscape

Transformative technological, regulatory and societal forces are changing the global economy causing the investment landscape to evolve. This is having an impact on asset allocation decisions with investment returns in traditional portfolios harder to realise. Digital assets can provide a new asset class for a new economy and investment landscape.
 
Complex market realities: Sluggish economics, market growth, and a global low-yield environment, combined with sustained low rates, and divergence in global central bank policy have all served to increase complications for financial markets. 
 
Technological innovation: Digitisation and technological advancements in areas like automation and artificial intelligence are changing how money gets transacted, managed, and how clients interact with their investments. 
 
Regulations: A steady increase in regulations combined with unpredictable shifts to existing laws is reshaping industries and has resulted in an uncertain operating environment, increased compliance risks and costs.
 
Demographic shifts: Populations in advanced nations are aging increasing the retirement obligations faced by both pension plans and individuals. The next generation of investors are also entering their prime earning and investment years and are open non-traditional investments.

Growth Potential

Digital assets are still a tiny market. When compared to traditional asset markets, which are more than $300 trillion globally, crypto assets make up a very small fraction. 
 
We’re only at the beginning stages, and as a young asset class, the market tends to be volatile. This can be a turn off for investors, but promising advances could be a sign that the best growth is yet to come.

There are encouraging signs of maturity. Banks and wall street activity in the space are starting to heat up, more enterprises are funding pilots and moving into production, the regulatory landscape is shifting and advancing, enterprise custodial products and services are beginning to emerge, and third generation blockchains are in production. The tiny size of the market combined with all these developments is a good sign that growth potential will materialise in the coming years.

A new asset class for a new economic & investment landscape

It’s to be expected that emerging technologies will encounter scrutiny and skepticism because people are naturally resistant to change. And so, the debate between supporters and detractors of cryptocurrencies and digital assets as to their value and future impact is far from settled.

It’s difficult to predict what the future holds for this new asset class as there are too many contributing factors that are yet to be clarified, all which can have a significant impact on future viability.

What is clear, however, is that transformative technological, regulatory and societal forces are changing the global economy and how businesses and individuals live, work and consume. They are causing the investment landscape to evolve as well. This is having an impact on asset allocation decisions with investment returns in traditional portfolios increasingly harder to realise.They are causing the investment landscape to evolve as well. This is having an impact on asset allocation decisions with investment returns in traditional portfolios increasingly harder to realise.

Digital assets could deliver real opportunities for investors by providing an asset class that compliments new economic and investment realities within the emerging digital economy.


Originally published at Blockchain Review.

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Anthony is the head of content and research at Intrepid Ventures.