Introduction
Cryptocurrencies are digital tokens secured by cryptography intended to be used as a medium of exchange. They are risk-on assets pegged to a certain dollar value, and they can be highly volatile, but they carry certain distinct advantages for investors as well as end-users.
Cryptocurrency (“Crypto”) is an exploding market. Global cryptocurrency adoption surged over 800% last year. 90 major countries are exploring CBDCs at one stage or other. Within the U.S. big players in both private and public sectors are investing in cryptocurrency projects (e.g. Facebook, Visa, Mastercard, U.S. Navy, the NFL, the list goes on). Iconic of the changing of the guard, Staples Center is now called Crypto.com center. Public recognition and adoption are skyrocketing, consequently so are institutional finance, lending and Venture Capital (“VC”) inflows.
Given widespread signs of hyperinflation, Cryptocurrency (“crypto”) has gained traction as a potential hedge from inflation, providing portfolio diversity and shelter from further debasement. 40% of the fiat in circulation was printed in the last two years. Both NASDAQ and S&P touched all-time highs in 2021. In contrast, crypto’s overall market cap remains below $3 trillion, giving it plenty of room still to run (the most bearish analysts compare the Crypto “bubble” to the Dotcom Bubble, which was $12T, $15T adjusted for inflation). Investment personalities like Ray Dalio and Kevin OLeary have begun to advocate for 3–20% portfolio allocation for every investor. The upside potential is opaquely huge, 5% exposure for every investor would equate to $500,000 per Bitcoin (BTC). Regardless of an investor’s exposure to securities and traditional finance, the emerging digital assets market carries such an exponentially greater upside that it merits inclusion in all portfolios.
Below is a surface-level introduction to some different areas I think mandate portfolio exposure within the cryptocurrency space.
Decentralized Finance (DeFi)
Retail investors tend to focus on Bitcoin as a store of value, but the technologies behind it are much more revolutionary and consequently much more reliable long term sources of value. BTC may have a place as a store of value, but savvy cryptocurrency investors should be far more interested in the developments happening in financial technology (“Fintech”).
Bitcoin runs on Blockchain and Distributed Ledger Technology (“DLT”), which is just beginning to have massive impacts in the Foreign Exchange (“Forex”) and DeFi spaces. Bitcoin (and other cryptocurrencies) are global currencies, making their potential for disruption in Forex markets enormous. El Salvador famously adopted Bitcoin as their national currency last year because remittances make up a quarter of their GDP. El Salvador’s move alone is expected to cost central finance and Forex lenders hundreds of millions of dollars a year by opting for a decentralized currency. Bitcoin is global pay, a feature that has yet to be fully realized.
Additionally, DeFi has emerging applications at the consumer level with massive potential for disruption in the centralized finance and banking industries. Traditional savings accounts yield 0.5% annual percentage yield (“APY”) or less, meaning what the bank pays consumers for the use of their liquidity is basically nothing. Because blockchain technology allows for impersonal and decentralized but secure financial transactions, savings and lending protocols can be managed without a centralized arbiter. Decentralized banking enables exceptionally higher consumer-level yields, with a baseline of 20–40% for minimal risk lending and savings protocols using Stable Coins (1:1 US-Dollar-alikes on blockchain) and exponentially higher yields for higher-risk assets.
Blockchain and DLT are especially crucial for decentralized finance because they allow for complete transparency and security. All transactions made on-chain are instantly made part of the public record, and can never be changed or erased. This has enabled an unforeseen level of universal, worldwide competition in the lending markets and has unrealized ripples in other spaces.
GameFi
Among the major ripples still to come from tokenized assets and decentralized lending are massive impacts in the gaming and esports spaces. Bitcoin may have set the stage, but newer cryptocurrencies, with Ethereum (ETH) leading the way, changed the game with the deployment of Smart Contracts. Smart Contracts are algorithms embedded in the cryptocurrency token with pre-set contingencies baked in. This technology fundamentally lets ETH users do more with their tokens than buying, selling, and trading. Smart contracts allow tokens to mint non-fungible tokens, (“NFTs”) fuel video gaming, accrue interest, host web sites, as well as a developing variety of “real-world” applications. These tokens can operate “on” different networks like Ethereum, Solana, and Avalanche, or they can form their own base-level (“Layer 1”) cryptocurrency transaction network. Smart contracts allow for specific terms, like lending agreements, to be transparently and securely included in the design of tokens with specific utility, and enable simple, peer-to-peer cryptocurrency transactions.
By tokenizing in-game assets, games can charge and reward players in real money transactions. There are already some household names in this space. Axie Infinity, a Pokemon-alike Play-to-Earn (“P2E”) battle game developed by the vietnamese company Sky Mavis and running on Ethereum, has done upwards of $4 billion in volume. Early adopters have benefited so much from the game’s exploding popularity they quit their day jobs. Axie is a shining star in this space running on a highly over-congested network, without much traction in the West or a fully functioning mobile app. With numerous projects targeting beta tests for Q1 and Q2 2022 on ETH and other blockchains, the GameFi space is in its infancy.
Web3
Smart contracts are now ushering in a rapidly growing Web3 ecosystem, in tandem with a growing Metaverse narrative in the public eye. Web2 is the term coined to represent the current era of centralized, commercially dominated internet applications. Every Cloudflare or AWS outage reminds how embarrassingly overexposed the online community is to the whims of specific web-hosting giants. The term Web3 represents an incoming era of decentralized website hosting through the blockchain. Using smart contracts, Web3 promises to usher in a whole new era of internet life. Web3 objects can interact in complex ways, enabling users to own and participate in part of the governance of their favorite web protocols and to interact with objects over the internet in more complex ways. The new gaming community being built in the “Metaverse” by Meta, Sandbox, Decentraland, and others is dependent on Web3 technology to facilitate cool interactions between NFTs and virtual “land.” With the Metaverse expected to form a core part of day-to-day business interactions within the next two years, Web3 will be a huge money-making opportunity.
Yield Farming
While retail investors tend to see crypto as a game of accumulation, purchasing and holding on for dear life (“HODLing”) is the most risk-on way to approach cryptocurrency investment. If the value of the asset goes down over the HODLing period, even if it first went up before going down, investors potentially make negative returns, losing out on part or all of their investment.
Even at the retail level, many cryptocurrency centralized exchanges (“CEXs”) offer incentives for “staking” crypto (making it illiquid in order to help facilitate transactions along the network). These returns can run up to 15% APY, but some chains can require weeks to “unstake,” and we feel these incentives are disproportionate to the risk taken on.
In comparison, many decentralized exchanges (“DEXs”) offer substantially higher returns for less illiquid investments. To take advantage, investors need to form liquidity “pairs” using equal value of two different tokens. For each farm, this requires the investor to track the value of both tokens in the pair, because the value of the overall liquidity pair (“LP”) is an aggregate. However, the DEX benefits so much from the available liquidity, and its decentralized nature lets it spread the profits equitably, so they are able to offer yield farming returns exponentially greater than staking bonuses. LPs can be removed from a farm and liquidated in a matter of minutes, making this option both lower risk and higher return than staking.
Many DEXs partner with finance firms to create continuously compounding “vaults” for their farms. Manually compounding requires a transaction with gas each time, so auto-compounding also dramatically increases APY by allowing the balance in the farm to snowball faster. Accounting for compounding rates, returns on these vaults can regularly vary between 1,000% and 100,000% APY. 1000% compounding returns on the low end means a token can lose 90% of its value and over the course of a year, the investor will break even. If the token appreciates, the investor’s gains will be stratospheric. Yield farming can be risky, as high emissions generally have a deflationary effect on token price, however, many DEXs offer respectable APYs without needing to pair with DEX tokens for liquidity. This should be a core strategy for longer-term HODLers.
Principal Risks
It is impossible to guarantee that your investment in crypto will meet your expectations. The value of investment as well as your returns may vary significantly. You may lose part or all of your investment. I have no professional licensing and this is not financial advice, however, kindly consider the following risks before investing.
Market Volatility
The market price of Bitcoin and other cryptocurrencies are subject to extreme fluctuations. The value of your digital assets could fall dramatically (potentially to zero). The digital asset market is impacted by a plethora of factors including macro-level economic events (political uncertainty, regulation by foreign entities, global inflation and recession risks) as well as micro-level competitive factors (changes in user preference or competitive advantages among other chains).
Regulatory Uncertainty
Crypto investments are not FDIC insured. In most jurisdictions, Cryptocurrency is not accepted as legal tender. Although the SEC has indicated it has no intent to ban crypto, federal, state, and local regulation of cryptocurrency is still developing. Federal, state and/or foreign governments may restrict the development, use, or exchange of cryptocurrency. It is expected that regulatory standards for digital assets will launch in the U.S. in the next year, with the first wave targeting Stable Coin issuance and lending. The developing regulatory framework is uncertain, but hopeful, with Congress soliciting input from the heads of major CEXs. No position in the market is completely insulated from and adaptable to all such challenges.
Security Breaches
In parallel with accelerating adoption rates, crypto-related scams and hacks are also on the rise. Cryptocurrency exchanges, especially decentralized exchanges, are relatively new and lack central ownership, and are in most cases largely unregulated. Therefore, cryptocurrency exchanges may be more exposed to fraud and failure than established, regulated exchanges for securities, derivatives and other currencies. Cryptocurrency exchanges are also subject to cyber security risks. Cryptocurrency exchanges may experience cyber security breaches in the past and may be breached in the future, which could result in the theft and/or loss of digital assets and further impact the market value.
Yield farming through a finance firm exposes the user to potential security concerns at both vault (financier) and farm (DEX) levels. Security breaches at either level could potentially impact investors’ funds. These risks can be mitigated through the use of free Smart Contract auditing services by several cybersecurity firms, but cannot be eliminated entirely.
Unfavorable Capital Rotations
During times of net outflows of capital from the cryptocurrency sector, intramarket price action is dictated primarily by rotation of capital from one chain to another. Unfavorable rotations may cause impermanent or permanent loss in defiance of technical and fundamentals analysis (“TA/FA”). Even awareness of these risks does not prevent impact by them due to their unforeseen nature, so you cannot guarantee avoidance of unfavorable rotational plays.
Conclusion
Invest at your own risk. Doing your own research is highly recommended. However, I think at this point in time the potential upside of cryptocurrency exposure for investors far exceeds the likely downside. Times are shifting. Change is coming. Is your portfolio ready?
