As discussed in our previous guide, cryptocurrencies are considered a high-risk asset class, and has a reputation that reflects this.
The following guide will explore a number of features, including aspects such as volatility, liquidity and security – aspects that need to be considered and kept in mind, especially if investing within the world of cryptocurrency.
Since their inception, the return of many cryptocurrencies has been extraordinary. Bitcoin was first priced at 1,309 bitcoin per $1 by New Liberty Standard in October of 2009. It has since continued to increase and move past numerous milestones – $1, $10, $100, $1,000, and $10,000 levels.
In the first few years, Bitcoin was a project being driven by a small group of innovators. The real question is whether there is scope for more returns. A strong argument can be made that there is.
The peak market capitalization of the entire cryptocurrency market was approximately $820 billion in 2017 – an extraordinary increase. Up until 2016, the market cap remained far closer to $10 billion. However, even the peak market cap of $820 billion remains minuscule in comparison to developed industries such as equities and gold. The gold market is approximately $7.7 trillion while the global equities market is approximately $73 trillion.
Cryptocurrencies are undoubtedly highly volatile. Rapid price spikes and crashes can occur in a matter of seconds. Liquidity has a significant role to play in this high level of volatility.
With the cryptocurrency market being almost entirely made up of retail investors, the high level of liquidity provided by institutional capital is lacking. The majority of the stock market is comprised of institutional investors, around 90% according to William J. Bernstein. These large players along with the maturity of the market lessen the volatility.
While cryptocurrencies could easily swing 10% on news that might not even be legitimate, stocks are priced close to analysts’ estimates. An unexpected earnings announcement or expected profits update will almost definitely result in a price swing.
Yet it is nowhere near the type of swings that are seen in the cryptocurrency market. Cryptocurrencies are currently lacking both the institutional investors and the maturity of the stock market.
Liquidity plays a huge role to play in the volatility of the markets and regulation, in turn, has a huge role to play in the liquidity of the cryptocurrency markets. If a clear regulatory system is established, it will be far more attractive for institutional investors to get involved in the market.
At the moment, institutional investors cannot risk being involved in unregulated markets. High levels of volatility are just one of the impacts of the lack of regulation. Other impacts include nefarious schemes such as pump and dumps taking place, large traders being able to move the market, and exchanges executing an illegal practice known as ‘wash trading’, to inflate their trading volume.
Correlation is the measuring the tendency of two assets or two asset classes that move together. If two assets were perfectly correlated and one were to increase by 10%, the other would too. If two assets were perfectly uncorrelated, and one were to increase by 10%, the other would decrease by 10%.
As it stands, cryptocurrencies are highly correlated to one another. This is why when bitcoin rises, all altcoins tend to follow and vice-versa. As an asset class, cryptocurrencies are showing little correlation with other asset classes. As the market continues to develop and mature, correlations with other asset classes are likely to develop.
One aspect of the cryptocurrency market which makes it considerably unique to other markets, is its immutable property. This shortcoming is due to the blockchain technology which governs cryptocurrencies.
This means that if funds are sent to an incorrect entity or if a hacker successfully gets access to an investors funds, there is no recourse to retrieve the funds once they are gone. Think of a mistaken transfer like a wrongly sent email: once you click on ‘send’, you cannot unsend the data.
In other markets, there may be consumer protection laws to provide some level of safety to investors but stolen or lost funds in cryptocurrency are essentially irretrievable. This means that security is substantially more important in cryptocurrencies than it is in a high number of other asset classes. Investors need to take the time to carefully set-up their wallet and security practices so that their funds are secure.
The nature of developing markets means that the vast majority of returns goes to a small number of entities. This happens time and time again as markets undergo their natural development. It is why mature markets typically only have a small number of companies still operating. Such companies include the car manufacturing industry Ford, in the United States .
If cryptocurrencies follow this natural development of markets, it is likely that only a few cryptocurrencies and projects will provide the need for all the key areas of decentralization, while the others provide subpar returns and remain at a low-scale or go out of business. This process occurs as markets go through the industry lifecycle.
In the early stages, there is rapid growth characterized by many startups and operating projects. In the later stages, competition intensifies and those who can’t keep up will be shaken out of the market, leaving just a few key operators. As the market matures, there is likely to be just one or two key products providing the needs for all of the user base.
2017 was highly characteristic of the growth stage of an industry, with thousands of projects popping up. As the bear market of 2018 progressed, some began to show signs of trouble such as decentralized social media platform Steemit cutting down on 70% of its staff and Ethereum consulting firm ConsenSys also cutting back on costs.
The progression of early-stage technology start-ups can be compared with cryptocurrency. The returns distribution of the top 80 pre-IPO unicorns – companies with over $1 billion in valuation – show 46% of valuation going to just the top ten with the rest being spread out across the other 70.
The vast majority of return is accounted for by just a small number of market leaders. The rest of the returns are spread among the rest of the companies. As cryptocurrencies progress through the industry life cycle, a similar returns distribution is likely to take place.
Apart from how the distribution of returns, one of the biggest expected developments in the cryptocurrency market is the role regulation is expected to play. The unregulated nature of the current cryptocurrency market makes it highly unattractive to institutional investors who wish to participate. If these institutions were to get involved now, they would risk legal action from clients for putting capital into unregulated markets.
Once clear regulatory frameworks are established, the arrival of institutional investors will provide a significant amount of liquidity to the markets. It’s probable that this will drastically reduce the levels of volatility.
The introduction of clear regulations may also result in some form of recourse being established for investors who lose funds due to business malpractice. For example, if an exchange mishandles an investors funds, they may be held liable to the investor for said funds, and the investor may be compensated after liquidation procedures.
Much still remains unknown regarding cryptocurrency assets and what their properties will be as the market begins to mature. Currently, cryptocurrency assets are highly volatile and risky. With that said, they still have the potential to yield considerable returns.
While much remains unknown about what exactly the properties of a more mature cryptocurrency market will be, opportunities await those willing to place their bets…
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