Fundamentals of cryptocurrency investment

Cryptocurrencies have emerged as a new type of asset class for investors. Today, there are over a thousand different ones listed on multiple exchanges.

Market capitalisation can range from several billion dollars to less than one hundred thousand dollars. As the market is unregulated and relatively new, prices are very volatile and can lead to dramatic fluctuations.

When a new technology disrupts markets at scale, it often results in new rules and fundamentals.

Fundamentals

When a new technology disrupts markets at scale, it often results in new rules and fundamentals.

a) Disclaimer

Caveat emperor

As the industry is decentralised and permissionless, investors need to follow the “caveat emperor” principle.

In other words, investors need to undertake extensive research before purchasing any token, as there are significant risks that the project will fail in the long run.

It is and will always be the token way or the highway.

Private keys

Trading in crypto often means trusting third-party exchanges with your assets. When storing crypto on exchanges, you do not hold the private keys: therefore you only own an IOU (I Owe You). It is a promise that the exchange will disburse the funds back to you when requested.

Be sure to store most of your crypto on cold storage: if you set up your system thoroughly, your tokens will be safe from any digital attacks (but not physical attacks!).

Kindly check our wallets review for additional information here.

Token utility

Before anything else, tokens should transfer tangible utility to its holders, or at least have utility in the foreseeable future.

Without utility, a token does not have any form of value.

Forms of utility or token functions include but are not restricted to:

  • Payment: facilitates peer-to-peer transactions
  • Incentive: enables the opportunity to earn dividends
  • Access: grants the right to access a product or service
  • Governance: ability to vote and participate in decision-making
  • Asset-back: claim to physical assets represented by digital tokens
  • Receipt: proof that an individual has donated or paid a bill
  • Ownership: stake in the project

It is essential to fully understand the token economy of a project before investing in it.

Projects can sometimes issue more than one token, making it confusing for end users. Be sure to understand what are the specific functions and how they interact with each other.

Last but not least, a token that only holds payment functions would be competing with high capitalisation and established cryptocurrency tokens such as Bitcoin, Litecoin, Ripple or Monero. This means fierce competition.

Fraud, scam, Ponzi & multi-level marketing schemes

Unfortunately, the cryptocurrency eco-system is flawed with multiple malicious agents and fraudulent projects.

With cryptocurrency, you are not protected against fraud and scams, because no one has the power to rewind a transaction.

Once you withdraw money from your accounts, there is no turning back. It is your responsibility to manage your tokens well, so be careful about fraudulent projects.

It is recommended to avoid any investment opportunities that:

  • Guarantee high returns in no time at all, promise to become the next Bitcoin or use website banners and social media campaigns with catchy headlines.
  • Do not promote token utility and do not advertise any innovative Unique Selling Point.
  • Are advertised by other investors that share referral links on a social media. Multi-level marketing schemes rely on contributors to get new investors onboard via attractive bonuses - a strategy derived from pyramid and Ponzi schemes.
  • Shared by an unknown individual on social media platform (direct messages or via groups and channels). Avoid any direct communication with outsiders engaging with you: they will most probably promote Ponzi and MLM schemes or attempt to attack your system via phishing and malware.

b) Definitions

Crypto terminology

  • Fiat: Money controlled and monitored by a central bank (dollar, euro, yen)
  • Cryptocurrency: Digital money that uses cryptography to secure transactions and create transparently additional units of the currency
  • Bitcoin: First cryptocurrency created by Satoshi Nakamoto in 2009
  • Altcoin: All cryptocurrency other than Bitcoin

Investment

  • Portfolio: Group of financial instruments held by an individual, groups of individuals or institution
  • Trade: Action of buying or selling an asset
  • Position: Commitment to buy or sell an asset
  • Long: Hold a position that will profit if the price goes up in the future
  • Short: Hold a position that will profit if the price goes down in the future

Valuation

  • Market capitalisation: eco-system value in fiat calculated by multiplying the price of one token by the total number (either circulating or total supply).
  • Circulating token supply: Number of tokens that are mined and available to use. Bitcoin circulating token supply in 2017 is around 16-17 million.
  • Total token supply: Maximum number of tokens that will ever exist whether it is in the present or the future. Bitcoin total token supply is capped at 21 million.

c) Time

Markets are open around the clock without interruption. However, trading volumes are never constant and subject to variation based on several factors:

  • Institutional money: financial institutions only trade during weekdays at regular working hours.
  • Geography: Trading volumes during the day in China or the USA will be higher than at the same time in the Middle East or the Pacific.
  • Mainstream media: Media coverage has a significant impact on trading volumes as they influence new investors to enter the market and often spread awareness on cryptocurrencies as a whole.

d) Unit of account

There are two markets investors can trade on:

  • Fiat to established altcoin. Depending on the exchanges, there are approximately a dozen cryptocurrencies you can trade against USD, EUR, CNY or GBP.
  • Bitcoin or Ethereum to altcoins. Most of the cryptocurrencies are priced in Bitcoin and Ethereum.

Navigating between both markets can become tricky, but it is essential to keep track of every entry and exit price so that you can assess the performance of your positions and portfolio.

e) Price (liquidity, volatility)

  • Volatility: Cryptocurrency trading can become very stressful once you fully comprehend how prices can be unstable. It is not uncommon to witness a 50% jump or pull down in price in a matter of a few hours.
  • Liquidity: Smaller market capitalisation tokens do not have enough volume for regular trading. In this scenario, it is sometimes difficult to exit a position. Be sure to take the aforementioned into account when investing in a low cap coin.

f) Market capitalisation

Often acknowledged as the primary indicator to evaluate the crypto economy, market capitalisations are calculated by the multiplication of the price of one token by the total token supply.

It can get misleading as the total token supply often differs from the circulating supply.

In a scenario where tokens are pre-mined and held by the founding team, the circulating supply may only represent a fraction of the total supply: the eco-system valuation can, therefore, reach absurd valuations.

For instance, the circulating token supply of Gnosis, a decentralised prediction market application, represented one-tenth of the total token supply during its initial coin offering.

g) Inflation

Additionally, some tokens are inflationist and follow a planned emission rate. If more tokens are added to the circulating supply, then the value of outstanding units is diluted.

With cryptocurrencies, the inflation rate is (for most projects) codified and transparent, allowing investors to estimate the future circulating supply and forecast the valuation.

h) Trust

The crypto-economy is often described as decentralised and permissionless, meaning users do not have to trust any third party when interacting with applications.

However, before a token is floated, users need to trust that the founding team has introduced the token fairly and that project development will meet targets.

It is not uncommon to witness extreme variations between the fundamentals of a project (stage, market) and the market valuation.

Investors need to assess a few key points before buying in:

  • Are developers active and aspire to improve the products?
  • Does the token provide utility to its holders?
  • Are the founding members legit and do they seem trustworthy?
  • Is the token distribution transparent and does the market capitalisation reflect the value of the project?

i) Opportunities

In cryptocurrencies there are two distinct investment opportunities available for investors:

  • ICO: these are new projects introduced by a token generating event. Caveat emperor is critical, as the founding members establish the rules of the game: it’s their way or the highway.
  • Floating tokens: these are already listed on exchanges and are traded around the clock. The market fixes the token price.

Floating tokens have dynamic prices while ICOs have a fixed price tag.

In general, you’ll need to do extra research on ICOs as they are at an earlier stage. After ICO completion, exchanges list the token, and it becomes a floating one.

Profile

An investment strategy tailored to your profile will help you design a better performing portfolio.

a) Involvement

Not everyone is willing to scan trading charts and keep up to date on a daily basis. Try to estimate how much time you are willing to invest in crypto.

It will help you design a portfolio customised to your investment profile.

b) Risk reward

Cryptocurrency investments can become very volatile, while you can make healthy profits overnight, you are not immune to incurring substantial losses.

Define your risk matrix and to what extent you are willing to enter less established investments. Are you risk averse or risk-taking? Your portfolio should illustrate your mindset towards risk.

c) Timeline

Each investment has an entry and an exit. It is crucial for investors to understand when they plan to close their position and lock in their profits.

Timelines should also be diversified and depend on your level of involvement.

d) Skillset and experience

Since the cryptocurrency market is at such an early stage, very few of us have extensive experience on the matter. Still, try to stick to your areas of expertise and to an industry you comprehend.

If you enjoy trading, focus on floating tokens, on the other hand, if you like assessing products maybe ICO investing is a better option.

It is more suitable to differentiate tokens by industry (gaming, prediction, cloud storage), if you come from an industry with a high cryptocurrency penetration why not invest in the token you deem best fit to disrupt your industry at scale?