Many investors over the past six to nine months have watched in awe as Bitcoin, Ethereum, and crypto related stocks have skyrocketed in value. Bitcoin, the largest crypto asset by a large margin, is up just under 100% year to date through 3/29/2020 and is currently trading around $58,500 per coin. At this price the market cap of Bitcoin is just above $1T USD. Other crypto assets such as Ethereum (ETH) are up even more.
Below: chart of Bitcoin (BTC-USD) over past year.
With impressive returns, promises of continued technological innovation in the space, significant institutional adoption, and governments around the world printing seemingly endless amounts of fiat money, interest in the space shows no signs of stopping. Below we will take a look at three distinct ways to dip your toe in the crypto waters.
Logistics of Ownership:
Before we dig into the differences between the myriad of crypto assets available and the choice of decentralization vs. centralization, an investor first must decide how they want to logistically enter the space.
There are two basic ways of investing in the asset class. An investor can directly open a crypto or hybrid exchange account such as Coinbase, Kraken, Binance.US, and Robinhood or buy an exchange traded trust. As of this writing there are no US listed crypto ETFs, but that is expected to change sometime over the next year.
If an investor chooses to open a crypto exchange account, it will be a comparable experience to a traditional brokerage account; but would trade partially or solely in crypto assets. Once assets are purchased (through a process very similar to stock purchases), an investor can either leave the assets on the exchange (generally not recommended; outside of Coinbase where the assets are insured) or taken off the exchange via ‘cold storage’ to a digital ledger. Going this route will give you direct ownership of the asset, power over how to store it, and of course a pure play on the price.
Another option would be purchasing an exchange traded trust where you get access to crypto through a traditional brokerage account or IRA. This can be more convenient and a way to consolidate all portfolio holdings in one place. These, look and feel like ETFs, with one important difference. The price of the trust can diverge from the value of the underlying crypto assets and often do. The Greyscale Bitcoin Trust GBTC varied from a premium over the actual Bitcoin value of 36% to a discount to value of -14.5% in 2021 alone.
Below: chart of Greyscale Bitcoin Trust (GBTC) Premium or Discount from NAV (Net Asset Value) in 2021
If and when an ETF comes to market, that should alleviate the premium/discount issue and investors could get easy access to pure crypto price exposure with the ease of any stock or fund.
True ‘Decentralized Network’ Crypto Assets:
The most tenured and largest crypto assets in the entire asset class fall within this ‘decentralized’ category with the ‘king’ being Bitcoin (BTC). A distant, but important second, would be Ethereum (ETH). In my opinion BTC and to some extent ETH, should make up the vast majority of any crypto portfolio. These assets have proven the test of time, have a high level of ‘decentralization’, been through good and bad times, experienced contentious ‘hard forks’, and both are being extensively used today throughout the world.
There are other crypto assets that meet the ‘decentralization’ definition, but due to lack of network effect/size, true use case, differentiation, and duration of existence, there are relatively few ‘investment grade’ opportunities out there.
This ‘decentralization’ is sacrosanct to many in the asset class, and many view assets with a strong centralized aspect as not truly crypto. In the case of BTC, decentralization is absolutely needed. Without it, Bitcoin’s main use case (digital store of value) would not work and it would be very vulnerable to regulatory shutdown and trust issues. Decentralization for ETH is very important as well.
Because BTC and ETH have incredible network effects, a long history (relative to crypto), a culture of innovation, and strong decentralization, these assets offer tremendous investment potential, with high, but reasonable levels of risk. The decentralization of these networks does decrease the risk of a central point of failure and allows more dynamic ecosystem development. That is a powerful combination, and likely why they are the top two crypto assets with market caps of just over $1T for BTC and over $200B for ETH.
Semi-Centralized/VC-Like Crypto Assets:
On the other hand of the spectrum, there are countless crypto assets that are more similar to ‘traditional companies on the blockchain’ with an associated utility token. Instead of investing in a decentralized network, this is more similar to investing in a VC/start up tech company with one important exception; there is no actual equity ownership. Instead, you own a crypto token/asset with a value that is determined by supply vs. demand.
Demand Component: Demand for the token comes from its utility. In general, if an investor can earn ‘interest’ from holding the token (especially via staking), its liquidity is fairly high, and there is a clear need to for network participants to use/hold the token it is a candidate for investment. There should be a strong reason for the token to be on the blockchain, future continued growth in demand for the token, and a large TAM (total addressable market). In addition, since these are centralized ‘company like’ assets, the management team has to be of high quality, drive, and integrity with a strong focused vision.
Supply Component: The other side of the equation is supply of the token. All else being equal, for optimal value accretion, a token with a simple/easily understood, well distributed, and low inflationary or even deflationary total supply is optimal. In a perfect world (as long as it does not interfere with the token’s utility) a programmed/non-arbitrary token ‘burn’ (similar to a stock buyback) is a way to create a value creating supply system.
If one can find a token/asset that has both sustainable growing utility demand and low/no inflation of supply (or even deflationary supply) that is a recipe for price appreciation of the crypto asset over time.
One example of an asset that meets the above criteria is the Binance token (BNB). Demand for the token has consistently increased over the past 3-4 years as exchange volumes grew and traders received a discount on trading fees if paid in BNB. In addition, when Binance launched their own blockchain similar to Ethereum, this added a multitude of new uses for the token, vastly increasing demand. On top of this increasing demand, there is a programed quarterly token burn in place that consistently decreases supply.
The result of the increase in demand and decrease in supply over the past several years has been significant price performance for token holders. The Binance token even appreciated in price vs. BTC over the long run, which is virtually unheard of in the space.
Below: Chart of BNB token vs. USD (green) and BTC (yellow) June 2018 - Current
XRP (Ripple) is another centralized/company type crypto asset with a use case and a relatively long history, although there have been several regulatory issues within 2020 and 2021. On the supply side of things, XRP is a materially inflationary token with 100 billion tokens to be issued over time, but only 45 billion in circulation currently. More than half of the supply has yet to be released into the market, which will cause a strong headwind for price appreciation for years to come.
Crypto-Related Stocks/Companies listed on the traditional exchanges:
There has more and more crypto-related companies listed on either the US or Canadian stock exchanges. Some examples of publicly trades stocks that are pure crypto plays would be Marathon Digital Holdings MARA and Galaxy Digital Holdings BRPHF. Marathon is a crypto/bitcoin miner, while Galaxy is a diversified crypto company operating in many different areas. This is a cost efficient and convenient way to get some exposure to the crypto market, but there are some important caveats to pay attention to if you choose the stock route.
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Volatility of crypto related stocks often times is actually higher than most actual crypto assets. If BTC is down 5%, crypto related stocks can be down 10% or more in the same time period.
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There will be come correlation to the crypto market, but there will also be company specific risk and overall stock market risk.
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Just like with any company, it is important to assess earnings (or future earnings prospects), analyze the company business plan in detail, and review the health the balance sheet
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Review what exactly the company does in the crypto space (investing in other companies, mining, asset management, exchange/trading, consulting, hardware, etc.)
For a risk tolerant investor, allocating a modest portion of their overall wealth (roughly 1% to 5%) to some higher quality stock/equity in the space along with a foundation in direct crypto assets (majority in BTC & ETH) can be a good strategy. When implemented correctly, this is a good way to get broad participation in the crypto ecosystem, limit the risk of a permanent loss of capital, while bringing an uncorrelated source of significant long-term returns into your traditional portfolio.
Eric Mancini, CFA, CFP, CAIA is the director of investment research and a wealth advisor with Traphagen CPAs & Wealth Advisors (www.tfgllc.com). Traphagen is an independent fee-only fiduciary RIA located in northern NJ.
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