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Investing in Cryptocurrencies

Cryptocurrencies are digital currencies that are secured by cryptography as a decentralised form of payment. They are created using a complex system of encryption algorithms.

Although there has been plenty written about cryptocurrencies over the past few years, some of the fear behind cryptos comes from a lack of understanding. They really can be quite tough to get your head around. So, we will try and make some sense of it all for you.

We will delve in to explaining what cryptocurrencies are and the blockchain technology behind them. We will look at how to trade them and what moves the prices, before looking at some of the risks and benefits too. There’s plenty to get through, so let’s have a look.

cryptocurrencies

What are cryptocurrencies?

Cryptocurrencies are a mostly digital currency and form of exchange, that uses cryptography (such as blockchain technology) for security. They are used as a means of payment but also a virtual currency and form of investment too.

Cryptocurrencies are increasingly popular. According to the FCA (Financial Conduct Authority), ownership in the UK has increased from 1.9m in 2020 to around 2.3m in 2021. However, the same study suggested that the level of understanding of what people were buying into was on the decline.

Interestingly also, the attitude towards crypto as an investment is shifting. People are increasingly using crypto investments and seeing it as an investment risk as a complement or alternative to mainstream investments. The number of people seeing cryptocurrencies as “a gamble” has reduced from 47% to 38%.

What cryptocurrencies can you buy?

The growth in the number of cryptocurrencies has been astounding. According to the statistics website, Statista, from just over 500 in 2014, it reached just over 10,000 at the peak in February 2022. Currently (early 2023) there are almost 8700 cryptocurrencies worldwide.

Here are the top ten cryptocurrencies that are available, measured by market capitalisation (according to coinmarketcap.com February 2023).

CodeNameMarket CapCirculating supply
    
BTCBitcoin$417bn19.3m (of 21 million max supply)
ETHEthereum$182bn122.4m
USDTThether$68bn68.4bn
BNBBNB$46bn157.9m (of 200m max)
USDCUSD Coin$41bn41.1bn
XRPXRP$19bn50.8bn (of 100bn max)
BUSDBinance$16bn16.1bn
ADACardano$12bn34.6bn (of 45bn max)
DOGEDogecoin$11bn132.7bn
MATICPolygon$10bn8.7bn (of 10bn max)

Volatility and regulation

Put simply, cryptocurrencies are extremely volatile. According to the FCA website, pretty much the first line on the whole crypto market says:

“Cryptoassets are considered very high risk, speculative investments”

The huge fluctuations in the prices of cryptocurrencies such as Bitcoin and Ethereum since September 2020 are a testament to the significant swings in price that can be seen on most crypto exchanges now. The FCA does not regulate cryptocurrencies and there is no access to the FCA’s Financial Ombudsman Service or the FSCS compensation scheme if you lose all your money trading crypto.

Elsewhere, cryptocurrencies have been given a mixed reaction. In April 2021, Turkey banned cryptocurrencies as a form of payment, causing a sharp decline in the price of Bitcoin. Whereas in El Salvador, Bitcoin is legal tender, Bitcoin City is under construction and the president trades Bitcoin with government funds.

Blockchain technology

Blockchain technology

A blockchain is a shared database that is a digital store of information. They and distributed ledger technology are used for maintaining a secure and decentralised record of transactions. Blockchain is vital to the existence of cryptocurrencies such as Bitcoin.

For cryptocurrencies, the blockchain is a series of blocks (transactions) that are linked together to form an unbreakable chronological chain. For every transaction that is undertaken to either buy cryptocurrency or sell cryptocurrency itself, the information is transmitted to a network of peer-to-peer computers (rather than just one central server). These then confirm the transaction which after verification process is placed in a ledger in a series of blocks. The blocks are chained together as a record of the transaction.

Whilst cryptocurrency owners are anonymous, blockchain technology means that the record of the transactions cannot be deleted and is therefore transparent.  

How do I trade in cryptocurrencies?

There are several ways to get exposed to trading commodities. Let’s look at how.

Crypto exchanges and holding a crypto wallet  

Joining a crypto exchange and having a crypto wallet is the classic way of owning cryptocurrencies. Popular cryptocurrency exchanges now include Binance and Coinbase. According to the own research by the FCA, around three-quarters of people in Britain that had bought cryptocurrency had done so via an online cryptocurrency exchange.

However, this method to invest in cryptocurrency and exchange is certainly not without its risk. Cybersecurity and hacking can be an issue in crypto ecosystem, whilst the scandal of the FTX fraud will have certainly rocked some people’s confidence to invest in cryptocurrency and digital cash.

Using a broker

You can also use a broker to trade cryptocurrency. Brokers such as eToro offer non-leveraged cryptocurrency investments. You can own cryptocurrencies just in the same way that you can own shares. Other brokers offer cryptocurrency CFDs (Contracts For Difference).

However, the increased risk of trading on margin for an already high-risk asset class has led to banking regulators placing restrictions on active trading of cryptocurrency CFDs for traders in some jurisdictions investing in cryptocurrency itself. For example, in January 2021, the UK’s FCA banned UK retail traders from trading cryptocurrency derivatives. Professional traders can still trade them though.

Crypto funds

Investing in individual cryptocurrencies can be a risky business as they come with huge volatility. This has led to the emergence of cryptocurrency Exchange Traded Funds (ETFs). A crypto ETF is invested in a variety of digital assets, that are linked to cryptocurrencies and blockchains.

There are several index funds to choose from. They tend to invest but not just invest in cryptocurrency systems or just invest in cryptocurrencies. They can focus on investing on Bitcoin mining stocks, Bitcoin futures, blockchain technology companies, and cryptocurrency exchanges. The ETFs they invest in do however often come with a hefty expense ratio (at least compared to other crypto ETFs), so be careful to investigate the details before investing them.

What moves cryptocurrency prices?

Cryptocurrencies are similar to other assets and investments. They can be impacted by supply and demand. Here are a few factors that drive price moves:

  1. Supply – the number of coins in existence can move the price. Cryptocurrencies are seen as being in finite supply. The rate at which more is released (Bitcoins for example are mined) into supply impact how the price moves.
  2. Sentiment – Market reaction to significant fundamental events, security issues, but also broad risk appetite will impact the price.
  3. Reputation – reputation can be important in an asset class that is notorious for producing bogus investments. Media coverage will certainly play a role here too.
  4. Use – How well cryptocurrencies are integrated into the global financial system will be key. The price of Bitcoin fell after Turkey banned cryptocurrencies as a payment option. However, if more countries allow cryptocurrencies as legal tender, then their prices will react positively.

The risks of trading cryptocurrencies

Exchange and cyber risk

The due diligence on the crypto exchange (the place where you exchange traded funds you hold your wallet with cryptocurrencies) can be a significant risk. There has been a lot of bad press surrounding the scams and this has certainly not been helped by the downfall of FTX one of the big and popular crypto exchanges around.

In essence, FTX fell like a house of cards as it supposedly used its valuation (made up by themselves) of its proprietary trading and crypto assets as re-tokens to use as collateral for its business. That, and also there reportedly being a serious lack of ringfencing of client accounts.

The trouble with buying crypto, is you may not know trustworthy your wallet is until it is too late. The very nature of cryptocurrencies leaves them highly susceptible to cybercrime and hackers. Perhaps this is one of the reasons why many investors and retail traders turn to financial brokers, most exchanges such as eToro, to trade crypto.

Lack of regulation

The world of cryptocurrencies can be a little like the Wild West. The decentralised largely unregulated nature of cryptos means there is very little oversight of the industry. It also means any investor protection is absent if your crypto wallet gets hacked.

Volatility

There can be huge volatility in how the prices of cryptocurrencies move. This can be positive and negative, but if you get caught on the wrong side it can cause extremely quick and painful damage to your other crypto assets and holdings too.

The volatility of the cryptocurrency market is one of the key arguments behind why it will be very difficult for cryptos to be a realistic payment function alternative to cash. In foreign exchange, a 1% or 2% move in a day is a huge swing in the valuation of a currency. Cryptocurrencies can often fluctuate over 10% per day.

There are some benefits too

Some benefits come from aspects of owning crypto investing in cryptocurrencies for financial health investment platform transaction purposes. Benefits, such as the privacy of private keys and information, the security of transfer of digital assets, the speed of settlement and the lack risk averse and of overbearing central authority and governance of cryptocurrency exchanges are all cited.

However, here are some benefits of buying cryptocurrency as investments:

Add volatility to a defensive portfolio

Volatility can also work in your favour. A portfolio that is skewed on the defensive side can have a dose of volatility injected in through cryptocurrency investments.

An inflation hedge

Cryptocurrencies such as Bitcoin are finite. There will only ever be 21 million Bitcoin in existence. Whereas, fiat money is seemingly in limitless supply, with central banks able to print as much as they like. This gives cryptocurrencies an inherent advantage. Basic economics would suggest that an increase in demand for a finite resource will increase its value. This is the argument to justify how Bitcoin enthusiasts arrive at such lofty potential valuations.

How to Safeguard Your Cryptocurrency

When we mention “send it to your wallet,” we are not referring to putting your Bitcoin into a physical wallet. To securely store your cryptocurrency, you need a cryptocurrency wallet that houses the code representing your cryptocurrency portfolio. There are two types of wallets available: software wallets and hardware wallets.

Software wallets are essential for active cryptocurrency trading as they provide easier access to your virtual currency. For instance, if you have a Coinbase account and purchase bitcoin here, you automatically receive a Coinbase software wallet.

On the other hand, hardware wallets are physical devices, resembling USB drives, and offer higher security compared to software wallets. These wallets are suitable good investment, for holding cryptocurrencies that you do not anticipate needing frequent or easy access to. Think of a cash app or a software wallet as a brokerage account or a checking account, while the hardware wallet serves as your savings account.

What is the recommended amount to invest in cryptocurrency

What is the recommended amount to invest in cryptocurrency?

Some experts suggest that investing in cryptocurrency is only a small fraction, typically ranging from 1% to 5%, of your net worth. When deciding how much of your diversified portfolio to allocate to crypto investments or to start investing in cryptocurrency, Feldman emphasizes the importance of limiting overall exposure and never, investing in cryptocurrency for more than you can afford to lose. While a small crypto exposure may enhance the risk-adjusted returns of a diversified portfolio, the precise investment amount should be determined based on your overall investment portfolio and risk tolerance.

Furthermore, it’s crucial to diversify good investment amount within the crypto market. The specific crypto coins and digital assets that you hold are significant factors to consider. Certain coins with promising long-term use cases and lower susceptibility to price manipulation may be preferred. Although the crypto market is known for high volatility, larger, more liquid cryptocurrencies tend to carry less risk compared to smaller, speculative ones. However, even the most established cryptos exhibit substantial price swings. Therefore, the mix of cryptocurrencies in your portfolio is essential to consider along with the overall investment amount.

At Stash, the recommendation is to limit exposure to any single crypto asset to no more than 2% of your overall portfolio to mitigate crypto-specific risks.

Is Cryptocurrency a viable investment option

After gaining a comprehensive understanding of cryptocurrency investing, you might be contemplating whether it’s a good investment choice to start by investing in cryptocurrency. However you start cryptocurrency investing, it’s essential to acknowledge that cryptocurrency investing is a high-risk asset, as mentioned earlier, due to its inherent volatility.

Consider this hypothetical situation involving the purchase cryptocurrency Bitcoin: You purchase a few units of Bitcoin, and suddenly, various factors lead to a surge in demand for the cryptocurrency:

Endorsements: Prominent public figures or business leaders endorse Bitcoin, attracting a larger number of investors.

Press Coverage: Bitcoin gains significant attention through movies, articles, or journalistic pieces, resulting in increased purchases.

Manipulation: Stock manipulators acquire a substantial number of Bitcoin units and persuade or coerce amateur investors to follow suit.

As a result, the value of each crypto unit experiences a sharp increase. However, it’s crucial to remember that cryptocurrencies can also experience rapid declines in value as quickly as they rise.

If you manage to sell your units at the peak of demand, you stand a chance to make substantial returns on your investment, similar to what stock manipulators often do. They capitalize on the high demand and sell their units at a significant profit.

Yet, it’s incredibly challenging to accurately time the sale of your cryptocurrency holdings. Timing the stock market alone is difficult, and doing so in a highly volatile market like cryptocurrency is even more daunting. The value of cryptocurrency can plummet dramatically within a few days or even hours. If you fail to sell your units before demand cools down, you and other traders could face significant losses on crypto holdings as their value nosedives.

However, savvy investors who buy cryptocurrency and are willing to embrace the risks may potentially earn substantial profits and buy cryptocurrency now. They need to closely monitor the cryptocurrency market and act swiftly when witnessing a surge in demand for the digital currency to buy crypto, and assets.

Nevertheless, it’s essential to reiterate that buying cryptocurrency should not serve as the foundation of your investment strategy. Prioritize low-risk investments, such as bonds and rental properties, as a starting point. Consider medium-risk investments, such as stocks or fix-and-flip properties, after that. Cryptocurrency, being a high-risk option, should only form a smaller portion of your investment portfolio.

As with investing strategy for any other investment, high-risk, investment decision, it’s prudent to invest in cryptocurrency only to generate a passive income that can absorb any capital gains tax potential losses you might incur from investing in cryptocurrency.

Cryptocurrency Investing Takeaways

There is much to think about if you are looking to invest in cryptocurrencies. As the FCA goes out of its way to highlight, they are an incredibly risky form of investment. However, they are also increasingly popular, and their acceptance many investors suggests that they are set to be a growing presence in portfolios for retail investors for years to come.

If you are interested, we suggest doing your due diligence. The lack of regulation means there are a lot of dud crypto assets that could lose all your investment. However, as with any other higher-risk asset, the returns can be significant too. 



Michael Griffiths has recently graduated with an Upper Second-Class Honours degree from Churchill College, University of Cambridge, where he read Economics and Specialised in Mathematical Economics an... Continued