In light of the major correction presently occurring, the below is especially relevant. How can you make money and mitigate risk in cryptos even when the overall market is down?
One of the problems that I have been wrestling with recently is my belief that while blockchain technology and cryptocurrencies are certainly destined for the future, it is difficult to capitalize on that belief without incurring huge amounts of risk. The options for investment in the space are essentially limited to investing in individual coins and hoping that they survive whatever correction and market forces occur in the future. This strategy is flawed for a number of reasons. Because the industry is so young, investing in individual coins gives LESS exposure to the underlying market than it does to the risks associated with that individual coin. How can I gain exposure to blockchain and cryptocurrencies in general without exposing myself to undue risk associated with individual coins?
Let's imagine that we're back in the 1990s.
The internet is just reaching consumers for nascent commercial use. As an educated investor, I'm confident that the internet will be around in 10, 20, 50 years and I want to invest in it. I decide to invest in companies that having promising ideas. Flash forward 10 years. The dot com bubble has wiped out the majority of dot com wealth and a large portion of dot com companies. Maybe I was lucky and bought Amazon at under $2 per share. More likely, I was unlucky and bought Pets.com at $11 per share (or higher) and have nothing to show for it.
With that knowledge in mind, how could an investor in the 1990s (retrospectively) have invested in internet technology without directly investing in dot com companies?
Invest in companies that facilitate access to the internet. Think companies like HP, Dell, and other computer manufacturers that allowed users to access the internet and engage in commerce. Similar to the crypto market today, the increased number of nodes on the internet network made the internet exponentially more valuable.
Invest in companies building the infrastructure around the internet. This means telecom and hardware companies that were building the physical networks that allowed the internet to exist.
Not invest in anything and wait for the winners to emerge.
Let's bring it back to cryptocurrencies: I am confident that blockchain and cryptocurrencies will succeed and I want to invest in them. I am worried that by investing in individual cryptocurrencies, I am less investing in the ecosystem as much as I am in those individual coins or companies and at the same time incurring lots of other risks as well. You're investing in something that uses blockchain but is also relying on lots of other things to break the right way.
As a crypto investor I'm worried about two things:
How do I ensure that my investment does well when cryptos do well?
How do I ensure that my investment don't do poorly when cryptos do poorly?
I've come up with a few ideas that can help diversify your portfolio while still maintaining exposure to cryptocurrencies.
Platform coins are cryptos that allow other cryptos to be built through the use of their protocols. While they can be held as straight currencies, their main upside is their potential to host other coins and become the "internet" for cryptocurrencies. Having other coins built on their protocol conveys two major advantages:
Explicit commerce of the underlying asset. As more coins are built on the platform, demand for that platform increases.
Implicit recognition that this platform/coin is stable and reliable.
Ethereum (ETH) is not only a good store of value, but is also the gold standard for platform coins. Its smart contract functionality and protocolization of tokens has allowed it to become the basis for 60% of all new coins that are created. When new coins are launched, they often utilize ETH because its protocol provides trust and security for both investors and coin founders. This multifunctionality will ostensibly allow ETH to better weather corrections as well as providing further sources of investment and capital generation.
Cardano (ADA) is effectively an offshoot of ETH. It was created by Ethereum's former CEO. Much in the way that Litecoin attempts to improve on Bitcoin's functionality by taking what it does and iterating, Cardano attempts to improve on ETH by taking what it does and iterating. It builds upon the benefits of the ETH platform while improving aspects of scalability and sustainability. Prospectively, ADA remains a speculative purchase (like other cryptos) but has the potential to muscle in on some of the territory that ETH has carved for itself. If it manages to become a platform for other coins, for decentralized applications, and for smart contracts, ADA can become a major player in the crypto space.
Exchange coins are proprietary cryptocurrencies released by cryptocurrency exchanges that have differing utility depending on the service. Depending on the coin being held, investors gain two benefits:
- Lower trading fees on that platform
The problem with these coins is that they are entirely dependent on their exchange for value. If their exchange collapses, the proprietary coin disappears as well. While I consider this to be a major risk, I also consider exchanges to be inherently more stable than other crypto ventures because they have actual revenue generation not dependent on cryptocurrency technology (merely the trade of cryptos).
# coins held/#coins in circulation * fees generated through trades * % of fees shared to coinholders
- Dividends are distributed as fractions of coins being traded on that platform.
The promise of passive income just by holding a cryptocurrency is enticing. Realistically, however, the yield is quite small at just a few percentage points for each. Still, the ability to make money even when the market is losing value is an advantage and an opportunity for diversification (since even when the market is losing money, people are trading).
The other promising thing about these coins is that as the exchanges become more popular, the value of the coins should increase. This appreciate in value adds another source of value generation.
I prefer Coss over Kucoin for a number of reasons.
- Coss is based in Singapore while Kucoin is based in China. Thus far, Singapore has been much friendlier to cryptocurrencies while China has repeatedly limited them.
- Coss is integrating fiat exchange, essentially making them a competitor to Coinbase. This will increase the number of users, increase the trading fees being generated, and increase the price of Coss. As far as I can tell, Kucoin has no such aspirations.
- Kucoin seems interested in promoting giveaways and contests which always makes me feel uneasy.
- Binance offers another proprietary coin. Unlike Coss and Kucoin, however there is no dividend. The advantage of the Binance Coin (BNB) is that users trading on the Binance platform can decide to pay their trading fees with BNB and gain a 50% trading fee discount. As a platform, Binance is the third largest exchange by volume. Similar to Kucoin, it is based in China, but seems to have a more solid user base and foundation. As more users move to Binance to trade, the value of its coin should increase.
There are also several companies that maintain exposure to cryptocurrencies through the manufacture of mining hardware. They appeal to me because although they have cryptocurrency hardware as one stream of revenue, they are not completely reliant on that revenue stream to survive. The companies listed below have diverse clientele for their products but have benefitted from the cryptocurrency boom.
Cryptocurrency mining remains an integral aspect of cryptocurrencies that rely on Proof of Work. In short, miners validate transactions, ensuring that the party sending the currency is the true owner and that they have the amount of cryptocurrency that they are attempting to send. This process of validation is reliant on complex cryptographic mechanisms that require huge amounts of electricity and processing power. Different types of mining hardware are more efficient at solving this cryptographic proofs depending on the algorithms being used.
Generally, there are 2 categories: GPUs vs. ASICs.
- GPUs are used by coins like Ethereum and ZCash.
- ASICs are used for coins like Bitcoin and Litecoin
Taiwan Semiconductor (TSM) is a large Taiwanese company that produces chips for a number of different companies and applications. Its chips are found in cell phones, computers, and Bitcoin mining software. TSM is one of the largest foundries that produces ASIC mining hardware. ASICs are specially designed pieces of hardware that effectively solve the SHA256 cryptographic. In addition to producing ASICs, TSM also produces hardware for companies like Apple, Qualcomm, Nvidia, and AMD. In addition to its year over year revenue growth of 12% from 2015 to 2016, TSM also sports a 2.70% dividend yield.
Nvidia (NVDA) and AMD (AMD) are well known GPU manufacturers. Nvidia's 1080/1070/1060 series chips and AMD's RX580/570/560 series chips serve as the backbone for many GPU miners. While the chips were primarily designed for gaming and graphics processing, they've found an arguably larger market for miners. While neither Nvidia nor AMD are completely dependent on miners for demand, the proliferation of cryptos in general have driven up prices for both manufacturer's chip sets. Nvidia's stock price has doubled over the last year and maintains a dividend yield of 0.27%. AMD has seen its stock price increase by about 20% over the last year but does not provide a dividend.
Those hoping to reap the benefits of the cryptocurrency market but are afraid of the volatility have options. Each of the above mentioned avenues provide their own risks and potentials for upside, but none have the exact same exposure as a pure investment in Bitcoin. Holding some of the assets that I've mentioned can help mitigate the risk associated with store of value cryptocurrencies.
Interested in more?
- Bitcoin/Ethereum/Litecoin buying guide.
- General altcoin buying guide with instructions on how to buy the above mentioned coins.
- If you plan on buying a significant amount of BTC/ETH/LTC, I recommend that you properly secure your cryptoassets.
- See here for commonly asked questions regarding cryptocurrencies, Bitcoin, Ethereum, and Litecoin.
Disclosure: I am/we are long BITCOIN, ETHEREUM. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: I have no positions in Nvidia, AMD, TSM and have no plans to initiate a position in the next 72 hours.