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Surveying the wreckage: seven rules for the crypto comeback

The essential checklist for long-term crypto investors
Surveying the wreckage: seven rules for the crypto comeback
  • Crypto's latest violent sell-off a wake-up call for investors and regulators
  • Sensible long-term investors need a framework to follow

Maybe it is time the grown-ups take charge. The carnage in crypto markets gave a spanking to peddlers of trashy tokens and it should remind speculators in more sensible coins of the risks they take on.

Greater regulation, the threat of which sparked the sell-off, is the consequence of pain from such events being widely felt. It’s also the result of the decentralised currencies threatening to undermine central banks’ control of money supplies.

Therefore, in a sense, crypto assets are a victim of their own success and investors should welcome oversight of coins as a sign the best ones are here to stay. That said, picking the winners isn’t simple and enthusiasts should ask what can be learnt from the tumult of the past week.

 

1. Position management is the first line of defence

More episodes of extreme price volatility are highly probable, so rule number one for crypto investors is circumspect position management. You should never invest more than you can afford to lose, least of all in assets that can sometimes halve in value in quick time.

 

2. Do your own research, don’t blindly follow Elon Musk

He's a charismatic and successful individual but Tesla’s (TSLA) chief executive attracts a lot of noise. Trading on every tweet by Elon Musk and trying to divine his intentions as if he was, well…divine, is a sure-fire way to get burned. It’s almost akin to the idiot following acquired by Brian in Monty Python’s biblical satire.

Elon may be a very naughty boy, but he’s not the Messiah. He’s also the head of multi-billion-dollar corporation, so if there are lessons to be learned, they are from Tesla’s business decisions not Musk’s personal whimsy.

Tesla’s U-turn on accepting bitcoin as payment for electric vehicles is logical given it makes significant revenues trading carbon credits to other businesses. These could be the opportunity cost of losing its ‘green’ tag by holding bitcoin, which uses a lot of energy to mine (computers guzzle electricity solving the problems for which coins are reward).

Other businesses have different pressures and while Tesla’s decision damages bitcoin’s credibility as a medium of exchange, the store of value argument hasn’t gone away and asset managers may be less averse, especially given inflationary pressures. After all, other hedges such as gold use a lot of energy to mine in the old out-of-the-ground sense, too.

 

3. The environmental risk is real: diversify proof technology

Still, the emissions issue is serious. Especially as asset managers are also subject to environmental, social and governance (ESG) considerations, both when it comes to managing their clients’ money and how it affects the cost of capital for their own businesses. If bitcoin is bête noire for pressure groups that narrative could put many asset owners off.

Bitcoin is so energy intensive because of the computers needed to crack mathematical problems. It relies on a proof-of-work process which verifies these have been solved and records coins on the blockchain. Industrialised ‘hashing’ of coins ratchets up the carbon impact and is one of the reasons proof-of-stake technologies, which instead reward an upfront investment with transaction fees, have been adopted by other blockchains.

Proof-of-work versus proof-of-stake is complicated but it is worth checking which technology coins are based on, as the latter is far more environmentally sustainable. The Ethereum network (ether is the native coin) is transitioning to p-o-s but some of the emerging blockchain protocols such as Cardano (ADA) and Polkadot (DOT), are further along.

Other networks, like web storage service Filecoin (FIL), have their own bespoke proofs that don’t require energy intensive hashing for coins.

 

4. Find protocols with real world uses

Cardano is a protocol that has applications in making the web and e-commerce, and commerce in general, less corruptible. It lists retail, agriculture, healthcare and finance as industries where it can solve problems.

Polkadot similarly is a protocol for the management of data and online economic participation. It works across private and public blockchains enabling users to maintain ownership and control of their data and still verify their identity and credentials to engage in activity. Basically, you can buy something online and satisfy security criteria without giving companies all your data.

Filecoin enables pooling of spare storage capacity to create a decentralised alternative to the cloud computing services of big tech firms.

Very recently, the Dfinity project, launched Internet Computer (the coin of this protocol is ICP). This aims to provide a backbone to the next generation of the internet, allowing smart contracts that offer scale, speed, security and cost savings. The applications range from decentralised finance (DeFi) products such as banking and insurance solutions, to tokenised assets and payments.

 

5. Diversify, full-stop

Instantly, it’s noticeable that several of these protocols (and there are many more) have overlapping aims and they won’t all be winners. Thinking back to an early age of the internet, whatever happened to search engines like AskJeeves or Lycos?

One of the most important principles for investing is to spread risk. This means crypto investors shouldn’t just buy one coin, but a basket.

Even more important is spreading risk across all asset classes. In aggregate, the starting investment in crypto holdings should never be worth more than 2 or 3 per cent of overall portfolio value.

 

6. Embrace regulation and understand its evolution will cause bumps

It’s also important to understand that when blockchain protocols have real world uses, their value and the trade in their crypto tokens invites regulatory scrutiny. For example, the widely adopted Ripple payment protocol was subject to a lawsuit by America’s Securities and Exchanges Commission (SEC) because it argued its native token (XRP) was being used as a security and therefore should be regulated.

Investors should expect such events and they may be a problem for protocols as they become widely adopted and the tokens are more sought after. This is especially true when protocols operate in sensitive areas for central authorities.

Engagement between the providers of crypto investment products and regulators in the west should be viewed positively, however.

In the case of bitcoin, they help to preserve the case for its adoption and the digital gold argument. Grayscale Investments, the world’s largest crypto fund manager, has voluntarily submitted Form 10 filings with the SEC for a third product.

Grayscale’s digital large-cap fund (GDLC), which tracks a basket of leading cryptocurrencies, joins its bitcoin and Ethereum products in being subject to greater SEC oversight and reporting rules. This status is part of the roadmap to eventually offer these products as exchange traded funds (ETFs).

 

7. Pound cost average – valuation matters

As reported in the Financial Times, the extreme volatility of bitcoin sell-offs may yet spook approval of more crypto ETFs. Wild price oscillations are also the reason to take a slow and steady approach to building positions.

Since the sell-off, several coins have made sizeable gains, but they aren’t enough to make back all the losses. As this volatility is inherent in the asset class, there is a textbook argument for building positions with regular incremental deposits over time. Something known as dollar or pound cost averaging, depending on which fiat currency you deposit in.

Simply put, it would have been better to invest £50 before the crash and £50 afterwards, than one £100 before.

In the second instance, a 50 per cent fall followed by a 25 per cent rise would leave you holding £62.50 worth of crypto.

In the first instance the same market gyrations would leave you holding £87.50 worth.

Of course, it would be best to always invest after a crash on the way back, but you can’t time markets that well. It’s best to apply the pound cost averaging principle and make monthly top-ups to positions which is a better bet for mitigating volatility risk than large lumpy deposits.

 

Summary

Understandably, the recent spate of selling will put some investors off crypto. Certainly, nobody should be under the illusion that this is an easy route to riches. That said, perspective is needed when evaluating the latest sell-off and what caused it.

One question to ask is: why should China want to torpedo decentralised currencies?

Environmental consideration is one legitimate answer, but it would be naïve not to think control is a big motivation. China wants to ensure the e-renminbi, its central bank digital currency (CBDC), will be the dominant form of money.

Put another way, China’s contempt is a sincere form of flattery. Cryptocurrencies will be targeted by governments and regulators because of their success.

Furthermore, activities like launching and ramping meme coins and non-fungible tokens (NFTs) are crying out for oversight. Interventions that affect the whole crypto asset class will be provoked by dodgier market practices and participants.

While this will cause longer-term investors pain, they must accept it as part of the trade-off for exposure to something hugely exciting. Crucially, however, that exposure must be disciplined.

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