From Bitcoin to Ethereum, Solana to Cardano, Polygon to Polkadot… cryptocurrencies are still top of mind for many investors. Whilst last year’s bull run appears to have cooled somewhat, interest in crypto remains high.
However, recent research has suggested that the majority of investors don’t have much of an understanding of these digital assets. Whilst this might seem normal – after all, who has time to read through all those white papers – investing in something you do not understand is a dangerous game. When done on a large scale, this can lead to bubbles – which, as we know, will inevitably pop at some point.
In this article, I will examine the crypto market to help you make a more informed decision before you commit your hard-earned cash.
On the radar, but not understood
The crypto market has exploded in recent years. In fact, by October 2021, 11.2% of the world owned a cryptoasset. At the end of the year, that had increased 15.5%. However, the Financial Conduct Authority in the UK concluded that, whilst awareness and appetite was high, fundamental understanding of cryptocurrency remained low.
Understanding your assets is essential when committing to an investment. With that in mind, let’s break down what we mean when we refer to cryptocurrency.
What is a cryptocurrency?
Cryptocurrencies are of digital currencies. They use encryption techniques as a security measure. These techniques are rooted in cryptography – hence the term cryptocurrency.
Like traditional money, or fiat currency, cryptoassets can be used as a payment method when purchasing goods and services. For now, this is broadly limited to online payments. You can also invest in cryptocurrency as a speculative asset, in the same way that you might invest in a foreign currency. However, as these assets pay no dividend and do not offer tangible value (they are not asset backed, as would be the case with stocks and property, for example), the investment case can often be a peculiar one.
Cryptocurrency only exists virtually. There are no physical coins, and tokens are held exclusively in digital wallets. Crypto is also decentralised, which means that it operates independently from any government or central bank. Enthusiasts are quick to point out that the elimination of banks can only be a positive for the end consumer – whether or not this is true remains to be seen.
How does it work?
Cryptocurrencies are bought and sold on exchanges, much like stocks and ETFs. They are stored on hot wallets (digital wallets that are connected to the internet, and therefore hackable) and cold wallets (offline storage devices such as a USB drive).
The payment mechanism is a peer-to-peer exchange. Cryptocurrency is transferred digitally from one person’s online wallet to another’s. The transaction is recorded on the blockchain, which is essentially a secure ledger of all transactions that occur on a given network. Bitcoin and Ethereum transactions, for example, occur on separate blockchains as they are tied to separate networks.
Investing in cryptocurrency
Whilst there are over 12,000 cryptocurrency tokens being traded today, just 20 of these make up around 90% of the market. In spite of this, all cryptocurrencies should be viewed as extremely risky assets. The value of tokens is infamously volatile, leading to the creation and destruction of wealth in very short periods of time.
Investors should also be aware that the attraction of cryptocurrency – it’s independence – also contributes to its risk. As an decentralised asset, it is unregulated. This means that no consumer protection measures exist if things go wrong.
Because it is decentralised, crypto is largely unregulated by bodies such as the Financial Conduct Authority (FCA). This means that if something goes wrong, you don’t have the same level of protection as you would with a regulated product. With the prevalence of crytpo hacks and cyber attacks, this can be daunting in itself.
It is worth bearing in mind that cryptocurrency is still in its infancy as an asset class. Valutations are yet to normalise, and regulatory bodies are yet to include them in their approach. Will this change in future? Time, as with all new developments, will tell.
Are you missing out on tax planning or investment opportunities?
I am currently offering a free financial review to new clients. Click the button below to book your session.
