Hardly any other asset class has grown as rapidly in recent years as cryptocurrencies and blockchain technology. In the first half of 2021 alone, 548 deals were transacted in venture capital, mergers & acquisitions and private equity, adding up to an investment volume of 8.7 billion euros(KPMG International). While the growth in institutional investments is thus over 100% year-on-year, investing in cryptoassets is also becoming increasingly interesting for private investors. In 2021, general interest in cryptocurrencies has surged, largely due to so-called “meme coins” such as Dogecoin and Shiba Inu, as well as an explosion in NFTs (non-fungible tokens) driven by well-known personalities such as Paris Hilton, Snoop Dogg, and Elon Musk. The emerging DeFi (Decentralized Finance) sector and the exploration of use cases in it by major financial institutions such as Paypal, Visa, and Square have also led to increased adoption of cryptocurrencies. Blockchain company Huobi surveyed 3,100 U.S. residents in mid-December 2021 regarding their views on cryptocurrencies, and a full 68% of respondents said they had invested in crypto within the last twelve months. Despite making a big splash in 2021, crypto has not yet managed to assert itself in the mainstream. The aforementioned study cites regulatory and security concerns, as well as a general lack of knowledge about the emerging blockchain sector, as potential hurdles to establishing crypto assets as a mainstream asset class.
What is blockchain technology? A short introduction
The cornerstone of blockchain technology was laid in 1991 by researchers Stuart Haber and W. Scott Stornetta, when they developed technology to time-stamp digital documents, making it impossible to backdate them or manipulate them after the fact. It was not until 2009 that this technology was given a practical application by the inventor of the digital currency Bitcoin, Satoshi Nakamoto. A blockchain is a decentralized database or ledger operated by the nodes of a network of computers. The information of the database is stored in so-called blocks and when the data capacity of a block is reached, it is closed and linked to the previous block with a so-called “hash”, creating a chain of data. So, as the name suggests, the blockchain is a chain of blocks.
A block essentially consists of three components: The stored data, an individual hash and the hash of the previous block.
Various types of information can be stored in the blocks. In the case of Bitcoin, it is information about the transactions in the decentralized ledger (ledger), such as the timestamp, the version of the cryptocurrency being used, and the hash of the previous block. A hash is a kind of digital fingerprint of the block and is calculated by a hash function. The hash function uses complex mathematical algorithms that allow the conversion of data of any length into fixed length data (in characters). If even one bit in the original data changes, the entire hash value changes. For this reason, it is suitable for verifying the authenticity of digital files. In addition, the decentralization of the ledger plays a crucial role in ensuring tamper resistance in the calculation of the hash.
The blockchain consists of a so-called peer to peer network: this means there is no central authority to manage the chain, but a network of participants who receive a copy of the complete blockchain and verify its transactions. Within this network, there must be a consensus regarding the global status of the blockchain. The consensus algorithm ensures that at least 51% of the nodes in the network agree on the next global state of the network. This ensures that each new block added to the blockchain is the only original version agreed upon by all nodes on the blockchain.
The linking of the blocks, the calculation of the hash in conjunction with the use of the consensus algorithm (in the case of Bitcoin Proof of Work) thus ensures a high level of security against manipulation of the data sitting in these blocks. That blockchain technology conceptually provides (in part with other consensus algorithms) the basis of the use cases of the various crypto assets, which I discuss in more detail in the following part of the article.
Common investment opportunities for retail investors in crypto assets
In the following, I will introduce you to some of the common investment opportunities in crypto assets. I deliberately do not deal with financial instruments such as derivatives (futures contracts, options, etc.), as these are mMn. a little “out of scope” for the private investor.
A cryptocurrency is a digital currency protected by cryptography. Many cryptocurrencies are built as decentralized networks based on blockchain technology. This combination makes it almost impossible to manipulate transactions. Cryptocurrencies are still rarely used as a means of payment in everyday transactions, but rather for remittances in an international context due to their fast transfers. Cryptocurrencies are predominantly popular as financial instruments.
What is the difference between Coin and Token?
The difference between a coin and a token is that the coin resides on its own blockchain, whereas the token uses an existing blockchain of a coin (such as Bitcoin) for its transactions. In addition, coins are considered digital currency, while tokens can take on various functions within an ecosystem.
Tokens can be divided into two categories: Security Tokens and Utility Tokens. Security tokens represent real physical assets, comparable to shares in a company, while utility tokens are created to provide token holders with access to services provided by the project once it is launched. Tokens are used, for example, in the context of ownership rights: In the case of non-fungible tokens, or NFTs for short.
What are NFTs (Non-Fungible Tokens)?
NFTs are unique digital assets. These are located on various blockchains (e.g. Ethereum, Solanda or Cardano) and can be traded there. NFTs were created to track ownership of digital assets, such as digital art, music, or even a piece of land in the metaverse. The use of NFTs is really quite versatile and could really find application in any form of digital unique asset. However, the difference with mainstream cryptocurrencies is that NFTs are not interchangeable, but unique. A bitcoin is, for example. interchangeable. If you were to exchange one bitcoin for another, you would get exactly the same unit back. NFTs, on the other hand, can be better compared to a one-time trading card or concert ticket: These are not interchangeable due to their personalization or unique attributes. NFTs are considered a large growth market in the blockchain space: the NFT sector generated $10.67 billion in trading volume in Q3 of 2021 (see Herrera, 2021). This is an increase of 704% compared to the previous quarter. As of January 15, 2022 alone, the global cumulative 30-day sales value with NFTs in the art sector was approximately $150 million (see Statista, 2022).
The officially most expensive NFT artwork “The Merge” by artist Pak was sold on December 2021 to 30,000 collectors who pooled for the total price of $91.8 million. The most popular trading exchanges for NFTs right now are Binance, OpenSea, FTX, and SuperRare, to name a few.
Staking is another way for crypto investors to earn returns. However, this possibility only arises with cryptocurrencies that use the so-called proof of stake consensus mechanism for validating transactions.
Staking allows the investor to operate its own validation node. When a block of transactions is ready to be processed, the cryptocurrency’s proof-of-stake protocol chooses a validation node to verify the block. Here, the more cryptocurrency the validation node has previously used as a stake, the higher the chance that it will be selected to validate the block. If the validation is successful and a new block is created, the protocol distributes a reward for the validation. The reward, which is made up of the block’s transaction fees, is divided among the stakes in the pool (proportional to the amount staked) and is designed to keep the blockchain decentralized and running. At first, this sounds more complicated than it is: As a rule, the investor who holds a cryptocurrency, such as Cardano (ADA) in his wallet must select a so-called stakepool to which he wants to make his cryptocurrency available for staking. After delegating the wallet to the staking pool and passing some time, the distributed reward just needs to be requested and you will receive the staking reward into your wallet. Basically like “interest” for blockchain nerds. 😉
Crowd-funding: ICO (Initial Coin Offering), IDO (Initial Dex Offering), ISPO (Initial Stake Pool Offering).
ICOs (Initial Coin Offerings) are conducted to provide seed capital to a crypto project through crowd funding. Participants in the ICO will receive a portion of the project’s tokens for their investment. In doing so, the crypto company is free to choose the token type for crowd-funding. An ICO in the form of a STO (Security Token Offering) lends itself to this type of fundraising due to the visible economic value of the security tokens, while utility tokens are easier to define in terms of functionality compared to security tokens. In the so-called IDO (Initial Dex Offering), the tokens of the company to be financed are provided directly via an exchange, such as Uniswap or Pancakeswap. A technically modified form of the ICO is the so-called ISPO (Initial Stake Pool Offering). This type of crowd-funding was introduced on the Cardano Blockchain and is considered a safe method, as here investors keep their cryptocurrency and only provide it for staking in the stakepools,. For this provision, investors will then share in the reward of the stake pool in the form of the project’s tokens. Thus, when staking, you forgo the regular staking bonuses (e.g. Ada) and receive the project’s token in exchange.
Why haven’t crypto investments hit the mainstream yet?
Crypto assets are far from having arrived in the German mainstream: In the study conducted by the software portal Capterra (a total of 7,890 survey participants, 1012 of them from Germany), only 16% of German survey participants stated that they own or have owned cryptocurrencies. A study conducted by Deutsche Bank with over 3,600 respondents from different countries (China, Italy, France, Germany, the U.S., and the U.K.) revealed various barriers to switching from cash to cryptocurrencies (see Laboure et al., 2020): Older respondents in particular (55 years and older) found cryptocurrencies difficult to understand, believed they led to volatile financial bubbles (like the dotcom bust), and saw them as financial instruments with low liquidity. However, even among the younger participants in the study (age groups 18-34 and 35-54), over 45% agreed with the statement that cryptocurrencies were difficult to understand. Also, over 45%- 60% (depending on age group) of respondents agreed with the statement that cryptocurrencies are volatile.
Knowledge of crypto assets also played a role in the study conducted by Capterra: 38% of crypto investors and respondents with investment intentions said they invested in crypto during the pandemic because they took time to research. In addition, 62% of respondents were concerned that cryptocurrencies would be used for illegal purposes. In the 2022 Crypto Perception Report conducted by Huobi, more than 40% of respondents said they had little or no knowledge of cryptocurrencies, while 28% said they had some knowledge. The biggest concerns expressed by respondents in this study about investing in cryptocurrencies were the lack of knowledge (52%), the lack of regulation of crypto markets (34%), and the high risk associated with crypto investments (42%) .
So, in summary, the hurdles of lack of knowledge, risk, and volatility of cryptocurrencies, as well as concerns due to criminal activity and lack of regulation, can be concluded from the consumer research studied. Of course, it is also interesting to observe that the respondents of the studies apparently did not express any concerns regarding ecological factors or that this aspect was not addressed in the studies…
Disclaimer: This article does not constitute advice in the sense of investment recommendations, but is intended for information purposes only. Do your own research and seek the advice of a professional if necessary.