What is Cryptocurrency?

By: Gridline Team | Published: 10/07/2021
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Est. Reading Time:
6 minutes

Cryptocurrencies are digital currencies on the blockchain, a relatively new computing paradigm that enables decentralized applications.

In other words, cryptocurrencies do not use centralized middlemen like banks to secure and verify transactions. Instead, they’re powered by a form of distributed cryptography.

The Growth of Cryptocurrency

A decade ago, crypto was a tiny niche, limited largely to the cyberpunk crowd and other small corners of the Internet. Times have changed, as a whopping 90% of institutional investors plan to enter the crypto market by 2026. Retail investors are also moving to crypto, with nearly one-fifth of America’s adult population already owning crypto.

Warren Buffett, one of the greatest investors of all time, has famously derided crypto, calling it a delusion and a mirage. Notably, his recent $500 million investment in one of the world’s largest pro-Bitcoin banks, Nubank, is part of a greater shift in positive sentiment towards crypto.

The crypto market is currently worth over $2 trillion. For comparison’s sake, there are $10 trillion of alternative assets under management.

Why Invest in Cryptocurrency?

In short, crypto is now a significant, unavoidable alternative asset class. Bitcoin is the best-performing asset of the last decade. For investors seeking alpha, there’s no better place to look.

For investors seeking portfolio diversification, cryptocurrency is also a powerful tool. While Bitcoin’s correlation to traditional asset classes is higher than it once was, there are over 11,000 cryptocurrencies, many of which remain de-coupled from traditional asset movements. 

For example, one analysis showed that ATOM, LINK, and XTZ, particularly, served as attractive assets to purchase whenever bearish sentiments in Bitcoin were high.

Types of Cryptocurrency Investments

As the very first cryptocurrency, Bitcoin remains the most dominant crypto investment. There are many other crypto investment strategies besides just buying and holding Bitcoin. For one, Ether (the cryptocurrency powering the Ethereum blockchain) is a close second, making up around 20% of crypto’s market capitalization as of writing.

Ethereum also powers many other categories within crypto, such as security tokens, decentralized finance, staking tokens, and non-fungible tokens. Let’s dive into each of these in detail.

Security Tokens

Tokenized securities are an alternative investment class that can expose investors to equity, debt investments, and even tangible assets like wine or sportscars. The security token industry is still relatively small and expected to reach $3 billion by 2025.

Security tokens are particularly attractive to institutional investors due to their regulatory clarity and reduced counterparty risk relative to traditional cryptocurrency investments. Security tokens also provide several benefits over traditional securities, including lower regulatory compliance costs, barriers, and increased liquidity.

Security token offerings (STOs) are subject to far fewer regulations than their IPO counterparts in the public equity markets. There is also no need for an ongoing regulatory reporting burden since detailed disclosures are not required like for IPOs, where companies must continue to file quarterly and annual reports for decades after going public.

Decentralized Finance (DeFi)

Decentralized finance focuses on the use cases of blockchain in financial services. The industry has matured significantly in the last couple of years, and DeFi has rapidly grown from obscurity to a $100-billion-plus industry.

Blockchain provides a foundation for decentralized finance by allowing peer-to-peer transactions without needing a middleman such as a bank or a brokerage firm. This technology allows users to transact directly with each other through smart contracts without going through an intermediary, providing more security and transparency than traditional banking models. 

The distributed ledger also ensures that all information is stored publicly, creating an immutable audit trail that cannot be tampered with retroactively. In addition, blockchain networks are permissionless, which means they do not require third parties to approve transactions before they can be completed. Crucially, investors retain custody of their funds instead of handing them over to a centralized entity.

Alternative investors seek out DeFi primarily for superior returns. In DeFi, double-digit APRs are fairly common, and this is at a time when the average interest rate for savings accounts is less than one-tenth of a percent.

Popular DeFi investment opportunities include Uniswap, Chainlink, and Aave.

Uniswap is a DeFi protocol used to exchange cryptocurrencies directly between peers (instead of through an exchange’s servers). As of writing, Uniswap’s native UNI token has grown 800% in the past year.

Chainlink is a decentralized oracle network that lets blockchain applications communicate with the outside world. Their native token, LINK, has, like most cryptos, experienced wild fluctuations but started at around $0.15 in 2017 and now sits orders of magnitude above that price.

Aave is a plug-and-play liquidity protocol that offers much more stable returns. You can earn healthy APRs by depositing crypto, as shown on their marketplace.

Index Products

One fast-growing DeFi investment area is index products. These are baskets of cryptotokens that provide a diversified portfolio through a single token.

Additionally, many DeFi index products have income streams on multiple levels. Besides the price appreciation of underlying tokens, index funds can earn trading fees as liquidity providers and gain yield farming incentives.

Options include the DAO Stonks Vault and the BED Index. The former offers access to a tokenized basket of FAANG stocks, while the latter is a market index composed of Bitcoin, Ethereum, and DPI in equal weights.

Staking Tokens

Staking is a process by which holders of a cryptocurrency “lock” their tokens to receive block rewards on a schedule determined by the Proof-of-Stake (PoS) protocol. 

The idea of PoS came from Scott Nadal and Sunny King, who released the first PoS system, Peercoin, in 2012. An adjusted version of PoS, called Delegated Proof of Stake (DPoS), is more commonly used today.

There are two main benefits associated with staking:

  1. Passive Income: If you're holding tokens long enough without selling them, then you start accruing interest payments automatically
  2. Asset Protection: Holding onto assets provides another layer of defense against market volatility since if markets go south, then there's still value locked up in those assets

Many cryptocurrencies can be staked for variable rewards, such as Tezos (XTZ), Cosmos (ATOM), and Ethereum (ETH).

Tezos

Tezos staking is a way for Tezos holders to earn interest in their holdings. This can be thought of as passive income, and it's an important source of funding and liquidity for the network.

Staking rewards are distributed at periodic intervals; depending on the block height, they may be distributed weekly or monthly. The more tokens you hold, the higher your chance of earning a reward at any given time. When staking, you will earn interest on your balances and any fees paid out from the network (for example, for creating new blocks).

Cosmos

Cosmos uses Proof-of-Stake (PoS) consensus for its mainnet instead of Proof-of-Work (PoW), which requires miners to solve complex algorithms to validate transaction blocks on the chain. 

PoS requires no mining hardware or energy consumption, and validators can stake their tokens to perform operations on the network, such as creating new blocks or adding transactions – all at zero cost.

Ledger reports that staking Cosmos yields an average of 8-10% returns, and assets can be withdrawn from staking after a 21-day waiting period.

Ethereum

As one of the oldest cryptocurrencies, many people are already staking Ether. Therefore, potential returns are diminished.

Non-Fungible Tokens (NFTs)

NFTs are a digital representation of unique items such as art, trading cards, virtual land, or anything that cannot be replicated or cloned. In short, they are the digital equivalent of collectibles.

To understand how NFTs work, it’s important to understand the difference between fungible and non-fungible assets. Fungible assets have the same value across different units (e.g., one ounce of gold equals the value of any other ounce of gold). 

By contrast, non-fungible assets have their value determined by characteristics that cannot be precisely duplicated (such as an original Andy Warhol print). Non-fungible tokens commonly include game-style avatars—such as in the case of Cryptokitties, which allows users to buy and trade digital cats on Ethereum using ERC-721 tokens. 

The most valuable part about these tokens was not their intrinsic value but rather their scarcity. Since there could only ever be one of any given Cryptokitty, demand for them skyrocketed as collectors sought to own one of these rare creatures.

The main way you can get exposure to this new asset class is by buying NFTs. 

Reuters reports that NFT sale volume in the first half of 2020 was just $13.7 million. In 2021, there was $24.9 billion in total sales. This includes a digital image selling at Christie’s for $69 million, a “CryptoPunk” selling for nearly $12 million at Sotheby’s, and “digital ape” NFTs with over $61 million in sales volume. 2022 YTD, trading volume fell to a 12-month low at just over $1 billion as the bear market continues.

Takeaways

Cryptocurrency is the highest-performing alternative investment class, pulling retail and institutional investors into the market.

With over ten thousand cryptocurrency investment opportunities to choose from, due diligence is crucial. Total or near-total loss of capital is more common in crypto than in any other investment class, making the research process more important than ever.

At Gridline, we provide an institutional-grade marketplace to search for investment opportunities and build an optimized portfolio while we handle the back-office work.

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