When we talk about investing in cryptocurrencies like Bitcoin, many concepts come to mind. Among them, volatility, exchanges, etc., and we trust that the benefits will outweigh the risks. In this regard, authorities such as the CNMV and the BdE warned of the risks of investing in Bitcoin, due to the strong revaluations experienced. In order to make the best possible decision, any investor must be aware of all possible alternatives.
On the other hand, cryptocurrencies have meant the leap to popularity of distributed databases. So much so that it is considered a revolutionary technology like the internet was in its day. However, it should be noted that although cryptocurrencies were created in the environment of distributed databases, investing in them does not mean investing in DLT. Investing in this technology as such is not possible, as it is not a product that can be marketed. It is rather a means to an end (as can also be Internet or Agile methodology).
Undoubtedly, the success of cryptocurrencies can be attributed in large part to distributed databases, as the underlying technology. Therefore, those investors who have decided to bet on this technology will surely think about doing so through cryptocurrencies. In this article, we will see the 3 most common ways to do it, as well as the associated risks and advantages.
Conceptually, there is no market to invest in a specific technology. However, there is the possibility of investing in products that make use of it. Investing in cryptocurrencies, therefore, does not differ much from investing in any other currency like the US dollar (USD) or the British pound (GBP).
The big difference lies in two main factors: first, in the platforms on which such investment can be made, that is, exchanges or trading platforms. Secondly, it is necessary to take into account the origin of the intrinsic value of these assets. In this sense, cryptocurrencies were born as means of payment, but have settled as mere investment products due to their high revaluations. The characterization in one group or the other will also be decisive for a possible investment.
Trading platforms offer the marketing of cryptocurrencies in exchange for traditional money or other cryptocurrencies. Some of them, called second-generation cryptocurrencies, can only be obtained in exchange for “first-generation” currencies, such as Bitcoin. The operation, therefore, is similar to that of any currency exchange business. In the case of exchanges, everything is done on a digital platform (some examples could be Binance, Coinbase, or Kriptomat), with the security implications that this entails.
Regarding the important decision factors, they would be similar to those of any other financial asset. It will be necessary to analyze past returns, project potential, management team, etc. In addition, other factors such as liquidity or security may be more relevant in avoiding fraud. Therefore, the most successful investor currencies are usually the most established in the market, that is, Bitcoin, Ethereum, etc.
Investment through participation
Another way to access the potential profitability of cryptocurrencies is through participation in their blockchain. Cryptocurrencies are deployed in decentralized networks, which implies that any user can access them and participate in their development. However, not all networks work the same way. The protocol of the networks is clearly conditioned by the consensus algorithm they use. Networks that operate with Proof of Work (PoW) base their operation on the collaboration of the so-called “miners,” while networks under the Proof of Stake (PoS) algorithm are built based on “staking.”
Therefore, each network works thanks to the collaboration of a type of user who, through their participation, makes it possible to validate blocks and develop the network. For all these activities, these users receive an economic reward, which can be very profitable. Currently, investment through these types of activities is focused mainly on mining and staking.Let’s take a look at what they consist of and how they can be profitable for investors.
Mining activities on any blockchain involve creating new units of cryptocurrency by solving the Proof of Work (PoW) algorithm. For these activities, mining nodes receive two types of compensation. On one hand, they earn a reward in newly created coins, and on the other, they collect transaction fees. However, these activities are not without risks:
- Electricity cost. For our node to be fully operational, it must be connected 24/7, so the cost of energy can end up being very high. Therefore, electricity prices are a key element.
- Level of rewards and fees. Processes like halving gradually reduce the rewards earned by miners. Therefore, the level of profitability must be calculated for each moment.
- Difficulty level. In PoW-based blockchains, the difficulty level determines our chances of solving the problem before other nodes. Currently, in networks as developed as Bitcoin’s, individual equipment is unable to mine cryptocurrencies.
- Cryptocurrency value. For obvious reasons, the higher the value of the mined cryptocurrency, the more profitable mining will be.
Due to the aforementioned reasons, mining is not always profitable. It is necessary to have a powerful equipment and to mine in a cryptocurrency whose network is not too developed. However, if the cryptocurrency appreciates enough, it can be a very lucrative activity. In the Bitcoin network, almost all mining is carried out by industrial mining farms, as it is the only way for it to be profitable.
Staking is the other great way to obtain profitability while collaborating with the reference blockchain. This activity is characteristic of Proof of Stake (PoS) protocols and involves locking up a portion of the cryptocurrencies to participate in the block validation process. The more cryptocurrency is locked up, the greater the chances are of the node being selected to validate the block and obtain the corresponding reward.
The main advantage of this method over mining is that it does not require large computing resources. Almost any personal computer can download and install the software and operate without any problem. This not only facilitates the decentralization of the cryptocurrency but also makes it a very accessible investment.
Regarding the profitability of staking, several factors must also be taken into account. Electricity costs or reward levels will continue to play a key role. Among some of the largest cryptocurrencies in the market, annual returns can range from 3.34% for Cardano (ADA) to 24% for Cosmos (ATOM). In any case, it depends on the aforementioned factors and the way staking is done. It should be noted that where the cryptocurrencies are deposited must be secure to avoid possible thefts.
The cryptocurrency market has grown tremendously in recent years. So much so that a multitude of financial products have emerged that allow for indirect investment in them. These are derivative products that allow investment in underlying assets (in this case, cryptocurrencies) without the need to buy them directly. Although this type of investment is more complex, its main benefit is leverage.
Leverage is defined as the ability to invest large amounts by providing only a proportional guarantee. For example, if a product has a leverage factor of x10, we will only contribute €1 for every €10 of investment. Obviously, guarantees are adjusted according to the evolution of the investment, so the final cost of it could reach 100% of what was invested.
Derivatives are financial instruments whose value depends on the price of another underlying asset. For example, futures and options are derivatives whose value depends on the price of an underlying asset such as a stock, commodity, or cryptocurrency.
Investing in derivatives allows investors to take positions on assets without owning them directly. Derivatives are used to manage risk and to speculate on the price movements of underlying assets.
In addition, investing through these products means that there are no equipment costs. The investment can be made through any generic broker or investment platform. However, as mentioned, these products are generally more complex to understand. Therefore, their use is not recommended if you do not have advanced financial knowledge. Below we mention some of the most well-known derivative products.
Futures and Options
Futures and options are the quintessential derivative products. Both are recognized by the financial industry as the ideal vehicles for diversifying retail and institutional strategies, but how do they work? To understand their operation well, there are several concepts that must be taken into account:
- Underlying – Asset from which the price of the derivative is calculated.
- Term and expiration – Derivative products usually have a limited lifespan. The expiration is the end of that term, and at that time the corresponding delivery (settlement) occurs.
- Premium or guarantee – The premium is the amount paid when contracting an option, while the guarantee is the amount that remains blocked in the contracting of the future, which will vary throughout the term until expiration.
- Strike – Price of the underlying from which the option can be exercised.
- Type of delivery – It can be physical or by differences. Physical delivery refers to the underlying asset, while delivery by differences involves settlement for the difference in value between the strike and the underlying at expiration.
- Option type – In a generic way, options can be of the call or put type.
With these concepts clear, we can move on to defining both types of derivative products.
Futures are financial contracts with a term, traded on an organized market, in which the price of the underlying is set within a certain period. For example, Maria agrees today with Ana to buy 1 BTC from her within 3 months (term until expiration) at the price of €15,000. This way, Maria will obtain 1 BTC for €15,000 in 3 months, even if at that time BTC is trading at €18,000. This is very important because it allows the price of an asset to be fixed at any future time today.
If the delivery in the previous example is physical, at the expiration of the future, Maria will obtain 1 BTC for €15,000. If the delivery of the future is by differences, she will then receive the difference of €3,000 between the price of BTC at expiration (€18,000) and the €15,000 that she had contracted initially.
These types of contracts serve to eliminate the uncertainty of a price in a future period. In addition, as it is a forward purchase, it is not necessary to disburse the money directly, so it can be used for other operations (the concept of leverage returns). These derivatives are especially suitable for covering possible financial losses, by guaranteeing the future price of a product.
In the case of cryptocurrencies, the main advantage of trading futures is that it is not necessary to have a wallet. As we are trading with futures contracts, we do not physically own the cryptocurrency, so it is not necessary to safeguard it. This can be a great incentive for traders specializing in these assets. The main market for these derivatives is the Chicago Mercantile Exchange (CME) but there are others.
Options consist of contracts for the right (but not the obligation) to buy (call) or sell (put) the underlying asset at a specified price (strike) at the time of expiration, in exchange for a premium. For example, today we pay €200 for a BTC call option with a June 2023 expiration and a strike price of €30,000. If at expiration BTC is worth more than €30,200 (strike + premium), then we will exercise the option and have saved money. If it is worth less, then we will not exercise it and will have only spent €200.
The advantage of these types of products is that they allow us to benefit from market movement only in the scenarios that interest us, in exchange for a premium. If the market moves in our favor, then we exercise the option and make money. If not, the loss is limited to the premium paid. Therefore, these derivatives are used for multiple investment strategies by financial institutions.
However, these products are complex in their operation. There are many variables to consider, and premiums paid are not cheap. In the end, they work like insurance, in which a premium is paid in exchange for covering us from an adverse scenario.
Other ways to invest in cryptocurrencies
Futures and options are the two main ways to invest indirectly in cryptocurrencies. By doing so through a derivative product, we do not buy the cryptocurrency directly, which saves costs. However, it also increases the complexity of the operations, which is not recommended. In addition to these two alternatives, there are other ways to participate in the performance of cryptocurrencies.
On the one hand, there is the possibility of investing in companies that mine cryptocurrencies. By purchasing shares in these companies, we are investing in the profitability of their businesses. If these companies are dedicated to mining cryptocurrencies and we invest in them, it is as if we were the “miners” ourselves. This has an undeniable advantage, as companies, due to their size, can access economies of scale and resources that are often unattainable at an individual level.
On the other hand, there are other financial products that can also be referenced to cryptocurrencies, such as ETPs. However, these products are more complex than those seen so far, and in most countries, they are not allowed.