TWO WAYS OF GAINING EXPOSURE TO THE CRYPTO ECONOMY Prepared by – GAYAN DINESH PERERA USQ MBA Student No -U1142643 BUS8203 1 INTRODUCTION The cryptocurrency market has experienced enormous growth ever since the emergence of Bitcoin in 2009. The global cryptocurrency market reached a staggering value of US$ 1782Billion in 2021. (Yahoo Finance 2022) In this essay, I will be critically evaluating the two ways that an average investor can gain exposure to the crypto economy. That is by way of purchasing crypto directly or buying stocks in companies that are involved in crypto industries. Emphasis will be given to the average investor’s perspective and opinion will be constructed using appropriate investment management principles such as portfolio theory. Crypto’s increasingly wide acceptance as a payment method and the anonymity and privacy embedded in the transactional process has been the key reasons for the popularity of crypto. Security risk and high volatility have been detrimental factors of crypto popularity. (cryptopedia staff 2021) INVESTING IN CRYPTOCURRENCIES VS COMMON STOCK As an investor, it is pivotal to understand the similarities and differences between trading cryptocurrencies and stocks. Emerging online marketplaces, trading platforms and mobile applications have been the positive factors for the growing number of investors in stocks as well as in crypto. Even though the process of investing in stocks and crypto has several similarities, there are also some fundamental differences. One of the notable differences in the regulatory framework. Stocks are generally securities that are regulated by securities and exchange commissions. (SEC). In contrast, many widely used cryptocurrencies including Bitcoin are not regulated securities. The most distinguishing difference between investing in stock and cryptocurrencies is the fundamental difference in what you are purchasing. Common stocks traded in stock markets represents a percentage of ownership in an entity and it is embedded with certain benefits such as dividend, voting rights, etc. In contrast, cryptocurrencies are dependent on how they are utilized and what they are intended to represent. (Marquit 2021) Many cryptocurrencies are digital assets that are meant to be used within the blockchain’s ecosystem, hence, do not represent any legal stake that issued the coin. Ex- Ether (ETH). On the other hand, many cryptocurrencies do not have a demonstrable value tide to the actual business operation and hence act as a store of value. Hence, these digital assets are best conceptualized as digital commodities which do not represent any stake in a business. 2 CRYPTOCURRENCY AS A LONG INVESTMENT Many prominent cryptocurrencies such as Bitcoin (BTC) and Ethereum (ETH) were launched with lofty objectives to achieve in the long term investment horizon. Bitcoin as per many crypto investors is the “digital gold”. It has been a notable fact that early investors in crypto projects have been richly rewarded when the project reaches the maturity stage. For an instance, if an investor invests in BTC by around 2010 when the price is around US$10 cents, the investor could have bought about 1000 Bitcoins. Assuming that the investor held the asset the entire time, the same 1000 BTC would have been worth more than US$61Mn by 2021 when BTC hit an all-time high of over US$ 65,000 per Coin. (statista 2022). That’s an enormous gain. However, realistically the no of investors holding into the highly volatile asset such as BTC for such a long period is smaller. However, the price appreciation of BTC over the last decade suggests that the longer-term investors would have been rewarded handsomely. However, the gain or loss of investment is mainly depending on the investor's risk appetite and investment expertise. Even though, statics suggest that almost all the key major cryptocurrencies have surged in value over the years but it’s paramount importance to figure out how they fit into average investors' portfolios. Investors are expected to strike a balance between risk and return. hence, they are trying to maximize the gains and limit the losses by estimating the risk and return of various investments including crypto. Estimating future returns and the risk associated with such returns can be trickier. Investors usually rely on historical data. While historical averages are a good gauge for traditional investments such as stocks and bonds, they may not be effective with cryptocurrencies. Bitcoin the oldest of cryptocurrencies has only been around for 13 years. Hence, the historical records are not long enough to rely on. (Kaissar 2022) According to the Investment giant Goldman Sachs, the ten-year stock market return has averaged about 9.2% over the last century in the USA. However, Goldman Sachs notes that S&P 500 has been generating slightly better returns with an average annual return of 13.6% for the last 10 years. (Business Insider 2021) On the other hand, in USA long term government bonds have generated about 6% a year over the last century. (The Bloomberg 2022) Meantime, the oldest cryptocurrency family the Bitcoin has returned about 220% a year during its 13-year span of the life cycle, which obviously from the average investor's perspective is not sustainable. Bloomberg notes that the annualized standard deviation is about 200% over the 3 same period. (Kaissar 2022) That makes the BTC 15 times more volatile than the S&P 500 and more than sixty times that of long-term bonds. (The Bloomberg 2022) One another attractive features of cryptocurrency are its ability to generate a passive income. As common stocks generate dividends the crypto could also be generating passive income through various means. One of them is the staking. Staking is a widely known passive income source for crypto holders with minimal risk. Many crypto exchanges offer the facility of staking where the holders are required to stake their coins for a set period of time for a return of fixed or variable interest which will usually be paid in the agreed value equivalent of the coin staked. Hence, in the longer run staking may work as a reinvestment tool where the revenue generated is automatically reinvested. (Market Trends 2022) Crypto saving accounts are another passive income generator of crypto. Rates paid on these crypto saving accounts are often higher than what you will find in traditional fiat saving accounts. Conversely, crypt flatforms such as Coinbase, Binance, Aqru, etc generate income by lending out the crypto assets saved with them and paying out a portion of the interest income to the savers. (Market Trends 2022) INVEST IN STOCKS IN THE COMPANIES ENGAGED IN THE CRYPTO INDUSTRY Investing in equities in the companies of the crypto industry is another option for an investor to gain exposure to the crypto economy. Several globally acclaimed businesses evolved around the crypto economy. One of them is the American crypto giant Coinbase Global, Inc which primarily operates as a cryptocurrency exchange. The entity was founded in 2012 and became a public entity by listing on the Nasdaq exchange USA in April 2021. (Coinbase 2022) From an average investor's perspective, we will review the financial position of Coinbase as our base case to evaluate the investing in the stock of the company. Financial performance of Coinbase as a case point to predict the market During the first year after going public, the company has recorded a fifteen-fold increase in 2021 revenue, to $ 7.84B, up from $1.27B the previous year. (Coinbase Inc, Annual Report 2021 2022) similarly, profit after tax (PAT) increased more than 11-fold from $322Mn in 2020 to 3.6B in 2021. This mammoth growth is mainly attributable to the boost in the crypto economy during the pandemic period. (Nga 2022) During the Covid pandemic global economies were slowly shutting down and people who had few options for spending their 4 discretionary cash and savings ended up buying digital assets such as cryptocurrencies through flatforms like Coinbase. The increased volume of transactions helped Coinbase generate monstrous growth in revenue by way of transactional fees. EPS (Basic) shot up to 17.9 from 1.86. (Coinbase Inc, Annual Report 2021 2022). Average investors, primarily look for the capital gain through price appreciation of the stock and dividends. Coinbase stock price has surged up to $ 368 from the IPO price of $ 250 in April 2021and it has eventually fallen to the lowest of $ 40.83 and currently trading at around $ 67.87. (Yahoo finance 2022) On the other hand, it has not declared any dividends for the last few years. Book value per share Q 1,2022 is 29.39 and the price to book value is around 2.28. (Yahoo finance 2022) As Coinbase benefitted immensely from the surging trading activities during the pandemic, it was also penalized when the trading volumes fell from the latter part of 2021. A combination effect of lower crypto prices and lowering volatility factor has reversed its performance the other way around in Q1 of 2022. Topline fell 27% YOY to $1.2B and net PAT reversed from $770Mn to minus $430Mn comparatively. (Investing.com 2022) Another factor that contributed to this shocking performance in Q1 of 2022 is the operating expenses which have been doubled in comparison to the Q1 of 2021. (Investing.com 2022) Overall, the market capitalization of Coinbase steeply declined by 80% to $ 17.78B as of 13th May 2022 from the old-time high of $89.83 in November 2021. (Companies marketcap 2022) In the same period, the total cryptocurrency market cap fell by 56% to $1.2T from $2.9T in November 2021 which is an all-time high. (coinmarketcap 2022) One of the main reasons for the reversal of bullish sentiment of the crypto market was the bank of crypto trading and mining in China which has wiped out the crypto market by about 40% within a month. (Editor the Hindu 2022). Accordingly, it is evident that the near-term prospect of the crypto-economy going to remain bleak. In short, crypto companies predict lower trading volume for the second quarter of 2022 and the remainder. The ongoing war in Ukraine and other socio-economic factors are also going to affect this adversely. 5 EFFICIENT CRYPTO PORTFOLIO AND MODERN PORTFOLIO THEORY Irrespective of being risk-seeking or risk-averse, the investors seek to gain profit. In many cases, the amount of profit or loss has a direct correlation to the amount of risk that the investors are willing to take. Modern portfolio theory (MPT) primarily assumes that an investor is riskaverse and seeks to find out the balance between optimal return and assumed risk. (Forbes Editor 2021) MPT involved a process of taking a batch of asset classes and calculating the weighting using historical data. Riskier investment often has the tendency of generating higher returns. Hence, modern portfolio theory stive to generate a weighted portfolio with the highest potential return for the least risk. The ratio between expected return and perceived risk is commonly known as the Sharp ratio. That can generate an efficient frontier graph which represents an efficient portfolio for various anticipated returns. (Forbes Editor 2021) 6 Calculating an efficient sharp ratio is highly reliant on historical data. While MPT and sharp ratios were originally designed for traditional investments such as stock investors can also use them for crypto investment as well. Unfortunately, the crypto economy is extremely fastmoving and susceptible to many changes. Hence, only a few major cryptocurrencies with historical data will be eligible for the calculations. i.e- Bitcoin, Ethereum and Litecoin, etc. Accordingly, moving along the efficient frontier will exhibit the efficient portfolios with the highest possible risk-adjusted returns. CONCLUSION The primary objective of any investment is the return. Investors are having various levels of risk appetites and accordingly they weigh the expected return against perceived risk and make the investment decision. As elaborated on the above, the leader of Cryptocurrency Bitcoin has generated a return of about 220% a year during the short span of its lifecycle. However, that kind of return is obviously unsustainable. Hence, its standard annualized deviation has been around 200% over the same cycle. That is approximately about 15 times that of S&P 500 stock or more than 50 times that of regular bonds. (Kaissar 2022) On the other hand, US stocks have returned about 9% a year over the last hundred-odd years. Hence, I would recommend for an average investor to strongly look for the option of buying crypto directly as a short- and longterm investment. In deciding the amount of investment, the average investor may utilize theories such as the Modern portfolio theory explained above. Thanks! 7 References Business Insider 2021, www.businessinsider.com, viewed 09 May 2022, <https://www.businessinsider.com/personal-finance/average-stock-market-return?r=US&IR=T>. Coinbase 2022, www.coinbase.com, viewed 09 May 2022, <https://www.coinbase.com/about>. Coinbase Inc, Annual Report 2021 2022, U.S.Securities and Exchange commission, viewed 09 May 2022, <https://sec.report/CIK/0001679788>. coinmarketcap 2022, www.coinmarketcap.com, viewed 15 May 2022, <https://coinmarketcap.com/charts/>. Companies marketcap 2022, www.companiesmarketcap.com, viewed 15 May 2022, <https://companiesmarketcap.com/coinbase/marketcap/#:~:text=Market%20cap%3A%20%2417.77 %20Billion,cap%20according%20to%20our%20data.>. cryptopedia staff 2021, www.gemini.com, viewed 06 May 2022, <www.gemini.com>. Editor the Hindu 2022, www.thehindubusinessline.com, viewed 15 May 2022, <https://www.thehindubusinessline.com/data-stories/data-focus/data-focus-cryptocurrencymarket-cap-declines-21-per-cent-as-panic-grips-investors/article65407532.ece>. Forbes Editor 2021, www.forbes.com, viewed 14 May 2022, <https://www.forbes.com/advisor/investing/modern-portfolio-theory/>. Investing.com 2022, www.investing.com, viewed 15 May 2022, <https://www.investing.com/equities/coinbase-global-income-statement>. Kaissar, N 2022, https://www.bloomberg.com, viewed 08 May 2022, <https://www.bloomberg.com/opinion/articles/2022-02-18/personal-finance-how-much-cryptoshould-be-in-your-investment-portfolio>. Market Trends 2022, www.analyticsinsight.net, viewed 15 May 2022, <https://www.analyticsinsight.net/4-ways-to-earn-passive-income-with-crypto-in-2022/>. Marquit, M 2021, www.thebalance.com, viewed 06 May 2022, <https://www.thebalance.com/should-you-invest-in-stocks-or-bitcoin-4121151>. Nga, L 2022, www.yahoofinance.com, viewed 15 May 2022, <https://finance.yahoo.com/m/66047dda-8116-3f06-84b0-94302711dbd2/coinbase-expects-morepain.html>. statista 2022, www.statista.com, viewed 07 May 2022, <https://www.statista.com/statistics/326707/bitcoin-price-index/>. The Bloomberg 2022, www.bloomberg.com, viewed 09 May 2022, <https://www.bloomberg.com/opinion/articles/2022-02-18/personal-finance-how-much-cryptoshould-be-in-your-investment-portfolio>. Yahoo Finance 2022, www.finance.yahoo.com, viewed 04 May 2022, <https://finance.yahoo.com/news/global-cryptocurrency-market-report-2022120800380.html?guccounter=1&guce_referrer=aHR0cHM6Ly93d3cuZ29vZ2xlLmNvbS8&guce_referr er_sig=AQAAAK-1jPygkXR4BD6YaoW-ajSrPEocsKgpmGv1zFrJjPSQjyhqCsYcEdK8wZQX31mR1yRKWH3foQf7fXYhvMVZaR>. 8 Yahoo finance 2022, www.finance.yahoo.com, viewed 15 May 2022, <https://finance.yahoo.com/quote/COIN/key-statistics?p=COIN>. 9