There is a reason why the Cryptocurrency and DeFi Revolution is gaining so much power at such a fast pace. There is a reason why Cryptocurrency coins ( Cryptocurrency Platform’s native coins, ex : Ethereum ) and Cryptocurrency tokens ( Decentralized Apps that run on Platforms and have their own token, ex : any ERC-20 token that run on the Ethereum Platform ) are so volatile in nature, which is something that helps them grow at such incredible speeds. By “Grow” I mean of course mainly the price of the Cryptocurrency ( I will call both coins and tokens under this general term ), but growth also affects other factors like usage and adoption. Since it is a Technological Innovation it already gives it a big push, after all, it is in every way better then what previously existed. There are a lot of other Innovations in many Industries and Fields all the time, but they can take long to become successful because they don’t have the advantage Cryptocurrency has. So what is this Force that gives this Revolution so much power ?
First let’s keep it simple and talk Business. In order to succeed ( let’s define “succeed” as a company that is international, its shares are public and it is listed on many major stock exchanges with plenty of costumers / sales ) companies have to go through many phases and challenges. In the end the success of a Company is defined by what Business it does and how it does Business.
In the “What Business it does” goes everything from the Product, Service or Solution to the how this Product is being sold, the Service offered and if the Solution solves a Problem. But you can have the best Product, provide the best Service and still fail.
That is when the “How it does Business” comes in. Here things like Expansion, Marketing, Management and Finance play a big Role to define the level of Success. You do not need a great Product ( at least in the beginning ) in order to succeed, all you need is to sell the Idea correctly.
So what a theoretical timeline of the success of a company would look like. You create a company, you raise capital and if your Idea is good you start doing Business. Then you can expand and consider going International. By going International you can make your Company Public and start selling your company’s Stock. This helps your raise more capital but it also allows others to participate in your company’s future. Here you can think of personal success where the stock of your company is valued more so you become rich. Or the success of your company where you have more costumers / offer more service which leads to an increase in the price of the stock giving you more capital to work with thus solidifying your company as “successful”. We can all define success in many ways and forms and it could be different for everybody, but in the end it all comes down to money ( in Investing and Business at least ).
Then there are 3 factors that play a role in the timeline of a Business.
What is the main purpose of a Business if not to make money. You can create a Business to usher in a new Revolution in an Industry or help many people with a service / product, but you need money to run the Business and pay for employees. You can think of the Foundation as simply the profit a company makes ( pure profit, after paying for things like cost of operation and other costs and expenditures ). If your company makes more then it spends, it can use that money to expand or invest. This growth will attract people who would want to share your success by investing in your company.
In this case Financial Capital. Usually in form of fiat money, but could be in form of shares of stock of another company, commodities and any other things of value. “You have to spend money to make money”, but if you have no money you have to raise it. If you are a startup and all you have is an Idea, you go to venture capitalists and hope for the best. If you already have a private company, going Public and selling shares of your company is another way of raising Capital. The classic way is of course taking a Loan at the Bank. None of those options are easy and you could end up failing to get anything at all.
An odd thing to include in this list, but one that will make more sense later. By Governance you can think of decisions. A private company can be governed by one Person alone who decides everything but also gets all the profits. A public company is governed by many Shareholders who then also share the profits. Those are the people or Institutions who buy stock of a company on the market ( a stock exchange for example ) and become “holders” of the shares of a company. Those shareholders may be given special perks and advantages for Investing. Beyond sharing the success of the company and making money through buying and selling of the stock, they may be given Stockholder Voting rights. They are then able to participate in the Governance of a company and vote for decisions. Some companies offer other perks such as Dividends. You can think of dividends as profits the company makes and gives back to Shareholders. There are benefits and drawbacks between a Centralized model ( Private company ) and a Decentralized model ( Public company ) that I will not get into here. However one important thing to note here is that to become a Public Company you have to fulfill certain criteria which are money and time consuming. And even after going public you may only be listed on some Stock Exchanges which would mean that not every single person in the world would be able to invest in it.
Now Let’s talk Investing. Simply put, when you Invest you want to make a return. You buy something in order to sell it later for a bigger price thus having a profit. You can view the act of Investment in two ways. You either Invest because you want to make money, or you Invest because you don’t want to loose money.
Typically if you want to make money you buy shares of a company ( to keep it simple let us focus on company shares and not in other things like real estate, buying which would also be considered a form of Investment ) to then sell them when they are more valuable. If the company you bought shares of is becoming more successful, you would assume that it would be reflected in the share price rising. But that is when a phenomenon called Speculation comes in.
Author Burton Malkiel in his book “A Random Walk Down Wall Street” argued against the Financial Theory which is based upon the assumption that all investors are rational and make rational investment decisions. On the contrary, investors are often irrational as they are prone to be influenced by their emotions.
Economists such as John Maynard Keynes ( and others ) said multiple times that “The market can remain irrational longer than you can remain solvent”.
So is the whole Stock Market a big gamble that reflects the emotions of many of its Investors and not the true success and value of the Companies ?
Malkiel also says that, ultimately, the market finds true value. In the short-term multiple news and developments can impact the price of a stock which keeps it away from its intrinsic value ( true value ). However, over the long-term, the market noise drowns out and stocks trade at their true value.
In previous posts I have already linked to the debate of short-term vs long-term Investing. In short-term Investing you try to predict the emotions of the Market. In long-term Investing you try to predict the success of a Company.
Ultimately when you Invest you try to predict the future. You can come to conclusions based on Research and facts that you collected, but in the end the Psychological part ( which I will discuss in later Posts ) of us plays a big part in this game of Investing.
So when you want to make money you Invest in something that can create value ( in form of a Product or a Service ). If you want to not loose money that is a different story. There are reasons why you would want this, and it is part of many people’s Risk Management strategy. Buying things like gold or oil would make you less money than Investing, but would be less risky. People who buy gold typically buy it as a form of Inflation hedge, so their value does not decrease overtime due to Inflation.
So then you have Investment in Business Stocks which is higher Risk and higher Reward. And Investment in Commodities ( gold, oil ) which are lower Risk and lower Reward. There are of course other things you can Invest in but I want to keep it simple.
So what does that have to do with Cryptocurrency and DeFi ? Before drawing any parallels and comparing things I want to propose something that probably many will disagree with.
Note : Keep in mind that the following topic will be about a point of view, for which I will try to bring arguments. You can absolutely disagree with it, but it is part of my Investment strategy which I am trying to describe ( hence it is called “How I do it” ). The goal of my posts is educational and I want to avoid giving any financial advice. However I think that this point of view will help people understand why and how I am Investing in this Financial Revolution. Perhaps this point of view will become a norm in the future and accepted, or perhaps it will never be.
Cryptocurrency as Investment
Many will argue that buying cryptocurrencies is not the same as Investing. Some will say that there is no product or no value being created. What I want to propose is that Cryptocurrency as a whole should not be viewed as one thing, as Bitcoin.
In the article “Buying Cryptocurrencies is not Investing” ( unfortunately I don’t know who wrote it ) the author says that “According to Warren Buffett, investing is a process where you take a productive asset, make some informed decisions about its future, compare its returns to the returns of other productive assets, and make a buy or not-buy decision”. In the article it is also mentioned that “[…]it all boils down to a simple distinction between gambling and investing”.
We are presented with two types of Assets, Productive Assets and non-Productive Assets. and their distinctions : “[…]non-productive assets are things like paintings, gold, oil, stamps, etc. With these kinds of non-productive assets you’re always looking for someone who’ll pay more for the thing than you did so you can pocket the difference. With productive assets on the other hand, you’re making business decisions that provide yearly or monthly cash-flow. You don’t necessarily intend to sell the productive asset just because the price went up. See, you’re more interested in the cash-flow it generates than in the principal going up”.
So things like Stocks of a Business are considered Productive Assets while Commodities like gold or oil are considered non-Productive Assets.
My point of view is that Bitcoin should be considered a non-Productive Asset, which also happens to be a great hedge of Inflation, that is prone to higher Speculation which could be seen as Gambling since the volatility derives from the emotions of the Market. It’s scarcity means that it will go up in the very long term, thus making it somewhat safer. But it’s nature of being non-Productive will make it prone to emotions in the short to medium terms.
Bitcoin’s community belief in the Decentralized power of the network is what makes it safer then gold in regards to its total supply ( among other advantages that I already discussed in previous posts ). Note that I didn’t say that the supply itself is the reason, but the belief in Decentralization. I suggest you reading the article “Can Bitcoin’s Hard Cap of 21 Million Be Changed?” to understand what I mean.
Gold as a material continues to be discovered in outer space and even on Earth every so often making it’s supply theoretically almost infinite. Bitcoin’s supply can only be theoretically increased if ALL of the participants will accept the change.Note that I did not say “majority” but instead said “all” because in the end if a majority decides to increase the supply of Bitcoin, a Network Hard Fork will occur. That means there will now be two Bitcoin Networks, one is the original and the other one with the higher supply. As long as any one person continues to run the old fork of the network there will only ever be 21 Million Bitcoins ever. The chance of everybody accepting this change are astronomically low and would probably mean the downfall of Bitcoin. But finding a whole planet made out of gold that could be mined and brought back to earth or somebody discovering the formula for gold would also make gold useless as a Commodity.
Just the supply is not the only reason for Bitcoin’s superiority as a Commodity. It has shown that it can compete as a contender with many people such as Steve Wozniak ( the creator of Apple products, not to be confused with Steve Jobs the best seller of Apple products ) acknowledging Bitcoins characteristics and even pointed out to its possible superiority. Whether Bitcoin is an upgrade of gold is another debate, but in the end both gold and Bitcoin are non-Productive assets.
Now to the Productive Assets. Here I want to compare traditional Business Stocks with Cryptocurrency altcoins ( altcoins are all Cryptocurrency coins or tokens that are not Bitcoin ). It is important to understand however that not all altcoins can be put in the same category and even considered Investment. One of the reasons why I would argue that Cryptocurrency coins / tokens can be seen as Investment are things like Staking and Yield Farming.
A quote from the report : “I have yet to find somebody who has really done their homework on crypto assets that isn’t truly amazed by the potential for the asset class.” -Michael Sonnenshein
Note : Staking and Stake Delegation are two different things. Staking means direct participation but will require physical hardware so that you become a node in the network. This in turn will bring you bigger rewards.
Stake Delegation on the other hand can be done with just your coins and no additional hardware. You Delegate your coins to somebody who is staking, who after subtracting their profits pay staking reward to you. Stake Delegation may also not give you the ability to directly participate in any form of Governance. Since you Delegate your coins, the one receiving this Delegation will be the one to vote and participate in the Governance. You are of course free to change your Representative ( the one you are delegating to ) at any time with almost no cost in most Cryptocurrency Projects.
A term used to describe the participation of a holder ( one that holds the Cryptocurrency coin or token ) in the Consensus of Proof of Stake and Proof of Stake like networks. Most of the time this act of participation gives the holder monetary rewards and some Projects even offer other benefits such as voting on different propositions. In comparison this is similar to a Business giving their shareholders the right to vote on decisions and giving out Dividends. Cryptocurrency Projects may change the reward % of this participation to attract more people to its network thus strengthening it and decentralizing it ( you can view the % rewards different Projects offer on staking as well as risks and other educational material on the website stakingrewards.com ). It is different to Dividends in the sense that the Cryptocurrency Projects will always offer staking rewards since they benefit both the holder and the Project. This also gives the benefit of exponential growth of wealth for the holder. If you stake Cryptocurrency you gain more of it with time, similar to how compound interest works. If the network is used more ( usage is the main proposition for value of Cryptocurrency Projects, by usage it is usually meant valuable transactions on the network ) and if Speculation ( just like in the Stock Market ) will work together, you will get more of something that is also gaining more value. But the constant cash-flow gives you an incentive to not sell the Cryptocurrency right away just because it grew in value.
So for example a Cryptocurrency Platform will offer services ( like the ability to built decentralized applications on it, or millions of other use cases that currently exist ) and give the ability to compound your Investment with time. Sure by buying Cryptocurrency coins / tokens you are speculating that the price will rise, but it is the same case in the Stock Market. Both Markets are completely irrational and mostly driven by emotions, one is just newer and have less Liquidity. The Stock Market exists since as early as the 12th Century while the Cryptocurrency Market exists for less then 20 Years ( as of 2021 at the time of writing ).
Critical thinking may lead you to ask the question : “So then where does the reward money come from”.
That all depends on the Project. There are too many different strategies to mention here so make sure to read the Tokenomics of a Project you are interested in. But here are some examples :
- using Inflation
Sounds quite odd but it is an interesting approach. There is for example an inflation of 1% of the total supply of coins per Year. If you stake your coins it will grow by 1% each Year. The rewards are distributed each cycle. Let’s define a theoretical cycle of 7 days. So each cycle ,as long as you stake, you receive rewards proportional to your shares ( if you happen to increase the amount of coins you stake, the rewards will be also increased the next cycle ).
After 1 Year has passed you reach the 1% reward and that leaves you with 1.01 coins ( assuming you never increased it and staked only 1 coin ). Note that this is not done with $ or €, it is done with those same coins that you use to stake. However and this is the important part, the people that do not stake their coins do not increase their holding, thus the Inflation effect is passed onto them. What this approach accomplishes is that it gives an incentive to lock up the coins which means that less coins are in circulation. If there are less coins in circulation and there is a high demand to buy them the price will rise due to supply-demand model. This Cycle Model also makes sure that you don’t need to lock your coins for the entire Year. Since the 1% is distributed among all the cycles during a Year you only need to have your coins locked up for that cycle ( locked up only means that you cannot transfer them to another wallets, some Projects allow locked up coins to participate in Governance and interact with smart contracts ).
- using Fees
This one is a simple Model. The fees that participants pay to use the network or the offered Service ( a DeFi Service for example ) are transferred to those staking.
- using Business profits
Some Cryptocurrency Projects have a focus on making Business with other Businesses whom they offer paid Services. The Project then allocates a certain amount of those profits to be given back to those who stake in the network. With a Governance perk, you may vote to increase the rewards if such a proposition will be put forward for vote.
In the end you gain this from staking :
- Your coins are not effected by Inflation ( if there is any present on the protocol )
- You are given voting Power ( if the coin / token offers Governance perk )
- You are giving strength to the Decentralization and Security of the network thus making it healthier
- You may be exposed to higher Rewards ( you can think higher Dividends ) if a Project is Business focused and has increased profits
Yield Farming ( DeFi )
I suggest you to read the Beginner’s Guide about this topic linked above if you want to understand the basics. And I suggest you to read “Liquidity Mining: A User-Centric Token Distribution Strategy” by Dmitriy Berenzon. The first gives you a broad and general Idea about Yield in Decentralized Finance, while the latter explains the concept of Liquidity Mining and draws some parallels with traditional finance. You can think of Liquidity Mining as an upgrade of IPOs ( Initial Public Offering ) and ICOs ( Initial Coin Offering ), where the distribution of tokens or coins is done in a decentralized way that is fair to all participants. That in turn has long-term benefits for the economics and health of the Protocol.
But basically you lock up two assets ( two Cryptocurrency coins / tokens ) in a smart contract and you earn rewards. An example of this would be locking up two assets into a liquidity pool of a DEX ( Decentralized Cryptocurrency Exchange ). Since DEX’s are peer-to-peer ( without a middle man ) they don’t have as much liquidity so they have to rely on people who can provide this liquidity. Essentially what that means is that you are lending your Cryptocurrency so that others may borrow it for trading.
People who borrow and use the Cryptocurrency in those pools will pay transaction fees, all of those land into a general pot which then redistributes it proportionally to the amount locked by those farming the yields. To incentivize more people that can provide liquidity to certain coins / tokens, some Projects may also reward users with their own tokens. These reward tokens may be coupled with additional perks such as Governance perks which ensure that people will want to hold these reward tokens and not sell them as soon as they get it.
So in simple traditional terms you can think of it like this : You put two different Stocks of the same amount ( 1:1 ) into a vault and you are given a document that states that those two Stocks belong to you and you can request to withdraw them at any time. People then take those stocks out of the vault and use them to trade. As they trade they pay trading fees which are then put into a general pot.
Then suddenly one of these Stocks rises in price and you want to sell it. You request the withdrawal of both of these Stocks and after some time ( it is in most cases not instant but also not long ) you get them both back with a % of the money from the general pot. However the owner of the vault decides to reward you for providing liquidity and making him money ( some of the money from the general pot may go towards the owner, since he is providing the service he needs to pay for maintenance and other things ).
Depending on how long you provided the liquidity and how much value you have done it with you receive a portion of the shares of his new company. These new shares rise in value the more money flows through the vault and the more people use it. Since that is not enough of an incentive he gives these new shares a Governance perk. Which would mean that you as a holder of these shares may vote on decisions and changes that the owner of the vault may propose.
And all of the above is happening without any middle men who you have to pay / trust and can be done from home with the use of your computer or phone !
So if certain Cryptocurrencies can be considered an Investment, then that means we can compare them to traditional Business Stocks. I am only going to focus on the 3 theoretical factors described above : Foundation, Capital, Governance and show how Cryptocurrencies have an advantage over traditional Stocks. That is one of the reasons why certain Cryptocurrencies have had such an incredibly high growth that outpaces anything in the traditional Stock market. Although it is not to say that other factors such as Manipulation and low Liquidity aren’t in play, they are, but they are not exclusive to Cryptocurrency, the Stock Market suffers from it too.
Cryptocurrencies have a much lower cost of operation and maintenance. The network is hosted by participants who are incentivized to do so through tokenomics. The only thing needed are developers who can even work remotely. Of course this is an oversimplified example, but it is to show that the resources necessary to run it are significantly lower. That is especially true for DeFi Projects, which is the reason they can offer such high yields. They don’t even need to rely on third party Service providers like Banks and Payment Services because the network itself does it all. That saves a lot of money ( traditional transaction fees much higher ), time ( traditional transaction time and availability much slower ) and removes the need for reliance ( if one of those Service providers goes out of Business you need to look for another ). The fact that the network works 24/7 means that there is no need to wait for a specific time to conduct Business transactions. The network is also not restricted or limited to any location, since it is on the Internet you can access it from anywhere at any time and make a Business transaction across the world to anybody without any limitations.
Raising Capital and holding it is also much easier. The ICO ( initial coin offering, similar to initial public offering of shares ) craze of 2017–2018 created many Projects that were issuing their tokens. Anybody could do it and there were no prerequisites nor necessity for technological knowledge. Many of those projects were useless and are now dead because they only wanted take advantage of the Economic Bubble at the time. However the ability to issue Cryptocurrency and sell it to others is not illegal and can be used to raise Capital and fund building an Idea. Regulation and Industry maturity has caught up to it which made it harder to scam people with another useless token ( the ICO Bubble is similar to many other Bubbles that happened throughout history in the Stock Market, like the Dot-com Bubble ). But even now it is much easier to create your own Cryptocurrency ( for example you can create your own ERC-20 token on the Ethereum Platform, whether you can convince anybody to buy it is another question ) then it is to issue Stocks for your Business. While Cryptocurrency can be traded all over the Internet 24/7 without interruptions, Stock Markets only operate on Business days and certain Hours of the day. Not to mention that to be listed on major Stock Exchanges you need to pay a lot of money and have big reputation. With Cryptocurrency DEX’s ( Decentralized Exchange ) there isn’t even a necessity to be listed, anybody can buy and sell it as long as somebody provides liquidity ( to be listed on Centralized Cryptocurrency exchanges you need similar requirements as with Stock Exchanges however ). You can also raise Capital to those Interested in funding your Idea by selling them your Cryptocurrency tokens, like Venture Capitalists, only now there is no limit as to who can do it. You can even borrow money using DeFi lending protocols instead of Banks, which is also faster and more convenient.
There are two types of Governance in Cryptocurrency, off-chain and on-chain. How Governance is done and who gets to decide anything is up to the Project itself to define. Off-chain Governance can be seen as somewhat similar traditional Governance of a Business, only it is done in a digital manner. On-chain Governance however is a Revolution on its own. In summary, some Projects use on-chain Governance which allows anybody who holds a Cryptocurrency coin or token to directly vote with a network transaction ( an interaction with a smart contract ) on proposals made by the Foundation running the Protocol. So a Foundation may propose a change to the protocol and the people can vote on it within seconds from their computer at minimal costs. Some Projects even incentivize this more by separating different holders ( or owners of coins ) into tiers and giving more voting power to higher tiers. It may seem like a weird approach but the Idea is that people who hold a higher stake ( have Invested the more money ) have more to loose if something bad goes wrong. So they will be less likely to become malicious and do bad things. Remember that the act of staking strengthens the Decentralization which in turn strengthens Security and health of the whole network. Here there are also psychological advantages. Cryptocurrency Governance ( whether off- or on-chain ) is much more transparent and open ( combined with the fact that the Cryptocurrency itself is in most cases Open-Source ). This means that anybody can see what is being done ( since the Ledger is completely you can even see how much money is spent by those running the Project ). Cryptocurrency Projects have to be more cautious and cannot get away with criminal activity as easily as traditional Businesses can.
The whole point of Investing is to make money. Whether you do it traditionally like it was done for so many years or whether you do it within a Revolution that is trying to re-imagine Finance and Investing from the ground up. As long as you are making money why bother with the definitions ? Both Markets are Manipulated by the rich and both Markets are run by emotions. The strategy of Value Investing can be applied for both Markets, the only difference is that the Cryptocurrency Market is still immature. But that can be seen as an opportunity. The Internet Industry when first created had many critics and its own Bubble. But those who have seen and understood it as a Revolution made a lot of money. Did it matter to those people if somebody said that Investing in anything Internet related back then was a complete Gamble into an Immature speculative market ? For some reason the ones who do not understand or want technology and innovation usually scream the loudest.
Keep in mind that by Investing in a Cryptocurrency you are not Investing in the Success of the Company or Foundation who run the Project ( a lot of Projects are run by non-Profit Foundations ) but in the Success of the Protocol. The more it is used the bigger its price will become. So if you can find ones that have great and helpful communities and have many developers building Dapps on them, they might be worth a deeper look.
This content is for Information and educational purposes only and should not be considered investment advice or an investment recommendation.