I have been looking into including cryptocurrencies as a high-risk high-reward component (10%) of my portfolio. This is a short analysis of where I see cryptocurrencies headed and what my strategy is.
In the first iteration I decided to stick with the two big cryptocurrencies - Bitcoin (BTC) and Ethereum (ETH). I’m looking to get some skin in the game and understand how the market behaves before investing in the lesser known cryptocurrencies.
Opportunities
Payment Networks
- Bitcoin can currently support 4-5 transactions per second (tps), Ethereum 1.0 is even slower. A traditional clearing system such as Fedwire supports upto ~1800 tps. This severely restricts the use of cryptocurrencies as payment systems.
- Ethereum 2.0 seeks to support 1000s of transactions per second, which is more realistic for a global payment processing system.
- There is no effort to make the Bitcoin core network more scalabale. Bitcoin layer 2 protocols such as the lightning network use the core blockchain in interesting ways to improve scalability.
- Even with enhancements, the current price volatility in cryptocurrencies prevents mass use for payments.
- That said, in the longer term (with the scalability problems solved), cryptocurrencies would benefit off the micro-transaction boom. For ex. pay 1 Satoshi (.0004$) to a tweet you like to support the tweeter. We’re already seeing this trend with Twitter’s super follow feature announcement.
Millennial Gold
- Due to the restricted supply, I strongly believe both BTC and ETH will eat into gold’s share as an inflationary hedge.
- BTC’s current market cap is at ~1T, Gold’s is at 4T. That puts Bitcoin at 25% of the current gold market cap. However, bitcoin ownership is much easier than gold and cryptocurrencies are viewed favorably by millenials over gold (purely basing this off of vibe).
- The US Fed’s Quantitative Easing program will make more investors concerned about inflation and move money into inflation hedges - real estate, gold and cryptocurrencies.
Future Use Cases (DeFi and NFTs)
- Both DeFi (Decentralized Finance) and NFT (Non-fungible tokens) are in the early stages.
- Recently there’s been some buzz about using NFTs as digital collectibles. I see this getting hyped up, underdelivering and getting nowhere (much like the ICOs of the 2016 era).
- However, in the longer term I do think NFTs will find interesting use-cases. For ex. each domain name could be an NFT, and you own the domain by claiming ownership of the NFT (bypassing godaddy, google domains etc).
- There is an increasing lack of confidence in the institutions globally (purely basing this off of vibe, again). This could be a push to increased participation in DeFi. For ex. consider the recent GME Robinhood scandal, instead of a centralized company like Robinhood, you could have a crowd-funded (through DeFi) decentralized smart contract that executes the market buys.
- I do think Ethereum is better placed to benefit from these use-cases since it’s scripting language (Solidity) is turing-complete and designed for writing smart contracts, while the Bitcoin scripting language (Script) is not.
Risks
Government Regulation
- I don’t think the US government will at least out-right ban all cryptocurrencies. But certain governments might (looking at you, India).
- For this reason, I’m only willing to invest 10% of my portfolio into cryptocurrencies.
Environmental Impact
- This is the bigger concern for me.
- Bitcoin (and Ethereum 1.0’s) Proof of Work (POW) verification model is unsustainable energy wise. The energy consumption of the Bitcoin network increases with the value of BTC, currently BTC mining consumes the energy equivalent to anywhere between Singapore (lower bound) to Egypt (upper bound) - source. This is true for any POW based cryptocurrency (ETH 1.0, LiteCoin etc.)
- With the Eth 2.0 upgrades, Ethereum will shift to the Proof of Stake (POS) model instead, which is much more energy efficient.
- For this reason, I’m more bullish about Ethereum than bitcoin.
Security Vulnerabilities
- Hacks are a big risk since the blockchain technology is in the very early stages (cue Mt. Gox).
- Typically, a hardware wallet is recommended to store your private keys for better security.
- However, since I’m only investing ~10% of my portfolio, and it’s a high-risk high reward investment, I’m willing to leave the keys with my wallet app (Coinbase) for the sake of convenience. I will research wallets if I continue investing into crypto next year as well.
- I don’t think the quantum computers breaking cryptocurrency threat is as big a deal. If current encryption schemes are broken by quantum computers, it will affect all financial systems. And I’d argue cryptocurrencies are better handled to deal with that issue when it arises since they’re open source. Read my article on quantum computing to get a primer!
Conclusions
Strategy
- Invest (gamble?) 10% of my portfolio into ETH and BTC in a 2:1 ratio. For the reasons mentioned above, I’m more bullish on ETH.
