In the world of investing, few rules are as sacrosanct as the old adage not to “put all of your eggs in the same basket,” which perfectly captures the need to diversify a portfolio across multiple assets and asset classes.
For most investors, this has traditionally meant diversifying between stocks and bonds, though other asset classes—such as commodities, real estate, and precious metals—have also long been considered potential diversifiers.
Cryptocurrencies offer investors another path to diversification.
Crypto as an asset class is unique from stocks, bonds, real estate, commodities, and other investment vehicles because it is not backed by a physical asset capable of appreciating in value, or a business capable of generating a profit. Instead, the investment thesis for crypto projects is dependent on the various use cases that their underlying technology makes possible.
Below, we define cryptocurrencies, discuss the multiple different use cases that they enable, and explain the role that they may play in an investment portfolio.
What is a cryptocurrency?
In short, a cryptocurrency is a digital asset that is secured by cryptography.
Cryptography, in this context, is a message-sending technique in which the sender encrypts a message, which must then be decrypted by the recipient. Cryptography allows for the anonymity, security, and decentralization that cryptocurrency is known for.
Most (though not all) cryptocurrencies are built on a technology known as blockchain, which is a decentralized ledger used to record transactions. Cryptography and blockchain are, in large part, what makes crypto’s various use cases (discussed below) possible.
The word “cryptocurrency” originated from the fact that Bitcoin, the world’s first cryptocurrency, was built on cryptography and originally intended to act as a currency. But it is something of a misnomer.
While cryptocurrencies can, of course, be used as a form of digital currency, that is just one of their many use cases. They have other uses, giving them intrinsic value for the underlying technology existent in each token.
Crypto Use Cases
1. As a Currency
The world’s first cryptocurrency, Bitcoin, was originally intended to be used as a currency that people could use to send money to each other over the internet free of a central bank or other intermediaries.
To this end, Bitcoin has had limited success. Currently, the Bitcoin network processes an average of between 200,000 and 300,000 transactions per day. That number is dwarfed by the estimated 108.6 million transactions processed each day by America’s four largest credit card networks (Visa, Mastercard, American Express, and Discover).
There are a few factors holding Bitcoin, specifically, back from fulfilling its original purpose. First, the price of Bitcoin (and other cryptocurrencies) is subject to quite substantial swings in value, which makes many people unwilling to spend their holdings. But beyond this, Bitcoin has become a major store of value (which we will talk about below). This has largely supplanted its original purpose as a currency.
That being said, there are crypto projects specifically designed to tackle these challenges in order to become true digital currencies.
Stablecoins such as Tether and USD Coin, for example, are a type of cryptocurrency that ties its value to an external reserve asset in order to reduce or even eliminate volatility. This makes it much more likely that they can serve as a currency.
Additionally, many central banks are exploring the idea of creating central bank digital currencies (CBDCs) which would essentially act as a digital proxy to real-world cash. The Atlantic Council has an interactive map highlighting the status of CBDCs around the world, including 9 which have been launched as of 2022.
2. As a Store of Value and Inflation Hedge
A store of value (SoV) is any asset that is capable of withstanding depreciation over the long-term—especially when compared against fiat currencies, which can be devalued by both inflation as well as the printing of new currency by central banks.
Gold, silver, and other precious metals have historically been considered to be good stores of value. This is primarily due to the fact that they:
Enjoy natural scarcity
Enjoy increasing demand
Are capable of being stored for long periods of time without degradation
Increasingly, it is believed that some cryptocurrencies may also prove to be excellent stores of value—especially those that share the same characteristics above.
Many experts, for example, believe that Bitcoin is likely to become a dominant digital store of value. As such, it is often referred to as “digital gold.” This is due to Bitcoin’s:
Recognition: As the oldest cryptocurrency, Bitcoin is also the most well known. By becoming a household name, Bitcoin has a certain level of “brand awareness” and trust that many newer cryptocurrencies do not yet enjoy.
Increasing Demand: As Bitcoin becomes more and more well known, demand for it as an asset and as a currency continues to rise, pushing it higher.
Scarcity: Bitcoins are created through a process known as mining, in which miners are rewarded a certain number of coins as they perform the work of verifying transactions on the blockchain. The total number of Bitcoins that will ever be created through this process is 21 million. Once that number is reached, no new Bitcoins will be created. If demand continues to increase, this built-in scarcity is likely to drive the price of Bitcoin higher.
Of course, Bitcoin is not the only cryptocurrency that can act as a store of value. Some studies have shown that Ether (ETH) may be a candidate to unseat Bitcoin as the primary digital source of value. Whether or not this comes to pass will depend on a number of factors, including, importantly, the network’s successful migration to proof-of-stake (POS) through a process known as “the merge” which will introduce deflationary pressure to the network.
3. To Facilitate Decentralized Applications (dApps)
Decentralized applications (dApps) are applications that are built on a blockchain network and depend on smart contracts—automated, self-executing agreements—to work. They are often similar to web applications in their user experience, but differ significantly on the backend.
Because dApps are built on a blockchain, they operate in a decentralized, distributed, peer-to-peer manner. This is directly opposed to the way that web apps work, as those rely upon a centralized protocol (HTTP). As such, dApps are a key part of what has become known as web 3.0.
The appeal of dApps is largely tied to three key factors:
Because they are decentralized, dApps are resistant to censorship and regulation
Also due to their decentralized nature, dApps are resistant to downtime. This is because a peer-to-peer network means there is no single server or computer that powers the application.
dApps are by nature public and open source, allowing for innovation within the space.
Most dApps are currently built on top of the Ethereum blockchain. According to State of the dApps, there are currently approximately 3,000 dApps built on the Ethereum network. That being said, there are a growing number of alternative blockchain networks (such as EOS, Tron and NEO) which also allow for app development. Ethereum’s popularity for dApp development has a number of drivers, including a growing developer community, network effects, a general ease of programming on the network, and a robust set of developer tools provided by the Ethereum network.
Decentralized apps can be created to fulfill a wide variety of purposes and needs, such as for:
Decentralized Finance (discussed more below)
4. To Facilitate Decentralized Finance (DeFi)
Decentralized finance (DeFi) refers to a subset of dApps that cater specifically to financial use cases. DeFi apps exist that allow users to save, invest, borrow, trade, make transactions, and much more. Like other dApps, DeFi applications are built on blockchain technology and smart contracts.
The value proposition offered by most DeFi apps is that it removes banks, payment processing companies, and other “middle men” from financial transactions. This can bring a number of benefits to consumers, including:
Reduced costs: Fewer middlemen means fewer parties fighting for a slice of each transaction, which ultimately translates into lower costs
Less regulation: At the moment, the DeFi industry is not regulated to the same extent as traditional, centralized finance (though this may change in the future).
Increased privacy: When you use a bank or other centralized financial system, your transactions are closely linked to your identity. With DeFi, transactions can be highly private.
Faster transfer speeds: In centralized finance, money transfers between two banks can take days due to internal processes. With DeFi, money can be transferred anywhere in the world in a matter of minutes or even seconds.
Ethereum is currently the network with the largest number of DeFi applications built on top of it, as is the case with dApps.
5. To Facilitate Non-Fungible Tokens (NFTs)
A non-fungible token (NFT) is a unit of data stored on a blockchain. In some ways, this is similar to cryptocurrencies and tokens, but it’s different in one important way: Fungibility.
When an asset is fungible, it means that it can be easily exchanged or interchanged with a similar asset. Dollar bills are fungible, because you can exchange one dollar bill for another. Cryptocurrencies and tokens are also fungible because they can easily be swapped without issue. One ETH will always equal one Eth; one Bitcoin will always equal one Bitcoin; one dollar will always equal one dollar. This is the basic premise that allows currency and cryptocurrency alike to facilitate transactions.
But when an asset is non-fungible, that means that it is unique. This characteristic uniqueness makes it so that a non-fungible asset cannot be exchanged, because it is truly one of a kind. An NFT is therefore unique data that lives on the blockchain. Each NFT is associated with a unique asset—which often lives off-chain—and is used to convey ownership of that asset on the blockchain. In this way, an NFT can be thought of as a sort of digital title of ownership.
Virtually anything can be represented on the blockchain as an NFT, from art and music, to collectibles, to vehicles, houses, real estate, and more. Just like physical assets, NFTs can be bought, sold, and traded on the blockchain.
The Ethereum blockchain network is one of the most popular networks for hosting and transferring NFTs. Other popular blockchains for NFTs include Solana, Cardano, and Polygon, amongst others.
A New Asset Class for Today’s Investors
As we can see from the discussion above, cryptocurrency is about so much more than just replacing fiat currency with a digital asset. It’s about leveraging new and emerging technologies—like blockchain and smart contracts—in order to disrupt and transform industries. With this in mind, cryptocurrency as an asset class can offer investors exposure to a wide variety of different use cases.
What role cryptocurrency plays in a broader investment portfolio will ultimately depend on the cryptocurrencies held within it.
Bitcoin, for example, as mentioned above, may be an effective digital store of value and hedge against inflationary pressure, synonymous with gold. Other cryptocurrencies, such as Ether, offer investors exposure to the burgeoning world of DeFi and dApps, which are expected to grow dramatically in coming years. This demand may translate over into rising prices, though that remains to be seen.
Because no single cryptocurrency is likely to dominate in all of the use cases discussed above, investors who are interested in investing in crypto are generally encouraged to hold a basket of different tokens. This is an effective way of diversifying your crypto investments, and is comparable to diversifying stock holdings across multiple industries.
Here at Allio, we believe that cryptocurrency has exciting potential to help build the infrastructure of tomorrow’s technological and financial ecosystem but currently as an asset, doesn’t have the regime in place to drive its price up. Bitcoin, due to its limited supply could come into high demand if the global financial system ever experienced hyperinflation. Rather than have our clients purchase a wallet or trade on a messy exchange with hidden fees to purchase coins, we prefer to seek this upside via the use of an ETF which includes the added benefit of not being directly exposed to the speculative underlying asset. That said, they are still volatile and investors should only purchase them if they’re willing to lose that entire portion of their portfolio. For that reason, we offer our clients the choice for whether they’d prefer to have crypto exposure, alongside traditional asset classes—like stocks, bonds, commodities, and real estate— for a truly diversified macro investment strategy.