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The Fundamental Flaw of Cryptocurrency Investing

By Sean Williams - May 1, 2018 at 8:36AM

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You're probably not focusing on what really matters.

Last year proved to be a record-setter for the cryptocurrency market. In just 12 months' time, the aggregate market cap of all virtual currencies rose by almost $600 billion, which worked out to a more than 3,300% gain. At no point has Wall Street witnessed any asset class gain over 3,300% in a single year before, nor will we likely ever see anything like it again in our lifetime.

Though cryptocurrencies have undergone their first "hiccup" in quite some time this year, they still bring a lot to the table that investors can rally behind.

A person holding a glowing golden lock, surrounded by latticework that represents blockchain technology.

Image source: Getty Images.

Catalysts galore in the cryptocurrency space

Perhaps no catalyst has been more promising in attracting investors than blockchain technology. For those of you who are unfamiliar with blockchain, we're talking about the digital, distributed, and decentralized ledger that underpins most virtual currencies and is responsible for logging transactions in a transparent and unalterable way. For the financial services industry, blockchain is a means to speed up the transaction validation and settlement process while removing traditional banks from the equation. For other sectors, blockchain offers a new way of storing and viewing data so as to track products in real time or more securely store and back up data.

Partnerships have also been another regular source of excitement. Ethereum, the second-largest virtual currency by market cap, has attracted approximately 450 members to the Enterprise Ethereum Alliance, many of which are brand-name companies from a host of industries and sectors, in just over one year's time. 

Meanwhile, brand-name companies like IBM (IBM 0.10%), which has been on the leading edge of blockchain testing and development, has partnered with the likes of Stellar to expedite cross-border payments in the South Pacific region. These are just two of what are likely hundreds of examples of how partnerships have excited investors. 

Virtual currency trading and investment are also dominated by the retail investor. Since practically all trading occurs on decentralized exchanges, and institutional investors won't put their money to work on these decentralized exchanges, it's allowed retail investors to control the show. The thing about retail investors is they have very limited means to bet against cryptocurrencies (a process known as short-selling). As such, there's a natural tendency for these retail investors to bet on upside in cryptocurrencies, which has been another instrumental puzzle piece in pushing market caps higher.

A hand reaching for a neat stack of hundred dollar bills in a mouse trap.

Image source: Getty Images.

Cryptocurrency investing has a fundamental flaw

But what if I told you that cryptocurrency investing has a pretty serious flaw -- and that it likely isn't any of the cadre of concerns you've probably heard about before?

Make no mistake, there are no shortage of issues with cryptocurrencies. For example, they lack the traditional fundamental metrics that allow investors to place "appropriate" valuations on assets. Without these traditional metrics, digital currency valuations are more guesswork than anything.

Yet this and other issues aren't what should worry cryptocurrency investors. Instead, the true fundamental flaw of cryptocurrency investing is that people are putting their money behind the wrong asset. In other words, they're buying virtual currency tokens, when the valuable asset is the underlying blockchain.

In defense of cryptocurrency investors, there aren't too many ways to get your feet wet in the digital currency space without buying virtual tokens. But the problem with purchasing tokens and assuming they have "value" is twofold. First, buying tokens for a specific virtual currency in no way gives the stakeholder ownership in the underlying blockchain. Second, even if a virtual token and blockchain work seamlessly with one another, greater adoption of a virtual coin doesn't in any way mean that the underlying blockchain is more successful, or that the project is generating more in the way of sales and/or profit.

Take financial services industry-focused Ripple as a good example. Its XRP coin shot into the stratosphere in January, briefly surpassing a $150 billion market cap after San Francisco-based Ripple announced a handful of deals. Some investors view the adoption of the XRP coin by financial institutions as a sign that Ripple's market cap should head higher, when in reality, XRP adoption has next to no bearing on what Ripple should be worth. In fact, of the three products Ripple offers, only one -- xRapid -- uses the XRP coin as a means to provide on-demand liquidity in emerging markets. With Ripple, and virtually every other cryptocurrency, digital token adoption has little to no bearing on valuation.

A magnifying glass being held over a balance sheet.

Image source: Getty Images.

The only smart way to get cryptocurrency exposure in the asset that matters

So, what's an investor to do? Should you want exposure to the cryptocurrency space, the best means to do so is by purchasing commons stock in publicly listed companies on stock exchanges. In doing so, you'll gain ownership in the assets that matter, and at the same time, you'll have access to financial reporting data and balance-sheet information that can allow you to make a reasoned call on a company's valuation.

Sure, you could head to a decentralized exchange right now and purchase the Lumens coins that IBM is using on its blockchain project in the South Pacific. But, at least to this investor, it makes a heck of a lot more sense to consider buying into IBM, which developed the blockchain project in the first place. Stellar's Lumens coin does nothing more than act as a facilitator to expedite these cross-border transactions being processed on IBM's blockchain network. Given the low barrier to entry in the crypto space, it wouldn't take much for IBM to develop its own utility token of sorts that could replace the Lumens coin at some point in the future.

Long story short, stop thinking of cryptocurrencies in terms of token adoption, and start think about the value of their underlying assets, which, in nearly all instances, means their proprietary blockchain technology. Ultimately, that's what's going to matter.

Sean Williams has no position in any of the stocks or cryptocurrencies mentioned. The Motley Fool is short shares of IBM, but has no position in any cryptocurrencies mentioned. The Motley Fool has a disclosure policy.

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