Cryptocurrencies have taken the world by storm. Since 2013, the value of all cryptocurrencies in circulation has soared from $1.6 billion to more than $1.6 trillion at Wednesday's prices, and roughly $1.4 trillion of that value was added in the past year, according to CoinMarketCap.
Bitcoin (BTC -0.41%) has been the leader of the pack, thanks to its first-mover advantage as the original cryptocurrency. However, in recent months, Ethereum (ETH -1.11%) has stolen Bitcoin's thunder. In the past year, Ethereum has gained roughly 1,600%, while Bitcoin is up 300%.
Ethereum has caught fire for a number of reasons, but the most important aspect of the Ethereum network is its use of smart contracts. These smart contracts built on the Ethereum network are spurring a couple of innovations that give Ethereum its value: decentralized finance (DeFi) and non-fungible tokens (NFTs), whose popularity should be closely followed by investors.
The DeFi movement can't be ignored
One of the biggest innovations spurred by the Ethereum network is DeFi. DeFi uses smart contracts on the Ethereum blockchain to offer traditional financial products, like insurance or loans, without the need of intermediaries like brokerages or banks.
These smart contracts eliminate the need for a trusted third party to verify the transaction. Nick Szabo, an early pioneer of digital currencies, likened them to digital vending machines. Smart contracts are programmable contracts between two parties that self-execute when specific conditions are satisfied. The third party is eliminated because the contract is programmable and exists on the blockchain, a secure and decentralized form of digital ledger technology.
The ultimate goal of DeFi is to eliminate third parties and make financial products such as loans, insurance, and trading more accessible to underserved markets. According to World Bank, 1.7 billion adults across the globe lack access to banking services. However, two-thirds of those do have access to a mobile phone and internet connection, and could benefit from DeFi. Given the problem it looks to solve, DeFi is a very attractive space right now.
A real-world example
Munich-based Etherisc built its first product, flight delay insurance, with smart contracts on the Ethereum network. It works this way: When a customer purchases flight delay insurance, it's recorded on the blockchain in smart contract form. If a flight is delayed by 45 minutes or more, the self-executing contract pays out customers instantly. The smart contract allows the customer to avoid making claims with an insurance company, making insurance more efficient.
Etherisc sees insurance as one industry ripe for disruption by utilizing smart contracts, saying they could make the purchase and sale of insurance more efficient, lower operational costs, and provide greater transparency into the industry.
Ethereum leads the pack when it comes to decentralized contracts, whose popularity has taken off this year. According to DeFi Pulse, over $63 billion was locked up in smart contracts as of Wednesday, a 65-fold increase from the $953 million locked up in smart contracts just one year ago.
Leading the NFT trend, too
The Ethereum ecosystem is perfect for another purpose as well: non-fungible tokens.
One of the problems in the digital age is the ease with which we can duplicate digital assets like images, videos, and songs. NFTs aim to make digital products more like physical ones, by giving them scarcity, uniqueness, and proof of ownership.
NFTs have exploded in popularity in the past year. According to NonFungible, there were nearly $67 million in sales related to NFTs in 2020. So far in 2021, sales are an astounding $840 million, representing over 11 times growth from last year's total -- and the year isn't over yet. Comparing the full month of April to the same month last year, NFT sales were up 82-fold. To say NFTs have exploded is an understatement.
The Ethereum network plays a key role in NFTs, as most NFTs are priced in Ether -- the digital token of the Ethereum blockchain. In fact, the earliest and most popular NFTs, with names like CryptoKitties and CryptoPunks, are run on the Ethereum blockchain.
Ethereum is my favorite cryptocurrency
While Bitcoin was the original cryptocurrency, I think the smart contracts built into the Ethereum network make it a better cryptocurrency to invest in over the long haul. After all, there's no denying the popularity of DeFi apps and NFTs -- which are largely hosted on the Ethereum blockchain.
However, when dealing with cryptocurrencies, investors must be careful of a potential bubble, especially in the NFT space. According to NonFungible, the average sale price for crypto art had dropped 60% from its February high through the end of April. If the NFT bubble does pop, Ethereum and other cryptocurrencies will take a hit.
As an investor, it's important to understand the volatility of cryptocurrencies and allocate your capital accordingly. Despite how much I like Ethereum, I also know the price could potentially correct 40% to 60% or more due to rampant speculation in the space.
This doesn't mean it's a bad long-term investment, though. The best approach as a long-term investor is to allocate a small percent of your portfolio to the cryptocurrency and dollar-cost average into that position over time. Dollar-cost averaging will help smooth out the average price paid for your position, as you should be buying along peaks and valleys along the way while keeping a long-term investment perspective in mind.