Cryptocurrencies, an analysis

Disclaimer: Admittedly, I am biased against cryptocurrencies, but I'll try to make this article as fair as possible. Just a reminder though.

Stories of people earning a windfall from the speculation of cryptocurrencies are not uncommon nowadays. Recently, stories such as these(link) '

If You Bought $5 of Bitcoin 7 Years Ago, You’d Be $4.4 Million Richer'

are appearing all over the place. This creates a snowball effect that attracts more investors and attention to themselves, causing a self-fulfilling prophecy of value appreciation. However, as history has proven itself time and time again, there is nothing that can rise in value that drastically without an actual product or object backing it up. I'll get to that later.

Fundamentally, the valuation of everything in the world depends on demand. That's the rule that underpins the entire economy since the beginning of mankind. Currency or not, a transaction can only occur under the condition of 'coincidence of wants'. Be it trading an apple for an orange, or buying an apple for $1, both parties must be willing to accept what the other party have to offer.

And what exactly does this have to do with cryptocurrencies? The meteoric rise of the valuation of these cryptocurrencies highlights a major flaw/point in our economy - that government-backed currencies are too lawful to be used. Most transactions with cryptocurrencies are used because of its anonymity, you don't have to declare income taxes on bitcoin gains, nobody will know if you wired millions of bitcoin overseas to pay for firearms or drugs, because there is no central bank or regulatory bodies acting upon cryptocurrencies. This mean that while originally the demand stems from these properties, more aboveboard parties such as banks and financial institutions are starting to join in where wall street companies are starting to accept bitcoin transactions because illegal or not, wherever there's profits to be made, people will be there.

However, what puts me off is that because of its growing acceptance, people assume cryptocurrencies are a good investment opportunity or a quick get-rich scheme. It is not, at least not by traditional standards.

For those who studied finance, you would have known the concept of beta, risk-adjusted returns and some, the modern portfolio theory. Basically it means that with increased returns comes increased risk. There's no way around it, at least not over the long run. Markets are increasingly becoming more and more efficient as technology involves, this also means that the appearance of a profitable opportunity appearing would quickly be known by (informational efficiency) and quickly seized by the influx of investors (allocative efficiency) dumping funds into what's hot.

I do not deny the emergence of cryptocurrencies is a lucrative new opportunity opening up. However, temporal opportunities are never a source of long-term investments. I emphasize long-term investments because while personally anything that isn't long term is simply not investments, many do not feel that way.

Traditionally, stocks and bonds have been the key players of anything investment related. While they still do so now, the creation of complex products as the result of financial engineering have brought many new financial instruments into the game - with cryptocurrencies as one of the newer big boys. That aside, the fact that stocks and bonds manage to hold their ground over the centuries are that they are easier to be intrinsically valued. Vanilla bonds pays out a fixed rate annually. Investors knows what are they gonna get, expectations are usually met. Stocks are for people with a riskier appetite, some mature companies rise slowly over the years while paying out dividends, some such as REITs provide more fixed income with lesser growth. Key point is, investors can reasonably expect some returns on their funds.

One simple concept highlighting this is
Total returns = Appreciation in price + Dividend/cash payouts

However, the valuation of stocks and bonds can be said to come from it's expected payouts, as seen in the discounted cash flow (DCF) or dividend discount models. The fact that these models exist, and also they can only be used in is because that a company issuing stock or bonds are expected to continue its business and generate cash for investors.

With the creation of complex derivatives and cryptocurrencies, this is no longer the case. While some derivatives are good, whereby is actually reduces risk, most amplifies them and increases its speculative capabilities. While I do not believe in derivatives as a suitable investment instrument, I do understand its purposes.

First-order derivatives have themselves an underlying traditional asset, meaning that these derivatives are created based on bonds and stocks or debt such as mortgages, such as a collateralized debt obligation (CDO). They still have something that are of intrinsic value in it, although the market valuation and intrinsic value can be very far apart, they do have some worth. Higher-order derivatives are derivatives built upon derivatives, and these can go up so many levels that one don't even know what underlying assets is the original first-order derivative based on. Even worse is that as derivatives stack upon each other, multiple asset classes can be lumped together into one huge mess.

The thing about cryptocurrencies is that THERE IS NO UNDERLYING ASSET. One can tell from simply observing that all cryptocurrencies start from nearly zero value, and as its use gets more widespread, so does its valuation. Obviously something with no underlying asset cannot have a cash payout, bringing us to the fact that

Expected total returns = Appreciation in price

This, if anything, is purely speculative. Speculative activities are NOT investment opportunities. Yes some people earned a million dollar from 10 bucks by buying (i refuse to use the word investing) into cryptocurrencies. Do you know where else you can get these kind of returns? The casino. Secondly, the other guy who probably achieved something like this, and also the creator of this type of business, Charles Ponzi. If you know who that is then you should get what I mean.

Previously as I mentioned, risk and return are correlated, but in most lessons of finance, risk is simply measured as standard deviation, which is the chance of fall in valuation. This means that risk is defined as personally, how much money would an investor stand to lose or make by taking on a certain amount of risk. However, one additional perspective I would like to add into evaluating risk is the ratio of successful investors vs total investors.

Imagine buying a US government bond that pays out 5% annual coupons. Out of 1000 investors, I'm sure all 1000 investors would be getting their 5% at the end of the year. For a corporate junk bond, out of 1000 investors, perhaps only 800 of them would be getting the promised returns while the rest defaults. For the investment in risky growth stocks such as technology, perhaps out of 1000 investors, 100 of them would see considerable returns. For a ponzi scheme such as most MLM nowadays, probably only 10 out of 1000 people in it would be sitting in the green, this is worse because it actually drags more and more victims into it.

In the case of cryptocurrencies I believe it to be no different. The percentage of winning investors are only the ones at the very beginning and that percentage is definitely not large. Yes cryptocurrencies is definitely here to stay, AS A WHOLE. This does not mean that any single cryptocurrencies is a good buy. Do not fall into the fallacy of composition. Stocks have existed for centuries and many have reaped great benefits from it, but I'm sure all of you can tell that this does not mean simply buying any stock is a good idea. Same as cryptocurrencies. That is not to say that one CANNOT make a windfall from buying cryptocurrencies, you can. I am just saying that it won't be a sustainable venture, if you even manage to gain anything from it in the first place.

If anything, cryptocurrencies is the biggest ponzi scheme since the 2008 financial crisis.  
Feel free to quote me on that.

"When you start thinking that you can create something out of nothing, it's very difficult to resist" - Lee Hsien Loong