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Blockchain and finance in 2019
Comparing Stocks and Cryptocurrency: Which is a Better Form of Investment?
Cryptocurrencies have come a long way since the inception of Bitcoin in 2008, evolving from the initial technological promise of disrupting the financial system, to a vibrant ecosystem of coins, tokens and variant technology with different applications across many industries. Given their explosive growth, cryptocurrencies have evolved to become a contending asset class for investors and traders. The ever-increasing coverage of cryptocurrencies and the mainstream has propelled this burgeoning market into new heights, despite the market downturn in 2018 after an exponential rise to all-time highs. Let’s take a look at the state of the cryptocurrency market, and how it compares to the traditional yardstick of the investment world, the stock market.
State of the Cryptocurrency Market
The creation of Bitcoin in 2008 sparked a massive technological revolution that, for the very first time, had the potential to fully disrupt the monetary system. The advancements in distributed computing and cryptography culminated into a robust new technology called blockchain, with the further potential of adding transparency, mass empowerment and accountability into traditional systems. Since then, a plethora of offshoots, variations and innovations have seen the cryptocurrency market grow into a diverse and rich industry. As it stands, there are over 2,000 coins and tokens that are traded publicly, with thousands more currently being developed. Although cryptocurrency – and its enabling technology, blockchain – represent a technological breakthrough, the volatile price movements have inadvertently resulted in the perception of cryptocurrencies as a speculative investment in the eyes of the public.
For us to truly understand the crazy price movements of the cryptocurrency market, let’s use the price of the biggest and most well-known cryptocurrency, Bitcoin as a benchmark:
Bitcoin (BTC) constitutes close to 60% of the entire market capitalization of the cryptocurrency market, and is therefore a good indicator of its state. As seen from the chart above, Bitcoin came to prominence with an exponential rise in price over a short five-year span. From a price point of less than $10 in 2012, it rose in value tremendously, growing to a peak of almost $18,000 by the end of 2017 ‒ a mind-boggling rate of return which was 18,000 times the original price. However, the market took a dive at the start of 2018, falling to lows of $4,000, and shedding 80% of its value in a single year. Given the relative infancy of the cryptocurrency market, sentiments and hype played a major role in the extreme volatility of cryptocurrency prices. Nonetheless, things are now looking more positive, given the renewed interest from the institutional market, and a resurgence in cryptocurrency trading.
Overview of the Stock Market
The stock market is the stronghold of the financial world, featuring a highly liquid marketplace of shares associated with public companies. Shares are highly regulated financial instruments that trade on public stock exchanges, the biggest of which are the New York Stock Exchange (NYSE) and NASDAQ, both located in the United States. With a monthly trading volume in excess of $1,400 billion, the stock market is highly diverse and liquid. Stakeholders in the modern financial world, including financial institutions, funds, governments and the retail public, are active in the stock markets to uncover financial opportunities, and grow their wealth. The digitization of information and advancements in technology have enabled financial inclusion in the stock markets, facilitating efficient trading of stocks for the greater public. Although different for every country, the most widely used benchmark for the stock market is the Dow Jones Index, as well as the Standard’s and Poor 500 (S&P500) Index, which tracks the activity of the top US-based companies.
Cryptocurrency vs Stocks: Factors to Consider
In order to have a complete understanding between both asset classes, it is important to understand the different factors that need to be understood and analysed. Let’s take a look at four key factors that will shed some light on both categories of investment.
- Trading vs Investing
Prior to delving into any class of asset, it is important to understand investment style. Fundamentally, trading is very different to investing. Trading is short-term oriented, and more inclined to leverage technical analysis (i.e. the study of historical price patterns and indicators to predict price movements). On the other hand, investing is more focused on the long-term and uses fundamental analysis, which entails thorough financial analysis of companies’ financial documents, and an evaluation of their intrinsic value. However, both investors and traders are natural participants of both the stock market and the cryptocurrency market.
A large percentage of institutional and retail participants on the stock market are long-term investors, given that active trading requires a higher level of skill and resources; also similar to the cryptocurrency market. However, the majority of trading is dominated by the retail market, given the lack of institutional participation as a result of a lack of liquidity and depth in the cryptocurrency market. Trading in the cryptocurrency market is also more complex because of the lack of quantifiable metrics to value coins and tokens.
- Risk Profile
A key metric for evaluating the riskiness of an asset class is to look at its volatility, meaning the rate of fluctuation in prices. The greater the fluctuation of an asset’s price, the greater the risk of the asset. Let’s look at the different risk-return trade-off for different categories of assets:
In modern finance, the return that one expects to receive is proportional to the amount of risk that is undertaken; in effect, investing in high-risk assets is likely to yield a high return. Stocks are considered risky in the traditional financial markets, as the prices of the stocks are directly correlated to the performance of the underlying business, which in turn holds a broad range of risks. Since the 1950s, the average rate of return of stocks amounts to an annual rate of return of 7%. Within the stock market universe, there is also a varying level of risks associated with each industry; technology-focused stocks are more risky while utilities or telecommunication companies are much more stable, and therefore less so.
Compared to the stock market, the cryptocurrency market is extremely risky; probably one of the riskiest assets in existence today. As the Bitcoin chart shows, cryptocurrencies can increase in value of multiple figures within a short time frame, and can deflate in value equally fast. The 2018 market downturn caused prices of coins and tokens to fall by more than 85% within a span of a year, which is unprecedented in comparison to any other financial instrument. The volatile nature of the cryptocurrencies can be attributed to the infancy of the market, which results in a relatively illiquid environment. The absence of liquidity can cause tremendous price movements and also foster manipulation from players with a large capital base.
Liquidity refers to the ease of buying or selling a financial asset in the market without affecting the overall stability of the price. The harder for an asset to be converted into cash or any other asset, the more illiquid it is. An illiquid market is disadvantageous since participants will face tremendous volatility and also incur higher transactional costs due to asset mispricing. Conversely, greater liquidity brings about fair prices, market stability and efficient settlement.
Given the cryptocurrency market’s relative infancy in comparison with the stock market, it is very illiquid. This can be seen in the extreme volatility of cryptocurrency prices, where a single large trade can significantly move the prices of the coin. Another illiquidity indicator is the spread between the order books, which is a culmination of bid and ask prices. The majority of coins have a significant gap between the bid and ask price, meaning that there is a premium between buyer and seller expectations which pushes up the cost of trading. This is inherent in a new market where there is relatively insufficient market activity in the early stages.
The stock market, on the other hand, is extremely liquid. Large orders do not usually impact the prices of a financial asset, due to the large trading activity between numerous market participants. For example, stocks listed on the NYSE canchange hands between buyers and sellers millions of times in a single day.
- Customer Protection
The role of regulations in the financial markets is to protect consumers in the event of adverse circumstances. The stock market is highly regulated by the relevant financial authorities in all respective jurisdictions. For example, the Securities and Exchange Commission (SEC) regulates all financial activities in the United States. Various processes are mandated by the financial authorities to provide full disclosure and transparency to the general public – such as companies listed on the stock exchange being required to publish quarterly financial statements. These mechanisms ensure that the public are well-informed of the state of any company at any point in time, as well being a recourse in the event of unfortunate contingencies.
However, the cryptocurrency market is not as regulated as the stock markets. It is extremely challenging for regulators to regulate a decentralized network, plus the complexities that this new technology entails require more time to effect regulatory changes. However, there are countries that have already laid out the regulatory frameworks for cryptocurrencies, and this is a positive step for the industry.
The cryptocurrency market has been in existence for merely 10 years, so it follows that there are glaring inefficiencies that may impede greater mass adoption and institutional participation. However, the potential returns from betting on a new technology can be extremely alluring, given the historic rates of returns that have been seen in the past.