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Thinking of investing in a cryptocurrency? Look at these factors first

There are key fundamentals and rules to investing in cryptocurrencies such as bitcoin, ethereum and dogecoin.

May 20, 2021 / 04:01 PM IST
Every cryptocurrency has a particular set of parameters that one should research before investing. One can broadly divide them into three categories: project metrics, financial metrics, and on-chain metrics.

Every cryptocurrency has a particular set of parameters that one should research before investing. One can broadly divide them into three categories: project metrics, financial metrics, and on-chain metrics.

What a week it has been for cryptocurrencies! Or should I say months! In the past six months, cryptocurrencies have seen their prices skyrocket on the back of tweets, comments on social media, and advice from people who barely know anything about how cryptocurrencies work.

As the price kept moving up, everyone felt the FUD (fear, uncertainty, doubt), and started pumping even more money in a typical mistake that every retailer makes, not just in cryptocurrencies but in every asset class.

The result: Over the past few days, many retail investors found themselves trapped in a situation they’ve been in before. Several times. And not just in cryptocurrencies, but in every asset class.

Here’s how the cookie crumbled:

One piece of negative news, and the panic crept in. Every dip in price was followed by another, with crypto markets wiping out over $600 billion in less than a week and most cryptocurrencies losing over 30 percent in a day. The "learned" advisers and experts among our friends, who had given their valuable inputs when markets were going up, suddenly disappeared.


Yet this isn’t the first time we’ve seen this happening. Haven't we all heard of retail investors - people who’ve put their hard-earned money on the line - take a loss after taking advice from people who know nothing about investing and are part of grapevines?

Indeed, many of us have lost money in the markets in a bid to make some quick money. This past week was no different in cryptocurrencies, and we fail to understand and learn yet again.

Cryptocurrencies, just like any other assets, are based on fundamentals. Although they might differ from the usual fundamentals that we apply to any other asset class, it still has particular rules. And if these rules are complied with, one can become rich in the long run, just like with any other asset class.

Even if we gauge the ashes of this past week's fire, the fundamentally strong coins and tokens did emerge like a phoenix. These coins suffered a burn, but their bounce-back was slightly quicker than the coins that had risen based on news flow and social media activity around them.

Cryptocurrency bloodbath: Global market cap drops by $177 billion as bitcoin and ethereum continue to nosedive 

While regulatory uncertainties still have a significant role to play, cryptocurrencies over the past decade have proved potent enough to be called an investable asset. So it's time to understand the fundamentals of a coin or a token before investing your next round into cryptocurrencies. Let's look at some of them:

Every cryptocurrency has a particular set of parameters that one should research before investing. One can broadly divide them into three categories: project metrics, financial metrics, and on-chain metrics. This list could be non-exhaustive and newer innovations can add or delete a few points. It still gives us a broader framework.

1. Project metrics

Every project that launches its token builds some qualitative aspects around its project and coins. These aspects are very close to how people analyse companies, but still, they have their uniqueness.

a. Read the whitepaper: Whitepaper is the crypto equivalent of a Draft Red Herring Prospectus (DRHP) that states every aspect of the project and the coin. The whitepaper is a technical document that every project displays on its website to inform its potential investors of the complete details. A good whitepaper usually puts forward the technology the project uses, the use case or the solution that it offers, its plans and roadmaps, and the supply and distribution dynamics of its tokens. It is always wise to ponder these points and do thorough research on the use case, as these are the first clues that can help the investor gauge the quality and longevity of the project. Also, if the project is just a me-too project and is addressing an already competitive market, then again, it's a no go.

Bitcoin plunges: A bust or a buy?

b. Who’s the team? While the project information is critical, it's the team that will drive the project and complete the plans. Hence, the track record of the team members is critical. It's also essential to see whether the team has the required skill or expertise to run the project and complete its milestones. If the team comprises people with no background in the industry, their project is catering to or has been part of questionable projects in the past, it doesn't deserve your money.

c. Tokenomics: It's essential to consider how a project distributes the tokens, and it can provide information on how the money raised by the tokens will be put to use. It would also help investors understand whether the coin can be mined, or how their total supply work influences whether it's deflationary or inflationary. Also, it is important to note how many tokens are the team and founders own compared with how much is available for the investors. A thorough analysis of Tokenomics might give investors an idea of any risk that exists. For instance, if only a few parties owned the vast majority of the supply, investors might conclude that this is a risky investment, as those parties could eventually manipulate the market.

2. Financial metrics

Just like with shares, trade-off between stability and higher returns, and liquidity and volumes traded are things you must consider before investing in crypto.

a. Market capitalisation: Market capitalisation (or network value) in cryptos is calculated by multiplying the circulating supply with the current price. This represents the cost to buy a particular token of that project. While market capitalisation may sometimes not give an accurate picture of the actual token in supply (lost keys and coin burns don't form part of active supply), market capitalization is used extensively to figure out the growth potential of networks. While many believe small caps to be risky, they may have good growth potentials. Others may choose large caps, which are believed to have more robust networks and stability even with limited growth potential. Doesn't it sound similar to equities?

Take a look at how 15 cryptocurrencies performed on May 19

b. Liquidity and volume: Just like equities, liquidity and volume of a trading coin or token are essential. It clearly states whether the coin is sellable without any problem at its trading price. Liquid coins are less risky than illiquid ones which may not find any buyers in a panic situation - as many encountered recently. It is also necessary to choose the suitable exchange to trade in cryptos as, usually, the top exchanges draw maximum liquidity compared to relatively small exchanges.

3. On-chain metrics

As crypto tokens are based on blockchains, and their data is freely available, it is necessary to consider the on-chain analysis of each token. While many websites give on-chain data, it is essential to cross-verify them from multiple sources, including running a node for the desired network.

While this aspect is slightly technical, it's necessary to understand each factor. Some good sources for on-chain data are CoinMarketCap's on-chain analysis of Bitcoin and Coinmetrics' Data Charts.

While people can pick and choose the data they believe in, the indicators to look at are:

a. Transaction counts: The higher the transactions, the better for the project.

b. Transaction value: While the transaction count can give insight into how many transactions are done over the network, many believe the value of the transaction is a better determinant. Again, higher the transaction value, the better it is for the project.

c. Active addresses: Active addresses are the blockchain addresses that are active in a given period.

While many consider active addresses a better unit, a few believe the unique address for a project determines its actual trustworthiness and belief amongst users.

d. Staking: Staking (in Proof of Stake projects) is another related concept with similar game theory. The basic idea of staking is that users stake their holdings to participate in block validation. As such, investors could look to the amount staked at a given time to gauge interest (or lack of it).

To sum it up, just like every asset class, cryptocurrencies also require deep understanding and fundamental analysis to build wealth over time. Hence, it is vital to study a project and invest rather than blindly follow rumours and social media activity. These rumors and social media activities might give some accessible opportunities, but strong fundamentals-driven coins turn out to be wealth builders.

Nilesh Maurya is Director-Investment Banking at Omega Capital Consultants. Views expressed are personal.
Nilesh Maurya is a Director-Investment Banking at Omega Capital Consultants.
first published: May 20, 2021 03:47 pm

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