Cryptocurrency volatility: Why the risk-reward tradeoff is skewed

Cryptographic assets are one of the most — if not the most — volatile asset class there is; you can make loads of money or lose everything. While for many the possibility of generating spectacular returns is the key attraction of crypto, are the risks consummate with the potential rewards?

In an effort to answer this question, this article explores the risk-reward profiles of a couple of different types of cryptographic assets. The first being Initial Coin Offerings (ICOs) and the second being existing coins and tokens.

Initial Coin Offerings

An ICO refers to the process of raising funds for early-stage crypto projects, in return for an issuance of a newly-created, native token. ICOs are an exciting category within the crypto sphere, with the potential to generate very high returns. A report from Mangrove Capital Partners, for example, found that the average returns across 200 surveyed ICOs in 2017 was an astonishing 1,320 percent.

Naturally, though, ICOs come with a higher risk profile than existing, tradeable coins in the market, just like how penny stocks are riskier when compared to the stocks of blue-chip (established) corporations. The reasons are many, but the main ones are the fact that a majority of ICOs do not have a working protocol or product at the outset, with only a theoretical conceptualization of their project as manifested in their white paper.

For investors, therefore, it is vital to understand that there exists a high statistical probability of failure in the crypto start-up world. In addition to this, there is also the issue of the absence of regulatory oversight towards ICOs, which translates into the non-existence of consumer-protection laws in the crypto asset space.

Existing coins and tokens

There are more than 1,500 coins and tokens currently being traded on exchanges. Under the BNC General Taxonomy, we can see that all cryptographic assets can be segregated into different categories based on their applications and the variety of use-cases they were intended for.

The risk profile of existing cryptographic assets is lower than that of ICOs for the simple reason that they have some history. Thus, investors can track the progression of the projects, whether they’ve met their deliverables and achieved the milestones set in their whitepapers. Time will tell if the technology and applications of a project are viable, and this will be reflected in its price. Besides the obvious volatility risks, the operational risks of securing cryptographic assets safely is a major point of concern especially as the masses are not really ‘tech-inclined’ when it comes to crypto, and the learning curve is relatively steep.

Overall, crypto assets are high-risk investments and the recent correction is a testament to that. The entire crypto market has decreased by more than 60% so far in 2018 from its December 2017 highs. However, looking beyond the short-term oscillations, there are some fundamental reasons as to why the volatility and risks appear as they do.

Ultimately, it’s a new technology

It has been well documented that the inception of revolutionary technologies — such as the internet — often entails initial periods of volatility, as the industry is immature and adoption is limited. Blockchain, the technology underpinning Bitcoin and a majority of other cryptocurrencies, has the potential to disrupt a number of industries and bring positive changes on a global scale, advancing the principles of transparency, efficiency and accountability.

The fact that Blockchain technology has been around for more than 10 years with no fundamental flaws, an exponentially growing list of applications, and a dynamic ecosystem that is constantly pushing the technological limits is a testament to its potential.

Utility leads to adoption

In order to achieve widespread adoption, crypto projects must offer viable solutions to real-world problems and thus warrant their usage. This is manifested in the utility — or uses-cases — of cryptographic assets. Using Bitcoin as an example, its dominant utility as a peer-to-peer medium of exchange is that it allows users to circumvent excessive banking (or any third party) fees and significantly reduce transaction times (although in reality, this utility has faced challenges in recent times as the Bitcoin network has attempted to scale transactions).

So essentially, Bitcoin allows users to engage in a global transfer of value at a fraction of the traditional cost and time. A greater rate of adoption will mean higher Bitcoin prices, due to increasing demand. Having a strong utility is therefore vital in substantiating the value of cryptocurrencies, and will ultimately benefit long-term investors.

The importance of due diligence

It is interesting to note that a recent study found that the cryptocurrency market is mainly driven by investor sentiment, and this leads to high levels of volatility. In addition, the technical nature of cryptographic projects makes it hard for many to understand them.

However, performing due diligence is a vital requirement in the investing process to ensure that one invests in cryptocurrencies that are fundamentally strong and possess long-term viability. Investing in good projects will significantly reduce your risk profile, assuming you’re in it for the long-term.