Cryptocurrency exchanges will go live soon. Are you ready to invest?

Extreme volatility means they should form only a limited portion of your portfolio

With the Supreme Court overturning the Reserve Bank of India's (RBI) April 6, 2018 circular on cryptocurrencies, investors in this asset class would be quite thrilled. 
 

Through the circular, the central bank had banned banks from providing services to cryptocurrency exchanges. Since investors could not transfer money from their bank accounts to a cryptocurrency exchange or get their money back from them, the decision had sounded the death knell of the industry. No wonder, there is significant enrhusiasm after the judgment and players are once again preparing to launch exchanges and peer-to-peer (P2P) platforms.  

Aftermath of the ban: Some exchanges relocated to other countries. Some switched to offering crypto-to-crypto trading. But C-2-C volumes were thin on the Indian exchanges. Investors who wanted to engage in such trading preferred international platforms that offer greater liquidity and better pricing.

Some exchanges, like WazirX, shifted to the P2P model, which operates as follows. Suppose A wants to sell cryptocurrencies and B wants to buy them. Both register on a P2P platform. A transfers his cryptos to the exchange, which provides the escrow facility. B transfers money to A's bank account. As soon as the latter receives the money, the P2P platform transfers the cryptocurrencies to B’s wallet. This model obviated the need for the exchange to have access to banking channels. 

After the RBI ban, many people believed that the government had declared cryptocurrencies to be illegal. This was not true. But this misconception caused many prospective investors to shy away from this asset class altogether. 

Regulatory risks remain: Banking services to cryptocurrency service providers will resume at the SC's behest. But one more risk hangs over the industry. A Draft Banning of Cryptocurrency and Regulation of Official Digital Currency Bill, 2019, exists that seeks to ban cryptocurrencies altogether. Even the RBI could come out with further regulations. 

Experts are hopeful the government will not take the draconian step of banning them completely. “Cryptocurrencies are here to stay. The bigger issue is, what should sovereign governments do to benefit from their advantages, rather than completely turning their faces away?” says Pavan Duggal, cyber law expert and advocate, Supreme Court. He informs that Belarus, Malta, Estonia and Switzerland have come up with new legislation on cryptocurrencies and blockchain. “India has an opportunity to learn from their experiences and see how best we can harness the positive potential of crypto assets,” he adds.

Banning cryptocurrencies altogether could be counter-productive. “Banning them will drive these activities underground. Instead, the government should allow trading but with proper KYC (know your customer) and anti-money laundering provisions in place,” says Nischal Shetty, founder and chief executive officer, WazirX. 

Exchanges going live again: Despite the regulatory risks, many players are getting ready to launch their services again. 

“If you wait, you will give a head start to your competition,” says Ashish Agarwal, CEO, BitBuddy, which plans to launch a mobile app for P2P transactions in Bitcoin. “We have already gone live,” says Rahul Pagidipati, CEO, ZebPay, which was the largest cryptocurrency exchange in India at the time of the banking ban with about 70 per cent market share. Shetty of WazirX says he is in discussions with payment gateways and these will get enabled within a couple of weeks.

Bear in mind that the number of cryptocurrency investors in India is not small — estimates say it could be 1.7 million or above.   

A high-risk asset class: There is a lot of concern among the authorities that cryptocurrencies are used for money laundering. Whenever Indian authorities crackdown on such activities, that could have an effect on prices. Investors in India will also be affected by how global, and not just Indian, regulations on cryptocurrencies shape up. 

This is also a very volatile asset class. On March 12, bitcoin had plunged 48 per cent in 24 hours, wiping out $ 93.5 billion in value, according to media reports. 

Moreover, cryptocurrencies may not provide diversification benefit. “Assets that are perceived to be risky tend to have a high correlation. As the equity markets were melting down this week, bitcoin too saw a very sharp correction,” says Vishal Dhawan, chief financial planner, Plan Ahead Wealth Advisors. 

No clear methodologies exist for determining the fundamental or intrinsic value of this asset class. “In the case of stocks, you can do discounted cash flow analysis or use valuation multiples to decide whether it is under- or overvalued. No such method exists for valuing cryptocurrencies,” says Dhawan. Deciding when to enter or exit then becomes a matter of guesswork or speculation. 

Despite the above-mentioned risks, if you still decide to invest in cryptocurrencies, make them a part of that portion of your portfolio where you engage in high-risk activities, like day trading. And limit the exposure to, say, 5 per cent of your total portfolio. “Invest only that portion of your wealth which you can afford to lose,” says Shetty. If gains in cryptocurrencies drive the weight of this speculative portion higher, sell and rebalance.        

  

To counter valuation risk, Pagidipati suggests that you use the rupee-cost averaging strategy. Also, have a long-term investment horizon. “The total number of bitcoins that can be mined is limited to 21 million. Demand will grow over time, so anyone who enters with a three-five-year horizon should earn good returns,” says Shetty. Investors should also limit themselves to the most reputed crypto currencies like Bitcoin and Ethereum. More than 5,000 of them exist today. Some are akin to Ponzi schemes, hence avoid the less established ones. 
 

When selecting an exchange, compare the cost of trading. Go with those that are well capitalised and have robust KYC mechanisms in place.

Precautions to observe when trading in crypto currencies

• Stick to the top two or three most popular currencies, and avoid the lesser-known ones
• Since this is a very volatile asset class, it should form only a small portion of your portfolio – money that you can afford to lose
• Since there are no well-established valuation methodologies for valuing crypto currencies, you should try to reduce valuation risk by following a rupee-cost averaging approach
• Stick to crypto currency exchanges that are well capitalised and have not suffered security breaches in the past
• Do pay heed to the cost of trading - 10 basis points is the norm