Comparing stocks to cryptocurrencies
By Peter B
There are many ways that an individual can invest their money. Some examples include stocks, bonds and real estate. More recently, cryptocurrencies have become a popular investment vehicle, attracting significant attention from a wide range of investors. Many have compared buying cryptocurrencies to buying stocks, primarily due to buying and selling on an exchange that operates in a similar manner. While it may seem as though purchasing a cryptocurrency on an exchange is like buying stocks in your bank account, there are distinct differences.
What are you actually purchasing
When purchasing shares of a company, an individual is purchasing an ownership stake in the company. That ownership stake may include the right to vote on important matters within the corporation, the right to receive dividends declared by the corporation and the right to participate in the distribution of assets upon liquidation. The rights that a shareholder of a public company is entitled to may vary from company to company, and from jurisdiction to jurisdiction depending on local securities laws.
When purchasing a cryptocurrency, you are not purchasing an ownership share of the company. In general, a cryptocurrency does not entitle you to any of the above mentioned rights, nor is the coin necessarily backed by any tangible asset. While there are new coins being launched that possess some of the characteristics of company shares (such as being backed by an asset or the right to a dividend), this is not the case with most cryptocurrencies to date.
The value of a publicly traded company’s stock is dependent on several elements. First and foremost, a valuation of the company is undertaken, where the company’s earnings, future cash flows, growth prospects, dividend payments, assets, liabilities and other factors are considered. Investors will then consider the elements above and attempt to determine the company’s value using methods such as a discounted cash flow. Finally, supply and demand play an important role in determining a stocks price, as the more a stock is in demand, the higher the price will generally rise.
Valuing a cryptocurrency, in most cases, is an arbitrary exercise. As most cryptocurrencies do not grant coin holders a claim on underlying cash flows or assets, traditional valuation methods cannot be applied to value the coin. Instead, most cryptocurrencies are priced based strictly on supply and demand. Investor logic, for the most part, is that the more popular the coin, and the coin is used for its purpose (example, transaction growth on Ethereum network), the more the value of the coin will rise alongside demand. (fill with valuation method on network effect).
Equity markets have existed for much longer than cryptocurrency markets. Over time, market participants have become increasingly sophisticated and the underlying value for many stocks has become known to investors. As such, when the price of a stock deviates from the valuation that investors have put on a stock (for example, a blue chip stock dropping several percent), many investors will quickly jump on the occasion and push the stock price back up. These market participants are able to determine what they are willing to pay for the stock, as they will value the company using well-defined methods amongst all investors.
The cryptocurrency market, on the other hand, has demonstrated much more volatility than the mature equity markets, as the underlying value of many of these coins are unknown to investors. Since an individual cannot value the company based on its partnerships and development team, the value of the coin reverts back to supply and demand. New participants are entering the cryptocurrency markets each day, ranging from new investors to sophisticated ones. As the markets mature, volatility will come down and cryptocurrency will eventually trade more similarly to the stock markets.
Insider trading and market manipulation
In virtually every jurisdiction with a mature stock market, there are securities laws designed to protect investors and prevent market manipulation. While these rules are never perfect and people will always try to game the system, there are clear rules to prevent such occurrences and well defined reprimands, which may include prison time.
There is much ambiguity surrounding the cryptocurrency markets and insider trading/market manipulation. Only recently have securities regulators began to question whether or not a cryptocurrency is a security, implying that if they were considered securities, that securities laws would apply to trading them.
Since there has not been clearly defined rules by regulators across the world, many cryptocurrency market participants have taken advantage of the seeming “lack of regulation” and have manipulated markets, whether through buying coins prior to releasing important news, or trading in manners that would constitute market manipulation.
As markets mature and regulation is well defined, the manipulation in the cryptocurrency should subside and markets should behave more fairly. However, the cryptographic nature of cryptocurrency creates an additional challenge for regulators to identify those who are breaking the rules and enforce penalties on them.
IPOs and ICOs
IPOs (Initial Public Offerings) are one method that companies can take their shares public and trade on public equity exchanges. In order to issue an IPO, an important component is the issuance of a prospectus. A prospectus is a disclosure document that provides a detailed breakdown of the company, all relevant information and all of the risks of investing in the company. This document allows the company to offer shares to the public, including those that are not considered “accredited investors”. This document is designed to protect all investors and to assure that they have the ability to do their research prior to purchasing stock of the company.
ICOs (Initial Coin Offerings) are one method that a venture may sell their coins to the public. An Initial Coin Offering may be used to raise money to fund development of a product, or to simply launch a product to the public for its use (example, utility token). Some ICOs are open to all investors, while others restrict the jurisdiction and the type of investors (requirement to be an accredited investor). These restrictions are generally to comply with securities law, and often to not be required to draft and issue a prospectus. A whitepaper is not nearly as comprehensive as a prospectus and would not meet most regulator’s requirements for securities law compliance.
More recently, a trend among larger ventures that are looking to issue tokens is to proceed through an STO (Securities Token Offering). The intent behind an STO is to comply with all securities regulations, and possibly to offer the equivalent of company shares in a tokenized form. It is costly to proceed via an STO as there is significant legal work required.
Many entrepreneurs and investors have used ICO’s to raise capital to fund their venture, in a lean an inexpensive manner. While philosophically, the principles behind “crowdfunding” a venture and incentivizing investors through tokens can jump start many ventures that would otherwise never have the capital to operate, many have taken advantage of the undefined regulatory regime and have cheated investors out of their investments. Securities regulators are mandated to protect investors and do so through securities laws. Some regulators have taken the initiative to work with new ventures to “streamline” the process and reduce the regulatory burden to help them get started.