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Crypto exchanges provide a platform for people to buy and sell cryptocurrencies with their fiat currency or to trade different cryptocurrencies for one another. These companies take a small fee with each transaction. Given the increasing popularity of crypto, exchanges with a lot of customers and high trading volume can wind up becoming very profitable businesses.

Some crypto exchanges become so profitable that they issue shares of equity in their company on a public stock exchange. This happened for the first time in 2021, when one of the oldest crypto exchanges was the first in the industry to become a publicly traded company.

Why would someone invest in crypto exchange companies? What might be some of the potential benefits and drawbacks to such an investment? We’ll answer questions like these, and more.

A Word on IPOs

First, investors should be aware of the fact that many initial public offerings (IPOs) create a lot of fanfare and buzz. But they don’t always deliver right away.

It’s not uncommon for companies to make their debut on the stock market at valuations that far exceed their true market value. It’s common for IPO stocks to see their prices tank shortly after going public.

While this doesn’t have to dissuade investors from a company they would otherwise remain bullish about, it’s an important thing to keep in mind.

Private investors like venture capital funds can get in on the action before the public, so they don’t care as much about what happens to share prices post-IPO. But for retail investors, buying a lot of shares on the day a stock goes public has quite often proven to be a mistake, at least in the near-term.

Pros of Investing in a Crypto Exchange

Some of the pros of investing in crypto exchanges include potentially taking advantage of rapid growth, owning a piece of crypto infrastructure in a regulated way, and holding a security that can be subjected to more traditional valuation methods than a cryptocurrency.

Rapid Growth

The growth seen in the crypto industry has been unparalleled. In 2015, the entire cryptocurrency market cap was about $7 billion. Today that market cap has risen to over $1 trillion, peaking at over $2 trillion in early 2021.

Bitcoin was only just invented twelve years ago in 2009. To put that into context, it took companies like Apple, Google, and Amazon an average of 20 years or more to reach a valuation in excess of $1 trillion.

If this growth continues at even a fraction of its current rate, then there is a chance that broad investments in the sector like crypto exchange stocks could see substantial returns on a 5-, 10-, or 20-year timeframe. (But as with anything having to do with investing, past performance is no guarantee of future results.)

Indirect Exposure to the Crypto Market

Investing in the stocks of crypto exchanges provides a proxy for investing in cryptocurrency itself. In other words, investors can gain indirect exposure to the crypto market, without exposing themselves to the potential volatility of crypto itself. Investors who aren’t sure about cryptocurrency as an asset class, or who would rather not learn how to own and hold cryptocurrency tokens on their own, might find these stocks appealing.

Buying shares of a crypto exchange lets investors hold a piece of the infrastructure that keeps the cryptocurrency world functioning. Most exchanges also have value beyond simply being brokerages for the buying and selling of cryptocurrencies.

• Exchange-hosted wallets allow users to send crypto off-platform.

• Some exchanges have begun providing staking services, where users who hold proof-of-stake coins can earn what amounts to a crypto dividend by holding those coins in their exchange wallet.

• Exchanges are even beginning to get into borrowing and lending services, letting users lend out their crypto to earn interest or take out a loan using their crypto as collateral.

More Traditional Valuation Methods

The shares are an investment in a real company with cash flow, earnings, a board of directors, and all the things that traditional investors are familiar with. This makes it easier for some investors to grasp than cryptocurrency itself. Crypto exchange stocks can be treated as any other equity in a portfolio. They can also be scrutinized in the same way, using valuation models like the discounted cash flow model, the dividend discount model, and others.

While it seems likely that crypto exchange stocks will have some correlation to the price action and value of Bitcoin and other cryptocurrencies, the relationship might not be 1:1. Traditional company metrics like quarterly earnings will likely also impact share prices.

Cons of Investing in Crypto Exchanges

Some of the cons of investing in crypto exchanges include the potential for speculation, regulatory concerns, a lack of historical precedent, the business models involved.

Potential for Speculation

While crypto markets are often criticized as being speculative, stock markets also have their fair share of speculators. And when crypto markets rally, it’s feasible that some investors could get overly bullish on crypto exchange stocks, creating a mania that ends in a crash. This might be the exact type of thing investors are hoping to avoid by choosing to invest in crypto exchanges rather than actual cryptocurrencies.

Then again, it’s also possible that crypto exchange stocks weather the storm of a crypto market downturn better than the crypto market itself. The phenomenon of exchanges being publicly-traded securities is too new to tell for sure yet.

Lack of Historical Precedent

2021 is the first year that any crypto exchange has been made publicly tradable on a stock exchange. No one knows exactly what will happen, how the securities will trade, what will impact their prices, and so on. Much of the outlook is conjecture at this point.

The future of blockchain technology itself, which powers cryptocurrency, is only 12 years old and also has a degree of uncertainty behind it.

Regulatory Concerns

It’s widely suspected that financial regulators will tighten the noose around cryptocurrencies at some point. What form that might take, and what the impact could be, is largely unknown. Some say that greater regulatory clarity would be a good thing, as larger investors would feel more comfortable entering the space with significant amounts of capital. Others believe over-regulation could cripple the industry and the asset class as a whole. Again, this is somewhat of an unknown.

Fee-Based Business Model

Typically, most of an exchange’s revenue comes from transaction fees. It has been noted that over time, fees like these tend to see downward pressure due to competition. In the world of stock brokerages, for example, trading fees on most platforms have fallen to zero in recent years.

While this could be a possibility, others have argued against it, saying that crypto isn’t analogous to stocks in this respect. Users are also paying for additional services like custody services, or holding crypto, which is an important factor to consider. An exchange-hosted wallet also lets users send and receive crypto transactions without having to create and manage a wallet of their own.

The Takeaway

Investing in crypto exchanges isn’t that different from investing in other companies. And as always, investors should educate themselves about what they’re buying and why. An investigation into the company’s activities, management, history and earnings reports would be warranted regardless of which company an investor chooses.

Photo credit: iStock/valiantsin suprunovich

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