Cryptocurrencies are sweeping the world in terms of news headlines but how should institutional investors react? Opinion on cryptoassets is polarised even if the ‘plumbing’, in the form of blockchain technology, is now widely accepted.
- Cryptocurrencies are booming globally and moving closer to the mainstream
- Investors face a large amount of hype and misinformation about crypto assets
- Cryptocurrencies may be useful as a diversifier in a portfolio
When Bitcoin is the subject of fervent discussion among financial practitioners it is easy to draw the conclusion that in 2020 there will be continuing volatility in crypto-related assets. Yet the real problem for institutional investors is that, while there may be potential uses and attractions, they are hidden underneath an immense amount of misinformation and hype.
“When institutions begin to consider cryptocurrency a legitimate asset class it will lead to a situation where individual savers have a proportion of their pensions held in a digital currency or invested in digital assets,” says David Mercer, the CEO of LMAX Exchange, a financial technology firm. “Even if it only starts out as a percentage point or two it will lead to extremely significant in-flows into the asset class.”
The current size of the crypto-asset market, according to Aaro Capital, a company that facilitates investment in the technology, is about $200bn (€180bn) compared with $18bn at the beginning of 2017. In the past three years over 500 funds have been launched in the distributed ledger technologies (DLT) and crypto-assets sector.
Bitcoin has made the initial investors millionaires or even billionaires, at least on paper. But if, as appears to be the case, most of the market capitalisation of Bitcoin is held by a tiny number of initial investors, most later investors face a serious risk of massive losses.
The initial controlling investors need to sell their Bitcoin investments to monetise their value. Selling requires an ever-increasing number of willing buyers. For an asset that produces zero income, and whose increasing value is solely determined by increasing numbers of buyers, it smacks of a Ponzi scheme. Initial investors, whether the famed Winklevoss twins – who, it seems, may have owned 1% or so of Bitcoin at one stage – or others, would have to find willing buyers to monetise paper gains. Any large-scale selling by large investors is likely to trigger a selling panic.
The one type of investor who will definitely generate profits from the crypto boom are those who have adopted the philosophy of the famed sellers of shovels during the California gold boom and provide services in the form of exchanges and the like for crypto-related transactions. But even here there can be confusion on the value that they can provide to institutional investors.
There are two key questions facing institutional investors if they want to be involved in crypto assets. First, what are the requirements in terms of credit intermediation, regulation and infrastructure and cost.
Second, and more importantly, what should be the role of crypto assets within a portfolio?
LMAX’s Mercer argues that there needs to be an internationally trusted marketplace for institutional-only cryptocurrency trading. “We need banks with sizeable balance sheets to start acting as trusted central credit counterparties to provide traditional fund managers or hedge funds with the funds to implement their strategies and trades on the direction of cryptocurrencies.”
But, as Max Boonen, CEO and founder of B2C2, one of the largest cryptocurrency liquidity providers, argues, the main premise of a crypto-currency is that there are no intermediaries in a transaction: “It is an ‘asset’ that cannot be taken away from you but the problem is that as a store of value it is extremely volatile.”
For institutions, though, there is another key question: are cryptocurrencies such as Bitcoin assets akin to others within a pension fund portfolio? “If you think are currencies, they are not assets – pension funds don’t buy currencies to speculate, they buy assets that happen to be denominated in a specific currency,” Boonen says. “No-one in their right mind would want their pension funds invested in Bitcoin because currencies are not assets.”
Pension funds are not in the business of trading currencies for speculative gains by betting on the direction of cryptocurrencies. It is therefore unclear what role a cryptocurrency offering zero yield would have within an institutional portfolio except as a source of diversification, alongside other volatile but zero-yielding commodities.
Yet despite their volatility and uneven infrastructure, cryptocurrencies are moving ever closer to the mainstream. Ankush Jain, a partner at Aaro Capital, says this is happening in well-regulated countries such as the UK, where financial regulations have been reviewing them, Germany, where legislation has been proposed to enable banks to handle cryptocurrencies, and Switzerland, which has led the way in establishing crypto exchanges. High profile institutions such as JP Morgan and Goldman Sachs are also taking the sector seriously.
Crypto asset advocates such as Jain argue that their volatility presents opportunities in a world where return expectations across almost all established asset classes are depressed. Cryptocurrencies also have almost no correlation to other asset classes, and therefore provide clear diversification benefits. For institutional investment, Jain sees several possibilities:
• Direct investments: these can be risky, however, especially when investing in larger amounts, given storage and execution risks.
• Futures: available if one has the expertise to trade them
• Passive funds: for example, through exchange-traded products. These offer capacity but are a blunt instrument. They have concentration risk (because of the dominance, for the time being, of Bitcoin)
• Active hedge funds: Jain argues these are a better option because of the inefficiencies presented by the market: “Active, agile approaches can best exploit return opportunities and manage risk effectively. They are often small and difficult to source and diligence.”
• Venture capital funds: these can offer purer forms of DLT exposure, but often have long lockups.
• Multi-managers: these can offer a diversified portfolio of active managers that employ a range of different strategies.
Different cryptocurrencies possess varying levels of monetary properties which, in turn, affect their relative usability as money. For investors, the challenge with investing in any crypto-currency is that the main argument that drives investment in Bitcoin is that the supply of Bitcoin is limited. That may be true, but the supply of cryptocurrencies as a whole is unlimited, with no substantial barriers to entry.
Ido Sadeh Man, founder of Saga Monetary Technologies, points out that the cryptosphere is populated with cryptocurrency products – all geared towards delivering value through their approach to solving different issues – but their value is not being driven by demand for cryptocurrency per se, but by user demand for the solution they provide. “It’s correct to say that barriers to creation are low, he says. “But it’s what comes after creation that really sets them apart from each other, and exercises and demonstrates where their true value proposition lies.”
Like any form of money, the value of a cryptocurrency is derived from a combination of the usefulness of its money-like properties and subsequent network effects. Unlike traditional currencies, larger cryptocurrencies are secured by their network value, points out Jain. The higher the value, the harder it is to attack the network. But that still leaves the issue that cryptocurrencies may have as much long-term stability as tulips in 17th century Netherlands as a store of value. For long-term institutional investors, that is still a deal breaker.
One development that may change that is the creation of so-called ‘stable currencies’ which are linked to more stable baskets of currencies or commodities. Linkages to fiat currencies naturally mean that the cryptocurrencies are no longer decentralised as there are implicit links to the monetary policies of the issuing countries in the currency basket.
Facebook with its Libra electronic currency is leading a new trend – that of corporations issuing their own units of exchange linked to baskets of assets. Whether that will take off remains to be seen. But for central banks and institutional investors it adds further complexity to an already difficult set of challenges.