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Cryptocurrencies: A match made in heaven – or hell

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Cryptocurrencies could offer handsome returns to hedge funds. Or they could be a disaster

KEY POINTS

  • Cryptocurrencies can often seem like purely speculative investments
  • There is substantial potential in the marketplace
  • Reputable investment firms are taking an active interest
  • The ultimate killer of cryptocurrencies as alternative money may be the lack of unique characteristics that make one currency preferable to another

Hedge funds and cryptocurrencies may seem a like a marriage made in heaven, or perhaps in hell, depending on your attitudes to both.  

The controversy is caused by a combination of factors. These include the retail rush into bitcoin, accompanied by huge volatility and exaggerated claims on the potential growth in value. Add to all those, confusion over what the underlying blockchain technology represents.

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For an asset that produces no income, and whose increasing value is solely determined by increasing numbers of buyers, bitcoin and other cryptocurrencies can smack 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 substantial investors is likely to trigger a selling panic. 

Moreover, bitcoin-mining entrepreneurs are reputed to be setting up facilities where power can be accessed cheaply. But electricity consumption required to ‘mine’ bitcoin is estimated by Digiconomist as already larger than the consumption of 159 countries including Ireland and Nigeria. 

yves choueifaty

Yet behind the confusion, chaos, regulatory arbitrage and fraud that has characterised the marketplace for crypto-assets there lies substantial potential. Reputable hedge funds, investment funds, investment consultants and technology platforms are taking an active interest. “There are terrible things seen in the crypto marketplace and the vast majority may eventually disappear, but a few will turn out to be interesting businesses,” says Marcos Veremis, a managing director at Cambridge Associates.

TOBAM launched a bitcoin mutual fund in November 2017, primarily as a research tool initially, both for exploring cryptocurrency developments and also for testing theories on market impact developed in-house, says CEO Yves Choueifaty. With daily trading volumes on exchanges such a LMAX Digital averaging only £50m (€58m), and $100m on a good day, compared with $15bn a day on foreign exchange, it provides a good laboratory for testing theory against practice.

LMAX Exchange Group launched a digital platform in May 2018 at the request of large institutional clients, says CEO David Mercer. It trades five cryptocurrencies – bitcoin, ethereum, litecoin, ripple and bitcoin cash – all tradeable against dollars and yen. It has over 100 clients, predominantly hedge funds which Mercer describes as the third wave of investors. This follows the first wave – of essentially the scientists behind the creation of bitcoin – and the second wave driven by hysteria from retail investors.

The barriers to entry in creating cryptocurrencies are low but what matters, says Michael Sonnenshein, managing director of Grayscale Investments, is the purpose for which they are created. “Bitcoin was intended to be a digital form of money, but today it is not functioning that way because the network is so popular that it has gotten bogged down,” he says. But, he adds, there is an enormous amount of effort being made to scale up the system. Despite the work being done on bitcoin, it is too early to see whether it will succeed as a transaction mechanism.  

cryptocurrency mining software at work

Cryptocurrency mining software at work

Bitcoin itself has had over 40 forks in its development, most of them having zero value, and there have been huge numbers of other crypto-assets created, most of which will disappear with time, Veremis says. Cambridge Associates sees crypto-assets as having essentially the nature of a venture capital investment, albeit with a higher risk than venture capital opportunities, on average.

Michael Sonnenshein

Michael Sonnenshein

Mercer sees the real value of cryptocurrencies traded on LMAX as the underlying blockchain technology that will, he argues, eventually be transformational in the settlement of trades on financial markets. “The winning technology will be the next Amazon,” he says. 

Choueifaty, however, makes a distinction between blockchain technology and cryptocurrencies, some of which do not even use blockchain technology. “The only real future potential use of cryptocurrencies is in the storage and measurement of value.” But bitcoin has seen tremendous volatility which makes it a poor choice for that, for the time being. His counter to this situation is that it is precisely the fact the bitcoin is not yet an adopted store of value, given its underlying characteristics, that gives it potential for appreciation. 

After the dust settles in the chaos of the cryptocurrency market, there will only be five to 10 cryptocurrencies left, says Sonnenshein. “What matters is the size of each digital currency network today. For example, how many users are there, how many wallets are open and how many transactions there are. Those are the metrics that are helping investors see where flows are going and will continue to go,” he says. As he points out, most of the protocols underlying cryptocurrencies are open source, so if a new feature or attribute comes along that remedies a deficiency in bitcoin, it can be integrated into the bitcoin protocols so that all the users and the infrastructure would not be forced to move away from it.  

“The winning technology will be the next Amazon”- Oliver Dobbs 

How should investors view crypto-assets such as bitcoin? The distinction between the underlying blockchain technology and the cryptocurrency characteristics is an important one. Yet both have their advocates and their detractors. As a store of value, cryptocurrencies may have as much long-term stability as tulips in 17th century Netherlands. Many of these currencies, as the US Securities and Exchange Commission and the UK Financial Conduct Authority are warning, are clearly scams. Some cryptocurrencies are well-intentioned but others are circumventing listing rules to crowdfund possibly interesting investment opportunities. 

But the ultimate killer of cryptocurrencies as alternative money may be that there are no unique characteristics that would make one cryptocurrency preferable to another. That is unlike real currencies which are backed by central banks, and whose valuations, for better or worse, are ultimately backed by the reputation of the central banks themselves. For bitcoin advocates such as Choueifaty though, the value of an investment is driven by the uncertainty and potential that it represents should it be successful. 

Perhaps cryptocurrencies are better regarded in the same way as having a flutter on a lottery. Perhaps worth having a bit of fun with but probably not worth mortgaging your house for – even for hedge fund managers.

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