Fintech: Conventional investors tiptoe up to cryptocurrency
As retail and high net-worth investors embrace cryptocurrency, delta one synthetics allow institutionals to allocate to this new asset class, but sceptics say that cryptocurrency is an immature market. They warn that catastrophic losses in crypto could destabilize the regular equity, commodity, debt and currency markets.
Things are moving fast in the cryptocurrency world.
In mid November, the price of bitcoin hit a then all-time high of $7,459. It had been a volatile ride, with plenty of dips along the way, but the 12-month performance was looking extraordinary. A year ago, you could have bought a single bitcoin for just $742. No doubt many investors were wishing they had and asking their highly paid financial advisers why they lacked the wit and imagination to put them into it.
Plenty of financial commentators have cried speculative bubble, of course, none louder than Jamie Dimon, chief executive of JPMorgan, who famously told the Delivering Alpha Conference back in September: “If you’re in Venezuela or Ecuador or North Korea, you’re probably better off using bitcoin than their currency. But that can’t possibly happen in the United States, unless you’re speculating. That’s not a reason to say something has value: that other people are going to speculate.”
Heaven forbid that JPMorgan should ever do anything like that itself, or finance anyone else speculating either. “That’s tulips,” Dimon confirms.
In November, it looked like investors might finally be taking notice of him. The world’s leading cryptocurrency fell sharply, hitting $5,618 on Sunday November 12, fully 25% off its high just days earlier.
Various explanations were offered for the latest fall. Dimon had suggested that world governments will close cryptocurrency down. In the days after his famed outburst, with Chinese authorities cracking down on cryptocurrency exchanges that they might have blamed for enabling capital flight, bitcoin fell 35% from $4,950 at the start of September to $3,227 two weeks later – before resuming its upward march.
This time analysts saw something more at work than the disapproval of big-name bankers or the efforts of governments to curb bitcoin’s use. The argument is that the very success of bitcoin carries the seeds of its own destruction, that the need to process high volumes of speculative turnover is exposing flaws in the underlying open blockchain technology and disagreements among the visionaries and drivers of bitcoin.
In August, bitcoin was subject to a hard fork, leading to the creation of Bitcoin Cash amid efforts to increase the block sizes being processed on the bitcoin blockchain to eight megabytes (8MB). This was in order to meet the needs of large players investing in bitcoin as an asset, rather than individuals using it as a transaction currency.
The market capitalization of the new Bitcoin Cash grew quickly, surpassing some of the nearest competitors to bitcoin such as Ripple and Litecoin, and approaching that of ether, the currency of the Ethereum network, the second-largest cryptocurrency.
But a further upgrade to bitcoin, scheduled for mid November was cancelled.
Daniele Bianchi, an assistant professor of finance at Warwick Business School who is researching cryptocurrencies, says that the large drop in bitcoin prices was probably due to the competition of Bitcoin Cash.
“Perhaps frustrated by the cancelled technology update of the original bitcoin blockchain, which was announced recently,” he says, “an increasing number of users are switching to Bitcoin Cash, which allows for bigger block sizing, giving ample capacity for everybody’s transactions, as opposed to bitcoin’s cap at 1MB blocks.
“Indeed, one of the main problems with bitcoin is that it does not scale up properly as more and more users adopt it. This makes transactions slower and slower as the block size is fixed. In addition, the segregated witness – ie SegWit2x – technology recently introduced by bitcoin scientists, raised questions about the progressive centralization of bitcoin mining towards big servers, something which is fundamentally against the original proposition by Satoshi Nakamoto.”
Bianchi points out that Bitcoin Cash addressed this issue by increasing the block size to 8MB to accelerate the verification process, with an adjustable level of difficulty to ensure the chain’s survival and transaction verification speed, regardless of the number of miners supporting it.
But Bianchi says that the security of the Bitcoin Cash blockchain is still unclear: “The internal fighting between bitcoin and Bitcoin Cash is probably here to stay for a few weeks and months. The situation is very fluid, and market valuations are both constantly calibrating and volatile, especially given supply is limited and everything is mostly driven by aggregate demand.”
Almost as disconcerting was what happened to Parity, a blockchain company offering wallets in various cryptocurrencies.
In November, a bug in the so-called library smart contract code around Parity’s multi-signature wallets left an anonymous user suddenly in control of hundreds of wallets. Apparently trying to back out of the treasure trove into which they had dug, the person deleted the library code and so has left frozen 587 wallets, holding a total of Eth513,774.16, roughly equivalent to $160 million.
There is no timeline for unfreezing these accounts and allowing owners access to their wealth. The company, whose website rather hilariously still broadcasts its Parity Ethereum product as being high-performance, ultra-reliable and future-proof, says that it is: “Working hard on several Ethereum improvement proposals (EIPs) that have the potential to unblock funds.”
However, it has to concede that there is no guarantee that such an improvement proposal could be implemented: “We will follow the will of the community and go through the regular EIP process like any other protocol improvement.”
The crypto world loves to describe itself as a decentralized one. If ever there was an incident showing the need for a central authority – a regulator or even a government – to resolve such a disastrous cock up, this surely is it.
But don’t count the world’s most famous cryptocurrency out just yet. With all this in the background, bitcoin’s previous climb quickly resumed. Within a week of that 25% fall in November, it had surpassed its previous high, touching $7,843 in value on November 16. By November 20, it had passed $8,200. A week later, it was $9,588.
At the start of this year, the total market value of all of the cryptocurrencies was around $17 billion. By early October, that had risen to $151 billion. By the third week of October, it had increased to $170 billion, according to CoinMarketCap, and by the end of November it was $300 billion, of which bitcoin accounted for just 54%.
Has the cryptocurrency world reached a point where it is self-sustaining? One of the long-term arguments for the value of cryptocurrency is that it will become the medium of exchange in the era of the Internet of Things, when our fridges are telling our supermarkets to deliver more groceries, and our cars – if anyone still owns one – are paying for road usage or battery charges without us ever fiddling for our wallets or loose change.
In the short term, the proliferation of blockchain technology startups funding themselves from initial coin offerings (ICOs) rather than through venture capital has increased the usage of core cryptocurrencies such as Ethereum and bitcoin to pay for early exposure to the latest sure-fire winner.
“What we have seen happen with all the recent ICOs is that there are now newly minted cryptocurrency millionaires and even billionaires, many of whom have no interest whatsoever in transferring that wealth back into fiat currency but rather intend to invest in and build out the crypto eco-system, diversifying into more ICOs,” Ryan Radloff, co-principal at CoinShares, tells Euromoney.
In October, CoinShares took a big step in forging a path for mainstream institutional investors to take exposure to cryptocurrency, launching two new exchange-traded notes on Nasdaq Stockholm.
These allow investors to gain exposure to ether, the currency of the Ethereum blockchain that is second in market size now only to bitcoin. The notes are denominated in Swedish krona and euros and are structured to derive a value for ether based on an index rate of the average of the three most-liquid of a select group of exchanges, daily.
Conventional investors know that bitcoin has been used by criminals. The smart ones presumably can sense that some ICOs are, if not fraudulent, then certainly puffed up like internet stocks at the end of the 1990s. But they are still intrigued and, even after the recent extraordinary bull run, are gripped by fear of missing out and grasping for any basis of valuation they can comprehend.
Step forward, utility value.
“Blockchains need a native token or coin. As more and more use-cases for the technology emerge to run tokenized assets and smart contracts, the utility value of certain tokens continues to grow and becomes a very interesting investment opportunity,” says Radloff. “We are seeing high net-worth individuals, family offices and increasingly hedge funds in the US, UK, Germany, Switzerland, Sweden and South Africa seeking exposure.”
The problem for those institutional funds is that, if they want to allocate 1% to 3% of assets to crypto and ask their custodian banks about holding private keys to crypto accounts, it becomes a tricky conversation.
“So, institutional investors are turning to delta one securities, with ISIN numbers – instruments that custodians are familiar with and can handle – to take exposure to cryptocurrency,” says Radloff. “And we are designing those products.”
CoinShares takes the view that a cryptocurrency must have sufficient cash-market daily liquidity to properly structure a delta one instrument that might itself be actively traded. Only 11 cryptocurrencies have more than $1 billion equivalent in outstandings.
Four now look important: bitcoin, with a market capitalization of around $160 billion in late November; Ethereum with $46 billion; Bitcoin Cash with $27 billion and Ripple with around $9 billion. CoinShares now has exchange-traded notes for bitcoin and ether and regulated bitcoin-managed funds.
“While it is important to acknowledge that exposure to an asset in its early stage of development, such as a digital currency, comes with a risk, trading ether on Nasdaq Stockholm provides investors with the protection provided by a regulated infrastructure, well-known marketplace and accessibility through their ordinary brokers,” says Helena Wedin, head of ETP services Europe at Nasdaq.
Bitcoin market makers quickly reported, after Jamie Dimon denounced the currency as a fraud, that JPMorgan had been handling orders from its own clients to buy and sell bitcoin tracker notes from XBT Provider, a CoinShares company, that preceded its new ether notes.
However, November’s lurching volatility will clearly be a deterrent to some family offices and institutional investors who may have been considering allocations to cryptocurrency through the now growing number of conventional-looking products, such as exchange-traded notes.
Jani Valjavec, co-founder of Iconomi, a firm building a platform for diverse investment vehicles allocating to a range of cryptocurrencies tells Euromoney: “If we are on a path from individuals investing in cryptocurrency towards hedge funds and other institutional investors that may one day lead to pension funds allocating to digital assets, the market is still very immature and still dominated by individuals and only just touching now the institutional world.
“Recent volatility in bitcoin may cause certain investors to stay out who are more used to equity market-style volatility of just 1% to 2% a day. That’s why we want to offer greater diversity than just focusing on bitcoin, which accounted for 85% to 90% of the market cap of all cryptocurrencies when we set up Iconomi at the start of last year but now accounts for just under 60%.
“I was talking to family offices in the spring of this year who were very nervous about investing in digital assets but who are now much more interested,” he adds.
Well, a climb from just under $1,000 at the start of the year to $9,500, 11 months later will attract plenty of interest, even if the conventional guardians of private wealth seek to discourage it.
In mid October, the chief investment office of UBS, which manages SFr2.263 trillion ($2.28 trillion) of client assets, chose to weigh in on the debate over whether or not cryptocurrencies are a valid investment asset class.
The UBS CIO follows a conventional line. It dismisses the chances of cryptocurrency ever becoming a widely accepted medium of exchange while governments demand tax payments in conventional currency, or of it even becoming a dependable store of value.
It describes bitcoin’s collapse in value in early September, following Chinese moves against bitcoin exchanges, as: “Worse than the collapse in the value of the German mark at the start of the Weimar hyperinflation”.
For any ultra-high net-worth clients wondering just how much they might have made if their wealth manager had screwed up the courage to put just a portion of their holdings into it, UBS has some stern words. “The sharp rise in cryptocurrency valuations in recent months is a speculative bubble.”
Euromoney has no knowledge whether Jamie Dimon, chief executive of JPMorgan, has a portion of his own riches managed by UBS or not, but we can almost sense him nodding furiously at all this.
Valjavec argues that the market in cryptocurrency investment is still in its very earliest stages on a long journey towards maturity.
“Most investments for nonspecialists in crypto are centred on bitcoin, the most famous token,” he says. “But there are already 1,300 digital assets and there will be many thousands more. We don’t yet know which ones will be the winners. It’s going to be very difficult for any investor to do due diligence on each, so we will move towards more passive, index-like investments.”
He suggests: “Some institutional investors will be attracted by futures contracts, others by exchange-traded products and ETFs.”
It is against this background that the announcement from the world’s largest derivatives marketplace, the CME group, that it intends to launch bitcoin futures before the end of the year (pending all relevant regulatory reviews) has attracted so much controversy.
Since November last year, when the bitcoin price stood at a mere $740, the CME Group has calculated and published the bitcoin reference rate, which aggregates the trade flow of big bitcoin spot exchanges to deliver a daily dollar value.
It is now clearly responding to increasing investor interest in the cryptocurrency markets by launching a futures contract.
“As the world’s largest regulated FX marketplace, CME Group is the natural home for this new vehicle that will provide investors with transparency, price discovery and risk-transfer capabilities,” says Terry Duffy, CME Group chairman and chief executive.
But deep concerns over the potential of such new derivatives to transmit volatility from the crypto world to conventional financial markets quickly spilled into public view when Thomas Peterffy, chairman of Interactive Brokers, a futures commission merchant, published an open comment letter to J Christopher Giancarlo, chairman of the Commodity Futures Trading Commission (CFTC) in mid November.
Peterffy wants the CFTC to require that any exchange seeking to clear any derivative of a cryptocurrency do so in a separate clearing system isolated from other products.
“There is no fundamental basis for valuation of bitcoin and other cryptocurrencies, and they may assume any price from one day to the next,” says Peterffy. “Cryptocurrencies do not have a mature, regulated and tested underlying market. The products and their markets have existed for fewer than 10 years and bear little if any relationship to any economic circumstance or reality in the real world. Margining such a product in a reasonable manner is impossible.”
The CME has talked up the likelihood of imposing many times higher margin requirements on participants dealing in bitcoin futures than in equity, commodity or currency futures, as well as imposing a 20% daily cap on price moves.
It is operating in a competitive marketplace with its own pressures to create new products. Its great rival, the CBOE [Chicago Board Option Exchange], has just published its own specifications for a planned bitcoin futures contract to be cash-settled in dollars, incorporating position limits on how many thousands of contracts any user can control on the long or short side.
But that does not calm the doubters. They point out that in a runaway bull market, futures will simply get locked limit-up day after day, with little trading possible while, much more worryingly, a big cryptocurrency loss that destabilizes members that clear cryptocurrencies will also destabilize the clearing organization itself and its ability to pay the winners and collect from the losers on the other products in the same clearing pool.
“Unless the risk of clearing cryptocurrency is isolated and segregated from other products, a catastrophe in the cryptocurrency market that destabilizes a clearing organization will destabilize the real economy, as critical equity index and commodity markets cleared in the same clearing organization become infected,” says Peterffy.
Could it be that the crypto-asset world of new digital tokens, representing a form of equity in new blockchain ventures that proponents say will transform many industries, could operate in stark separation from established financial markets?
Euromoney speaks to sources in the fintech and cryptocurrency world who envision these new censorship-resistant currencies expanding so quickly beyond the control of central banks and governments that they become their own decoupled financial system, achieving what the fanatics call ‘escape velocity’.
It seems more likely, however, that plenty of bridges will be built between fiat and crypto. Both are, in reality, driven by the same age-old forces of greed and fear.
It is fear of missing out that is now most pronounced among investors who have listened to the mainstream banks denounce crypto, while watching others grow rich as bitcoin increased in value by 1,000% in 12 months.
“If you think banks will remain loyal to fiat currency when they see a chance to make markets in, trade and profit from the crypto space, then I think you are misguided,” says Radloff. “I would suggest that within the next 12 months we will see large banks adding crypto trading desks and investing in a major way in the associated infrastructure.
“It’s public knowledge that JPMorgan, for example, consistently makes markets for clients in bitcoin-related products.”
The CoinShares ether notes seemed popular in early trading, attracting $10 million-equivalent in assets under management (AuM) in the first few days.
“When the group’s bitcoin exchange-traded notes – which are now at $330 million in AuM – launched in 2015, it took one year to attract the initial $10 million in AuM,” says Radloff. “The ether trackers achieved that in less than a week. Initial demand for the ether ETN from investors of all types has been exceptional, driving substantial volume for an un-seeded ETN; especially one in an emerging asset class. The community that was demanding the product has shown up in full force. Now the community has a new request – research.”
In an effort to service this new wave of investors who are requesting professional asset research, CoinShares Research is launching analyst coverage on Ethereum and its native token, ether, along with the top five crypto assets.
Meanwhile, other firms are bringing investment infrastructure from the established, conventional asset classes to the crypto world, such as passively managed tracker funds.
Iconomi, founded in 2016, describes itself as the world’s first blockchain-based digital asset management platform, offering various investment products, which it calls digital asset arrays (DAAs).
The Iconomi platform was fully opened for registration on August 1. Two months later, over 24,000 users had registered, depositing over $100 million equivalent in digital assets. Iconomi introduced Columbus Capital as one of the first announced DAA managers, managing Columbus Capital Blockchain Index (BLX), which works like a passive fund representing a majority of the total market capitalization of all digital assets.
“If you look back at the first iPhones 10 years ago, they typically had 14 icons for messaging, music, and so on,” Iconomi’s Valjavec tells Euromoney. “Look today at the vast number of high-quality apps you can have on an iPhone: far more and far better than Apple could have developed on its own. Tokens and initial coin offerings are like that. They will accelerate from here. There will be thousands and thousands more. We are building a platform where managers with a particular expertise in application of blockchain to certain industries might construct and offer digital asset arrays focused on digital assets for those particular sectors.”
Right now, it is crypto market beta that is attracting capital.
“At the moment, our biggest digital asset array is the Blockchain Index, managed by Columbus Capital.”
This is a passively managed index of 20 leading blockchain-based digital assets, weighted by market cap and adjusted for free float and trading volume.
“It has shown less recent volatility than the many investment vehicles based on bitcoin alone,” says Valjavec. “In future, active managers may produce more alpha-oriented arrays focused just on particular business areas being impacted by blockchain.”
Iconomi and the dozen or so individuals and institutions managing its digital asset arrays aim to apply traditional investment management techniques and processes to pure blockchain-based assets.
Paul Condra and Mrinalini Bhutoria, analysts at Credit Suisse, presented their findings after talking to blockchain startups, crypto investors and conventional venture capital investors in October.
“While investing in cryptocurrencies remains complicated for institutional investors,” they reported, “private investment firms are increasingly putting resources toward finding ways to provide exposure to the industry, while new funds are emerging that are entirely dedicated to the space.”
Over the next five years or so, they expect that “ICOs will shift from the largely unregulated ‘utility tokens’ of today to SEC-regulated ‘security tokens’, which currently represent less than 1% of the cryptocurrency market cap. This, along with a firmer regulatory framework, could catalyse more broad-based investment in the space.”
Another fintech source tells Euromoney: “There has been an almost comical attempt to pretend that ICOs are not securities just so as to avoid SEC regulation. But eventually we will come to a recognition that of course they are securities, effectively equity securities. That’s simply a work in progress.”
Mainstream institutional investors will want more assurance before making strategic long-term allocations to the asset class. There is a short-term, pump-and-dump flavour to many of the most recent coin offerings, with volatile early trading activity not likely to encourage long-term strategic allocations.
“Sure, greed is outstripping due diligence in some of the ICOs right now, but we will see the needed investor-protection rules emerging,” says Radloff. “We are working towards a professional, regulated and fit-for-purpose environment in which institutional investors are able to take exposure to this asset class.”
As the Credit Suisse analysts note, suggestions that bitcoin is a fraud are rather to be expected from incumbents in industries like banking that the new technology clearly threatens. But volatility itself hardly damns the asset class. Commodities have been volatile, currencies have. All we hear from banks these days is that they need more volatility, not less.
Bitcoin and others could be here to stay. As we learnt from a recent Credit Suisse symposium on blockchain and cryptocurrency, Bitcoin’s combined computing power is greater than that of the combined Faang (Facebook, Apple, Amazon, Netflix and Alphabet’s Google) stocks.
The technology has already quietly led to the creation of a massive de-centralized network that no individual enterprise would ever have the capital to build on its own.
Daniel Masters, co-principal at CoinShares, adds: “CoinShares is committed to delivering world-class research and professional-grade access to crypto assets.”
Masters should know what mainstream institutional investors and wholesale market participants want and need. He used to work at – look away now, Jamie – JPMorgan.
The hidden cost of bitcoin
The recent volatility of bitcoin and concerns that leveraged derivative plays on it might infect conventional financial markets come as worries also grow about the environmental impact of processing bitcoin blocks or mining them, an activity which requires miners to demonstrate proof of work in computer power consumed to verify algorithms.
For performing this essential task in a decentralized, trustless network, miners, often operating large stacks of computers in remote locations (many in China), are rewarded in bitcoins, which have soared in value.
Teunis Brosens, senior eurozone economist at ING and a former central banker, analyzed this in a recent paper suggesting that the hidden cost of bitcoin is the vast amount of electricity being consumed by these computers.
Brosens points out that mining a single bitcoin transaction consumes 260Kwh. That is enough to run a single US household for nine days. Digiconomist suggests that bitcoin processing is now responsible for about 0.13% of world electricity consumption.
If the currency were a country, it is now using power at roughly the rate of Ireland or Slovakia.
As mining can provide a solid stream of revenue, people are very willing to run power-hungry machines to get a piece of it.
“At current BTC prices, the block reward clearly and vastly outweighs electricity costs. Mining is a no-brainer for individual miners, but the benefit to society at large is much less obvious,” says Brosens.
Investors will probably remain more concerned about whether or not the recent volatility of bitcoin’s value raises questions about its sustainability.
Going back to first principles, one of the key attractions of cryptocurrency was supposed to be the ability to transfer value, including as payment for goods and services, at low cost in close to real time.
Last month, Coinfix launched yet another digital asset known as USC on the blockchain of Chinese developer Achain.
This will tokenize currency that users have deposited in reserve accounts at Coinfix. Users will be able to transmit payment in USC anywhere round the world within about 30 seconds at very low cost.
Kevin Yu, founder of Coinfix, has declared an ambition to use blockchain technology to ease the flow of investment in valuable assets such as commodities, including oil and precious metals. But the USC token is not intended as a speculative investment.
One USC will represent $1, which users must have deposited at Coinfix before their USC tokens go on the blockchain. USC will remain pegged one-to-one to the value of the dollar.
It’s a simple idea to put fiat currency on the blockchain.