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Private Investment Forum - Winter 2018

 

Cryptocurrencies as Investment Vehicles

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Most of us have heard of or read about cryptocurrencies, blockchain, ICOs, Bitcoin millionaires and such, especially over the past year. That’s all well and good; but fads, including investment fads, come and go all the time. The real question is: is it time to invest in this new, dynamic - and perhaps confusing, revolutionary, and highly speculative - asset class?

Goldman Sachs states that it is and that institutional investors can no longer ignore the sector.1 Perhaps. GS has been wrong before...

Crypto assets (we will not restrict our discussion here to crypto “currencies”) are now almost nine years old, have moved past their infancy and are scaling up rapidly. That being said, there is still a lot of progress to be made - and it almost certainly will be made. It remains to be determined at what speed, to what extent, and in what areas.

This new alternative asset class represents a paradigm shift; not just because of what it is, but because of the scale, scope of application, and speed of adoption.

The point of this article is not to persuade anyone to invest in crypto assets. I will assume that you are at least considering doing so based on a search for yield, diversification or non-correlation, or for some other reason. The challenge in this sector is to balance that yield, diversification, and lack of correlation with risk in a rational manner.

So, we will focus here on the next question: if you are considering investing, how do you do so safely and what instruments are available? You may well be surprised at the variety of instruments which are already available in the crypto space.

First, a request: in the main, those of you who are reading this article have decades of knowledge, experience, and wisdom in the financial field. Please don’t jettison those three invaluable assets when reviewing crypto investments! Human psychology did not change with the advent of cryptocurrencies; the fundamentals of trading did not change. What works in the fiat (non-crypto) world will work in crypto - with three changes: (1) things happen much faster (at least in part because crypto markets never sleep)2, (2) there is little crypto-specific regulation (but note that much general “finance-related” regulation applies to crypto-related activities), and (3) it is a young sector, and the infrastructure and players reflect that.

As a result, your goal should be to apply fiat best practices to crypto assets. Use the personal attributes that you have accumulated in the crypto space as you have used them in the fiat space all your professional life - but with a modicum of flexibility and creativity.

The crypto sector gained significant momentum in 2017: total market capitalization is approximately $500 billion as of this writing. While Bitcoin currently represents around 33% of total capitalization, that figure was well over 90% two years ago ago. (Anecdotally, the first recorded purchase with Bitcoin took place in April of 2010 when two Papa John’s pizzas were exchanged for 10,000 BTC. Each of those pizzas cost about $20 million at today’s BTC exchange rate.). As of this writing, Bitcoin is worth more than $10,000 and more than 8,000,000 transactions per month are concluded using it.3

Noteworthies such as Sir Richard Branson, Bill Gates, Ben Bernanke4, Al Gore5, Peter Thiel, and Marc Andreessen now support crypto assets.6 In fact, Lewis Fellas, a former portfolio manager of the world’s largest academic endowment fund, Harvard Management Co. (valued at $35.7 billion), recently departed to establish a digital currency hedge fund.7 Even Saxo Bank analyst Kay Van-Petersen, who correctly predicted BTC would reach $2,000 this year, has now “conservatively” predicted Bitcoin’s total market cap to reach $1.75 trillion (which would make BTC worth $100,000) and make up 10% of the $5 trillion average daily foreign exchange market volume, within 10 years.8

Crypto Asset Investment Vehicles

Crypto assets as investment vehicles are structured very similarly to fiat vehicles. We describe the six main categories of crypto investments below. In all cases, one can invest directly or through one or more existing funds.

Trading

Just as stocks trade on exchanges, so do cryptocurrencies. Here we also see blue chips and large-, mid- and small-caps, and long and short strategies, with futures currently available and options virtually certain to follow. (The CFTC approved the first crypto derivatives exchange in July of 2017).9

ICOs

Initial coin offerings (ICOs) have been much in the news. Essentially, ICOs are a type of crowd funding. Viewed another way, ICOs are disintermediated seed/VC/PE investment, i.e., investment which is raised bypassing Silicon Valley in the U.S. and other traditional channels in other countries. Coins or tokens are directly purchased by the public. The tokens themselves represent the value of the ecosystem in which they are used, and not the company per se. During the past year, we have seen ICOs raise $1.25 billion, surpassing early stage VC funding.10

Private Equity

Private equity in the crypto space is growing at a tremendous rate, with $3.7 billion invested in 2017. Mark Cuban11 recently backed a $20 million venture fund in the sector, further demonstrating growing adoption. Most, but not all, of the PE investments in the crypto space focus on the blockchain (basically, public ledger) companies. (More details on the blockchain will have to wait for a future piece).

Lending

Fixed-rate lending is conducted peer-to-peer on various crypto exchanges. A few exchanges also extend credit for leveraging long positions and lend currencies for short positions, and do not offer a peer-to-peer structure. The daily interest rates on these fixed-income investments is far higher (usually between 4 and 10 basis points per day, but occasionally even higher) than what is available on fiat markets. Counter-party risk is minimized as lending is 100% secured with liquid assets at 1-30 day terms. To our knowledge, there has never been a default. Lending can be an excellent way to enter the space while avoiding crypto volatility. At present, however, there is only one fund which offers a lending investment vehicle.

Mining

In the cryptocurrency space, “mining” is the rather tongue-in-cheek term used for using software computations to solve algorithms which “generate” cryptocurrencies and “drive” the decentralized public ledger (the blockchain). In fact, it is the former which funds the latter. One can purchase shares in a “mining pool” such as BitClub Network, invest in mining funds, or mine directly (with an ASIC and some surprisingly simple software).

Index

Virtually all crypto index funds (and there are several) track a single cryptocurrency. Most track BTC only, but a few track a different large cap cryptocurrency. The first professional crypto index, CAMCrypto 30, which tracks the largest 30 cryptocurrencies by market cap based on Russell/FTSE rules, was launched last year. One fund offers a tracking share class for this index, which fills an important gap in the crypto space.

FoF

One of the most recent additions, there are now at least four different funds of funds which are dedicated solely to the crypto space. The advantage of these structures is the same in the crypto space as in the fiat space: the managers have greater expertise (presumably) in the crypto space than the average investor, and a single investment results in a diversified portfolio. Of course, this all comes at a cost, and the fee structures of funds of funds in the crypto space are all much higher (2/20) compared to the usual fee structure for a fund of funds in the fiat space (generally around 1/10).

Futures

Although the advent of Bitcoin futures trading on CME and CBOE garnered most of the attention in December of last year, LedgerX was actually the first exchange to offer Bitcoin futures, in September of 2017. This is a rather esoteric form of investment in an already-esoteric space, so I would not recommend it for anyone but the most devoted aficionados.

Thus, the variety of investments in the crypto space is actually greater than most realize. With the space poised to grow significantly, the real question is: why not make a small investment in the space? - rather than: why make one?

For investors seeking to diversify, increase yield, and be creative, the crypto sector offers numerous attractive options with substantial potential for growth. Time will tell whether Goldman Sachs was correct in its assessment, but the sector is certainly worth consideration.

ABOUT THE AUTHOR

Timothy Enneking is the founder and managing director of Crypto Asset Management, LP, which manages two crypto-focused funds, a “master” fund based in the US and a “feeder” fund based in the Cayman Islands.

SOURCES

1. https://cointelegraph.com/news/institutional-investors-can-no-longer-ignore-bitcoin-goldman-sachs
2. Please see the author’s OpEd piece on Crypto Time here: https://www.coindesk.com/life-crypto-time/
3. https://blockchain.info/charts
4. http://www.zerohedge.com/news/2017-08-27/bernanke-flip-flops-will-be-keynote-speaker-blockchain-conference
5. https://www.cryptocoinsnews.com/bitcoin-enthusiast-al-gore-star-inconvenient-truth-follow/
6. https://www.oddsbusters.com/us/bitcoin-gambling/interesting-facts-bitcoin/rich-famous-people-bitcoin/
7. https://www.bloomberg.com/news/articles/2017-08-17/ex-harvard-money-manager-is-said-to-launch-digital-currency-fund
8. https://www.cnbc.com/2017/05/31/bitcoin-price-forecast-hit-100000-in-10-years.html
9. http://www.cftc.gov/PressRoom/PressReleases/pr7592-17
10. https://www.cnbc.com/2017/08/09/initial-coin-offerings-surpass-early-stage-venture-capital-funding.html
11. https://www.cnbc.com/2017/08/22/mark-cuban-backs-new-20-million-cryptocurrency-venture-fund.html

 
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