LEVATUS Perspective | Who’s Afraid of the ‘Big Bad Crypto Currency Wolf’? Is It Portfolio Managers?
Crypto assets, including crypto currency, have burst onto the scene with quite a bit more than a simple huff and puff. What does it all mean for your portfolio and investments?
The Big Bad Wolf did not just torment the Three Little Pigs. His big eyes and big teeth also gave Little Red Riding Hood quite a scare. Yes, as fairy tale villains go, the Big Bad Wolf has a big, bad reputation. While his misdeeds did lead to the destruction of a lovely straw home, and a reasonably nice stick home, there was another side. Once those Three Little Pigs got past their state of denial, the huffing and puffing incident became the catalyst for the construction of a lovely stone home and while Little Red Riding Hood emerged shaken, she also emerged wiser.
Crypto assets, including crypto currency, burst onto the scene with quite a bit more than a simple huff and puff. While Bitcoin launched in 2009 attracting not much more than grunts of dismissal, the more recent velocity of activity seems to have brought with it substantially more attention and a certain amount of fear and denial in certain corners of financial markets. The denial first appeared on the quarterly calls of public companies that operate in industries most likely to be disrupted by the technology of blockchain and decentralized finance (DeFi). We see it now in some corners of portfolio and investment management too. The question of how to address crypto currency and crypto assets within the context of overall asset allocation and investment management is serious business, and it begins with the basics. If you want to skip to the bottom line though, just scroll down to the section titled, Huff and Puff and …
Crypto Currency and DeFi Basics | The Simple Holds the Secrets of the Complex
DeFi is short for Decentralized Finance. The system seeks to democratize accessibility to many financial assets and to remove the cost of intermediaries. It does this by using blockchain technology to build records of transactions, whether they be financial, legal, or otherwise, without the need for an intermediary third party. In essence, DeFi is a set of products and services that act as a replacement for the middleman, institutions ranging from banking to insurance. DeFi is enabled by building a digital fingerprint of transactions that can serve as proof of ownership and which is not validated by just one intermediary but thousands of decentralized networks.
At present, most DeFi Blockchain offerings are a hybrid of centralized and decentralized applications. The majority of these are deployed on the Ethereum platform. Ethereum is a global, open-source coding platform for decentralized applications (apps). Experts have described it as “a world computer that cannot be shut down”. It is the blockchain (blocks of information that are linked together in a permanent chain) used for lots of applications, including Ether, which is the native currency of the Ethereum blockchain. (Ether is often mislabeled Ethereum.) On the Ethereum blockchain software developers can write smart contracts. A smart contract is a programable contract that allows two counterparties to set conditions of a transaction without needing to trust another third party for the transaction.
Digital currency is a particular type of decentralized financial (DeFi) asset. Bitcoin is one type of digital currency. How is value built? Digital currency, like Bitcoin, need to be used as a system of transactions in order to have value. The system of transactions is where its value is created. Actions that impede a digital currency’s use as a system of transactions, whether they be regulatory hurdles or security events, will dimmish a crypto currency’s ability to build value as an asset. This is one of the reasons that so much volatility has entered the markets recently and also one of the reasons that dollar cost averaging is a valuable portfolio management tool for those active in this space.
Crypto Assets | Clarity Found in Portfolio Management Basics
Many people have built significant wealth via investments in digital assets. Positions that started off as small holdings have grown to be life changing amounts of money. Now what?
The answer begins with a series of questions. Why are you holding the asset? Would you buy as much of it if you were deploying new cash today? What is the digital asset’s role in your portfolio? Is it a store of value? Is it protection against inflation? Is it a growth asset? Is it money you will need in the next 3 years? Once you know the answer to these questions the calculation of how well the asset can do its job begins.
Risk and Opportunity
If the role of crypto assets in your portfolio is growth, it is important to identify both the risks and opportunities that impact the assets’ ability to not only grow, but to grow at a rate that compensates you for the risk undertaken by making the investment. Part of this is understanding if risks are even quantifiable.
If the role of the crypto asset in your portfolio is to protect you from a black swan event caused by the historically unprecedented amount of liquidity created by the world’s central banks, the question becomes whether current correlations suggest it will be able to fulfill that role. Have correlations shifted over the past several years? The answer is yes.
One of the unique characteristics of early stage companies and industries is that it is next to impossible to identify the ultimate winners and losers. The risk of holding just one of the players in the space is, therefore, high. This is especially true in the currency sphere of crypto assets. There is a chance that the value of any one of them could go to zero. This is always the case, but especially so in early-stage industries. The value of owning a basket of assets (versus a one-shot chance) increases when an asset is in this early stage.
Another characteristic of early-stage asset classes is that they tend to be strongly momentum driven. Limits on liquidity drive powerful moves in both directions. It is therefore important to understand how much incremental exposure to early-stage asset classes will add to the volatility of your portfolio and its ability to meet growth and cash flow requirements. As prices rise, future potential returns decrease.
Correlation
At least part of the confusion over the role of digital assets in portfolios has occurred because of the changing correlations over the past five years. Several years ago, crypto currencies were categorized as a hedge against black swan risks in traditional markets. In fact, back then, a case could be built for that role as the correlation with traditional assets like equities was quite low. Meaning, if traditional assets like stocks went down, digital assets tended to do well. More recently that correlation has broken down however, and a pronounced correlation with speculative growth stocks has emerged. Of course, this is quite the opposite of what you want from an asset that is supposed to hedge against risk.
Being cognizant of changing correlations is important in understanding where and whether a crypto asset fits in your overall portfolio. Do you have other assets already doing the same job? Which is better?
Embedded Costs
High fees eat into long term returns in any asset class and crypto currency is no different. Exchange fees, network fees, wallet fees and transaction fees can be significant and vary widely across digital platforms. It is important to do your homework. In early-stage investments fees tend to be high because liquidity and competition is low. When asset prices rise, fees become more important because the incremental return available declines.
As an example, smart contracts have a fee on the Ethereum Blockchain. This fee is called Gas. Required ‘Gas’ for a contract is based on the computational effort required to validate and process the data and transactions on the blockchain network. The price of ‘Gas’ fluctuates depending on demand; think peak hour surcharge from UBER. If it is a busy time of day ‘Gas’ can cost a lot.
Smart contracts are where a lot of the more revolutionary work in crypto assets is occurring. It is notable that the fee for writing a smart contract must be paid in Ether (ETH), the natural currency of the Ethereum blockchain, which creates a natural source of demand for Ether. Fun fact: Gwei is the name for fractional amounts of ETHER.
In addition to transaction fees, exchange fees and wallet fees can add up as well. While these fees are high now, it is likely that as more competition comes into the market fees will come down.
Taxes
Taxes are another element of expense to be cognizant of. Over the last several years the tax and reporting laws on crypto asset transactions are becoming clearer and accounting experts in the field are emerging. With this the IRS is cracking down. The question of whether a taxpayer has transacted in digital currency is now on page one of tax reporting documents. Each transaction with crypto creates a taxable event on both sides. The responsibility for tracking taxes is now borne by the owner rather than a custodian due to the decentralized nature of the asset.
A note on the confusion around crypto currency transactions: the name, crypto currency or digital currency is misleading from a tax perspective, because the IRS does not view crypto currency like a currency at all. The IRS views crypto currency as an asset, just like a stock or bond. This distinction is important because it means that cryptos are subject to capital gains taxes, which could either be short term or long term. It is not treated like currency.
Structural Risks
Investors need to be properly compensated for the risks they undertake in an investment. This means risk should be compensated for with a proportional amount of potential return. The higher the risks the higher the required returns necessary to make an investment attractive. As an example, a stock that has three times the volatility of the overall market should have three times the return potential if an investor is being properly compensated for the risk they undertake when buying the stock. The same is true with digital assets.
Environmental and Regulatory risks are two structural risks that are front and center with of digital assets. On the environmental front, Tesla’s recent announcement that they will no longer accept Bitcoin as a method of payment due the negative environmental impact of ‘mining’ the coin is significant. Remember, the value of a coin is its ability to facilitate transactions, so diminished transactional value equals diminished value.
A quick clarifying note on crypto mining: ‘mining’ is the part of the crypto process where computers go out and solve math equations and in so doing earn Bitcoins. The total amount of Bitcoin available is 21 million. It is getting harder and harder to solve these equations and the number of Bitcoin awarded for each solution is going down, which means that energy consumption by the super computers solving the equations is going up.
From a regulatory perspective Bitcoin’s connection to illicit activity such as the recent Colonial Pipeline ransom payment has increased the scrutiny. While the regulatory scrutiny is intense, in some ways attention by the SEC, IRS and OCC is creating the necessary foundation for a long-term trajectory for the asset class. While some would argue that the amount of risk created by environmental and regulatory risk is not quantifiable, and therefore the value of crypto currency is not investable, there are others who see these factors as very hard to analyze but necessary growing pains toward a sustainable future for the asset class. With this said, return potential needs to compensate for these risks.
Custody
Custody of crypto assets is different from the custody of traditional financial assets which sit at custodians like Schwab, Fidelity, Vanguard, and a host of others. Remember, crypto assets are all about eliminating the middleman. With this, however, certain risks fall back to the owner. Private keys, which are used to conduct transactions and access crypto holdings, are a complex combination of alphanumeric which are held directly by the owner of the crypto asset. They are extremely difficult to remember and can be stolen or hacked, so safeguarding your private keys is quite important.
Online wallets are a potential solution, providing user friendly interfaces to the Blockchain network, but they have also proven susceptible to hacks. The same is true of cryptocurrency exchanges. Working with reputable firms who are spending money on security and finding ways to protect your private keys is important. Access to a crypto wallet is determined by pairing a public key and a private key. If you lose your private key you it is just like losing your wallet. The money is gone.
Disruption
Portfolio managers need to integrate an understanding of digital assets in their analysis as much for the opportunity as for the potential disruption to other industries. Said differently, if one of the objectives of decentralized finance is to remove the cost of intermediaries … who are the intermediaries!
Clearly traditional banks are in the cross hairs of the crypto and DeFi revolution. At a minimum, the potential for disruption means that banks will have to spend more money trying to compete. For banks that are not well managed it could mean fading into irrelevance. These are important risks to be aware of when considering the future value of existing holdings. The same can be said for businesses around insurance contracts and real estate deeds and a host of other contract-based services. A recent article by Gillian Tett in the Financial Times called out the risk to traditional equity trading business on Wall Street, saying, ‘Blockchain technology may change equities trading for good’.
The cost of disregarding the impact of crypto assets resides not only in opportunity cost, but in miscalculating the risk and potential in existing holdings. Coinbase, the recently publicly listed crypto currency exchange, hints at this in its S-1 document when it discusses traditional assets that move on blockchains. Included in the company’s outlined growth strategy is a section called: “Tokenize new assets.” “We will invest in infrastructure and regulatory clarity to pave a path for the digitization of more traditional financial assets, to help pave the path for new assets to be represented as crypto assets.”
Asset Allocation | Understand Your Own Risk Tolerance
Volatility and risk tolerance is critical to assessing the appropriateness of investments in your portfolio. Crypto assets and Decentralized Finance are early stage. At this stage there is lots of potential, but liquidity is more limited, and the winners and losers are less clear. This causes volatility to be quite a bit higher than in more developed industries. If the value of your portfolio swung by 50% in a matter of months would it impact your lifestyle? Siphon off day-to-day mindshare? If you are involved with an innovative new technology would it enrich you sense of discovery? Asking more of your wealth means expanding the definition of how an asset impacts your life.
Huff and Puff and …
The world of crypto assets is still relatively new territory. That said, the inflow of money to digital assets in the past year has been eye-opening. Over the fourth quarter of 2020, institutional trading volume in crypto currency grew over 110% to $57 billion, while retail trading volume grew by almost 80%. Coinbase, the digital currency exchange, now services 7,000 institutional accounts. The initial public offering of Coinbase itself served to legitimize and shine light on this rapidly evolving asset class. Coinbase’s IPO through direct listing gives us a sense of where we are in the arc of crypto assets’ impact on capital markets. We are certainly far from where we were several years ago, and perhaps at a point where crypto markets will influence traditional markets more than most currently realize.
The disruptive impact of crypto assets on mainstream businesses such as banking may be where crypto assets have their biggest impact in the near-term. While the asset class is small, the disruptive change it has ignited will impact the long-term value potential of traditional industry groups that continue to operate in the traditional way. This is important whether you are invested in crypto assets or not. The long-term staying power of many crypto assets will be defined by their ability to reduce friction in markets. From this perspective one thing is clear, not all crypto assets are created equal.