In the year 1637, in what is now the Netherlands, market speculators bid up the prices for tulip bulbs to astronomical amounts. In one alleged transaction, a single bulb of the Viceroy variety was traded for 1,000 pounds of cheese, 12 sheep and 8 pigs.
The Tulip Mania, as it was later called, ended with a crash in prices and many people were stuck with tremendous losses. But at least they could plant the bulbs they purchased and expect flowers in the Spring.
The same cannot be said for those who purchased Bitcoin during the run up in prices at the end of 2017. When the market collapsed in 2018, what were they left with besides a string of 1’s and 0’s?
Following the news that the number of users of all digital currencies doubled in 2018, a study by Cambridge University concluded that the death of Bitcoin amid an 85% drop in price has been ‘greatly exaggerated’ by the media.
Fortunately, there is still a growing ecosystem of companies around the globe that see the benefits of this new technology and understand how to leverage it. Bitcoin and its underlying blockchain technology could be the answer to providing billions of people with access to financial products due to its flexibility, speed and low transaction costs.
Whether there is value in these promises and whether Bitcoin could become a new asset class was discussed on a panel I moderated at the In|Vest West conference. (See Invest West Conference 7 Minute Summary)
What is a cryptocurrency?
A cryptocurrency is a digital or virtual currency designed to work as a medium of exchange and/or store of value. The “crypto” part comes from the strong cryptography that is at its core and is used to secure and verify all transactions. Essentially, cryptocurrencies are entries in a distributed database, called a blockchain, that is managed by a network of computers all running the same open source software.
What is Blockchain?
A blockchain is a just database that is duplicated across multiple computers connected by a network (usually the Internet). In the language of cryptocurrency, a block is a record of new transactions (which could be the location of some cryptocurrency, or medical data, or even voting records). Once each block is completed, it’s connected to the previous block, creating a chain of blocks: a blockchain.
Blockchain is also referred to as a distributed ledger technology.
What is Bitcoin mining?
Mining is how Bitcoin transactions are verified and stored in a block on the blockchain. The term mining is used because when a new block is created, the miner is rewarded with new Bitcoins, which is the only way that new coins can be created.
In order to store Bitcoin transactions, the miner’s computer must be the first on the network to solve a cryptographic puzzle. Use these links if you are interested in learning more about blockchain, how blocks are mined or who created Bitcoin.
What is a wallet and why do you need one to hold cryptocurrency?
According to Phil Woods, Founder of the Abele Group, a crypto wallet is software or hardware that allows you to store the encryption keys for one or more cryptocurrencies that you own. Every wallet is designed to hold one or more specific crypto(s), so with over 1,600 different cryptocurrencies in existence, there are a lot of different wallets available.
Four Biggest Hurdles
The four biggest hurdles that cryptocurrency must overcome before it can be accepted as a mainstream asset class are:
Liquidity is one of the biggest hurdles for institutional firms including crypto in client portfolios because it impacts market stability, best execution and transaction time. If their trading desk can’t quickly move in and out of an asset class, the firm is less likely to invest in it for clients.
Equities can be instantly traded on any of the dozen US-based stock exchanges with a very tight bid/ask spread noted Bradley Kellogg, COO of Flyer, a technology vendor providing trading connectivity between buy side and sell side firms as well as post-trade processing services. The same cannot be said for cryptocurrencies that have a very wide spread across the 185 mostly unregulated exchanges around the world, he said.
A lot the spread is due to lack of trading volume in all but the most popular cryptos as well as the lack of infrastructure and connectivity between the exchanges and traditional electronic trading networks. However, earlier this year, Kellogg’s firm launched the Flyer Crypto Gateway, a cloud-based ecosystem that connects trading applications directly to the leading cryptocurrency exchanges, providing a standard interface enabling market data streaming, order routing and post-trade processing.
The early adopters of Bitcoin and crypto technologies were mostly self-taught, explained Adam Richard, Head of Distribution at investment bank Entoro Capital. But now those same people need to be the ones to take an active role in educating the public in the advantages of adopting Bitcoin and cryptocurrencies and interacting with them.
Even after a thorough explanation, many people still walk away without quite getting it, Richards reported. While he agreed that crypto is not easy to understand, neither is the US dollar, but people still use it every day, he noted.
Educating people about the benefits of digital currencies is much more difficult when the media projects Bitcoin and cryptos in such a negative light, Richard lamented.
One aspect of cryptocurrency is that is difficult for people to understand is the control and storage of private keys. When someone buys, trades or is paid some Bitcoin (or any other crypto) they are assigned unique encryptions codes, called private keys. If these codes are misplaced or deleted, then the digital money they point to are gone as well.
Technically, they aren’t lost, since there is a permanent record of them on the blockchain. But without the keys, the currency is completely inaccessible. There is no way to ever get them back.
In fact, an estimated 20% of all Bitcoin ever mined are missing because the owners lost their private keys, Woods reported. At the height of the market in December 2017, that represented $50 billion in assets (only $12 billion now) that would be forever lost, he pointed out. It’s like searching for buried treasure, but you lost the map that shows where you put it!
People are much less likely to use something of value if they don’t feel comfortable holding it and there is no convenient third party to safeguard it, Woods suggested. This has slowed the adoption of crypto technology since investors are inherently uncomfortable holding things of value themselves, he stated.
Before the internet and online brokerages, holding a physical stock certificate was the only way you could prove your ownership. Today, all of the data is stored digitally at a custodian bank like BNY Mellon or State Street. But even though all of our investments are stored in digital form, no existing custodian supports actual digital currencies.
Woods firm, Abele Group, which is based in Singapore, is preparing to launch Abele Trust, a digital custodian, which will store cryptocurrency keys for both retail and institutional clients. This custodial service could encourage more investors to buy digital assets since there the risk of loss or theft would be greatly reduced.
At the end of the day, this isn’t a technology problem, Woods insisted. The technology exists to solve the digital custody problem. This is a user adoption and a financial services regulatory problem, he noted.
The accessibility hurdle can be boiled down to one aspect: converting fiat currencies (i.e. Dollars, Euros, Pesos, etc.) into cryptocurrencies. Coinbase is the most popular crypto wallet that offers a simple process where users can purchase one of eight cryptos (Bitcoin, Bitcoin Cash, Ethereum, Ethereum Classic, Litecoin, 0x, Zcash, USD Coin and BAT) from a US checking account or with a credit card.
But even though Coinbase operates in over 33 countries with has more than 20 million customers around the world, this is still a small fraction of the total number of consumers and investors who could potentially use cryptocurrency.
More mainstream firms are warming up to access to crypto. Robo-advisor Wealthfront recently announced an integration with Coinbase that will allow clients to view their crypto holdings alongside their other investments.
Is Crypto Just Another Bubble?
Bitcoin was trading at around $1,000 at the beginning of 2017 and was almost $20,000 by December. It proceeded to crash and was as low as $6,200 by early February 2018. It recovered to around $10,000 but has slowly bled value and has been under $4,000 for the past few weeks.
Is crypto just a bubble or does it have underlying value that will eventually be realized?
Kellogg suggested that we look back to the dot.com bubble, when Amazon.com went public at $90 a share. Everyone thought CEO Jeff Bezos was nuts for selling books online couldn’t touch feel or look at the jacket and during the following dotcom bust Amazon dropped to $6. If you had invested $10,000 in Amazon then, today it would be worth about $2.6 million, he noted.
The skepticism people exhibited regarding Amazon’s future success is similar to what we’re seeing around cryptocurrencies, Kellogg proposed. But this will change as new applications are released that offer new ways to use crypto that are cheaper, faster and/or more convenient than what consumers now have (which is pretty darn good when you think about it). Also, new infrastructure is coming online, like the Adele digital custodian and Flyer’s Crypto Gateway that will enable other firms to build services on top, he stated.
If you compare the development of crypto infrastructure to a baseball game, then the players would just be warming up, Woods stated. We’re not even in the first inning, he said.
Can cryptocurrencies be considered investments even though they don’t have attached cash flows?
Cryptocurrencies are not an investment, Woods agreed, they are an instrument of value. But the real value is in the underlying technologies of blockchain and distributed ledgers that will modernize financial services and reduce friction in transactions and also reduce the number of people and institutions required to process every kind of financial transactions he predicted.
Considering that less than 1% of people in the world even know about blockchain technology and only about 10% of them use it on a regular basis, the potential for growth is tremendous, Woods proposed.
Some of the use cases for Bitcoin and other cryptos help to drive the underlying value, Richard insisted. It is not limited by geographic borders and is resistant to censorship. These positive aspects can also be seen as negatives since these features also make them attractive to the dark side of the Internet.
Bitcoin is also the first non-sovereign currency that ever reached this level of popularity and market cap size, Richard explained.
How do you make a market in cryptocurrencies if they are so difficult to value?
You’ve got to have people who are going to take both sides of the trade, Kellogg explained, which could be market makers or specialists that would sit on an exchange. But in order for that happen, it requires institutional adoption and the infrastructure at prime brokers, for example, doesn’t exist yet. Goldman Sachs announced back in May that they were planning to start trading Bitcoin futures for their clients, although there have been no follow-up reports that this has begun.
In September, Goldman had to squash new reports that they had abandoned their Bitcoin trading plans and reported that they have been clearing Bitcoin-linked futures contracts offered by the CBOE and CME since May and is providing clients with liquidity for those trades. They are also reportedly working on a Bitcoin derivative known as a “non-deliverable forward,” because of demand from clients.
Asset manager VanEck has been consistently trying to get a Bitcoin ETF approved, according to Richard, having submitted and withdrawn two SEC filings and recently submitted a third. But that’s not going to happen until the exchanges agree to uphold stricter standards across the board. The New York State Attorney General polled all U.S. exchanges about their operational security, information security and their trade surveillance and was not at all pleased with the results, he reported.
If the latest VanEck filing goes through, their Bitcoin ETF would launch sometime in 1Q 2019. The had previously raised concerns about Bitcoin such as the extreme price volatility and the ability for customers to withdraw funds.
Another obstacle for Bitcoin ETF approval is valuation, Woods asserted. That’s because most regulators are used to the 4:00pm daily market close and an agreed upon universal value for most securities. But right now, there is no agreed upon daily price mark for Bitcoin or any other cryptocurrency. Without that, no major accounting firm will agree to audit the books and records for an investment fund or other vehicle. So, you’re stuck with the using their middle and lower tier auditors who don’t have the same clout in the industry or with with regulators, he noted.
What are the benefits of asset-backed tokens?
Blockchain technology has the potential to disrupt the Wall Street syndication process and asset-backed tokens will be the key, Woods believes. Asset-backed tokens are just instruments whose value is based on an underlying asset. In this case, the asset is an income stream or fractional ownership of a larger product that is represented by the token.
Asset-backed tokens could be used by real estate developers to replace bank construction loans, Woods suggested, which typically require 20% of the capital be put in up front for any project. The bank would then syndicate out the risk by selling off pieces of the loan to other investors through bonds or equity tranches.
But using asset-backed tokens blockchain instead would allow the developer to directly structure a deal with a lower the cost of funding and combine both syndication and distribution into a single instrument and a far simpler overall process, Woods stressed. This would be beneficial for large banks since they wouldn’t need the 15-20 people normally involved in a real estate or bond deal.
it also offers the ability to offer these deals directly to investors who traditionally don’t have access to alternative investments, which is democratizing finance, Woods proposed.
Another benefit of asset-backed tokens is to represent fractional shares in private equity or hedge funds, Kellogg explained. It not only reduces the paperwork required, but also increases liquidity since it enables owners of both asset classes to quickly move in and out of their investments, which isn’t normally possible, he noted.
A little over a year ago, venture capital firm Blockchain Capital created a token for a $10 billion evergreen fund, which was then used to invest into startups in the cryptocurrency and blockchain ecosystems, Richard stated. That token has been actively trading on crypto exchanges around the world, just like an ETF would on a securities exchange.
We will need to see more larger companies issuing asset-backed tokens for them to start taking off, Woods commented. The first “legitimate” bond offering via blockchain was issued by the Commonwealth Bank of Australia three months ago. According to the bank, the bond will be the first in the world to be created, allocated, transferred and managed with blockchain technology.
A Swiss multinational did some analysis and realized that they could issue an Ethereum bond token with a 7% coupon and save themselves 300 basis points by going direct to consumers rather than going to Wall Street, Woods reported. Why do I need to go to a debt capital market desk on Wall Street just to issue. Ultimately, it will be large, multinational corporations who drive the usage of blockchain technology to lower their cost of funding.
The Crypto Tipping Point
Part of the reason that he based his companies in Asia is because the tipping point has already happened there, Woods explained, based on how quickly consumers have moved away from traditional forms of payment to mobile QR codes. It is almost impossible to buy anything with cash in Shanghai or Beijing, he reported, because everyone uses WeChat or AliPay.
Visa came up with a study in 2016 and not a lot of people read it. But even in the what we would define as the emerging market world 30 percent the population is comfortable without having cash or credit cards for three to five days. That’s remarkable in a place where cash is generally key and people have safety attached to that asset. So the tipping point is happening with cashless payments using QR codes for everything from your identity to your financial instrument the payment.
The US is quite behind in this space, Woods observed, since we are very much tied to the Visa/MasterCard way of the world. But the Visa network is only as good as its ability to process transactions more efficiently than anyone else. As soon as distributed ledger technology can process two to three million transactions per second, just like the Visa card network, then you won’t need a credit card anymore and it will be game over, the disruption happens instantly, he stated.
It’s unlikely that Visa or Mastercard would ever move their network onto blockchain because of the risk, Kellogg noted. They are risk averse because they don’t want to cannibalize their current network. But their biggest customers, such as retailers Walmart and Target, are experimenting with blockchain technology to speed up payment processing, he reported.
Widespread implementation of blockchain technology and asset-backed tokens will enable the industry to move from T+3 to T+0 settlement, Richard claimed. But there are two major hurdles that must be overcome by a private or consortium blockchain, which are achieving the number of scalable transactions per second and maintaining user privacy. He believes that in late 2019 or early 2020 we will see the first blockchain networks approach thousands of transactions per second.
Crypto Brings Efficiency
Distributed ledger technology combined with artificial intelligence and big data are going to eliminate up to 30% of the jobs in the front-, middle- and back-office because we won’t need as many people involved in trading anymore, Woods proposed. And that’s just when you’re the broker dealer, not including the DTCC or OTC counterparties or market makers. Everything related to trading can now be accomplished on closed networks that are privately permission, he stated.
These technologies will continue the trend of price compression and banks, asset managers and wealth managers will need to greatly increase their operational efficiency, Woods warned. The most profitable bank in the world is operating at a margin of only about 18 to 22%. Crypto wallet Coinbase, which has more accounts than some of the largest broker dealers, is operating with about 78% profit margin, he reported.
Richard’s firm, Entoro Capital, is a broker-dealer who helps issuers raise the capital and the companies that are doing the issuance and the tokenizing of those securities are creating the infrastructure today to make this process much simpler for the other participants. There are companies building technology to handle compliance and other heavy lifting for tokenized securities issuance, Richard noted.
There have been quantitative studies done to determine how much savings can be achieved, Richard reported. A scenario with a $50 million private placement shows up to 40% savings for all parties over a five year period.
Cryptocurrency Asset Class
Howard Marks, the co-chairman of distressed debt investor Oaktree Capital Management, said “Bitcoin is not an investment, it’s a trade.” The billionaire investor also made reference to the “Greater Fool Theory” — an argument that explains an asset’s price not by its intrinsic value, but via the expectations of market participants.
Now that most of the speculators have, hopefully, been chased out of the market, we will see if the remaining participants can stay focused on leveraging the underlying blockchain technology to change the world.