“A purely peer-to-peer version of electronic cash would allow online payments to be sent directly from one party to another without going through a financial institution.” Satoshi Nakamoto, October 31, 2008
We have all heard of cryptocurrency by now, whether in the news, rags to riches stories from early adopters, overnight successes of new fintech firms, or physical crypto ATMs appearing on street corners. While the crypto name is familiar to most, we hear many wanting to know more about this evolving technology.
While we are not crypto experts when it comes to the underlying technological applications, nor the complex coding behind blockchain, we are curious investment managers. This article aims to cover what cryptocurrency entails, how it works, and the investment implications in this emerging asset class.
What Are Digital Assets and Blockchain Technology?
Evolution of Cryptocurrency
NFTs and the Metaverse
Hurdles to Widespread Adoption
Methods of Cryptocurrency Investments
A Fad or the Beginning of Something Extraordinary?
We describe an asset class as an investable universe. Digital assets refer to a large universe of digital tokens used for various practical applications. What underpins these tokens is blockchain technology. Blockchain technology is a peer-to-peer decentralized distributed ledger, which is a public record and not owned by any one person or entity, allowing a public validation of a particular transaction. Transactions are recorded in "blocks" and then linked together with previous transactions to form a "chain." Blockchain was originally envisioned in 1991 by two individuals working on a cryptography-based system as an early blockchain-like protocol. It is a record-keeping/fact-checking process that validates the chain of ownership by individuals who match complex coding outputs and are then awarded cryptocurrency in return for their work. Think of this concept as a publicly accessible, non-corruptible digital ledger of transactions. There are two ways this is accomplished (and how transactions are verified). Either by proof of work or proof of stake, both entailing their own complexities and pros/cons. The benefit of blockchain technology is that the original record cannot be altered once a transaction is completed.
The original cryptocurrency, Bitcoin, was published through a proof-of-concept public white paper by a still unknown Satoshi Nakamoto back in 2008. The general concept was to create an alternative to fiat currencies. This would allow individuals to freely transfer money anywhere across the world and pay for goods and services in a global environment. Just as important, it would not be constrained by today's banking system hours or limitations and ultimately done at a lower cost.
On the launch of Bitcoin back in 2009, the proof of concept and actual transactions were limited to the transfer between early adopters and the intellectually curious wanting to explore the new technology. It wasn't until May 22, 2010, that the first real-world commercial transaction was completed. An individual, frustrated with the hoarding environment in Bitcoin mining, offered up 10,000 bitcoins for someone that could deliver two pizzas to his home in Florida. A taker of this transaction, based in London, accepted the bitcoin while placing an order at a local pizza store to be delivered (a value of $60 at the time and $400 million today).
The predecessor firm of LEO Wealth, LeoGroup LLC, was involved in structuring the first Sotheby’s sale of a Stradivarius violin using bitcoin. This was the first instrument of this importance and value to be the subject of a bitcoin-priced contract. The multi-million dollar bitcoin contract was conceived and engineered by LeoGroup and executed in February 2014.
The sheer price increase of Bitcoin from fractions of a cent to a high of US$65,000 in 2021 has gained cryptocurrency global attention. Since the launch of Bitcoin, it is estimated that there are now over 6,000 digital coins. The total market cap of digital coins now exceeds US$2 trillion, a feat that took Apple over 40 years to accomplish, has taken crypto a mere 13 years. In the past few years, many other coins have come to market, all with various uses and benefits. What has started as a unique idea of blockchain has evolved into cryptocurrency seemingly overnight. There is now an even wider breadth of digital coins and their intended uses, including but not limited to the metaverse, decentralized finance (DeFi), non-fungible tokens (NFTs), stablecoins, and even ESG & Carbon Credits. There is even adoption at the national level, with El Salvador as the first country to accept Bitcoin as its official legal tender in 2021.
Bitcoin was the pioneer in using blockchain as an alternative to a fiat currency. Ethereum, on the other hand, was built as a platform for programmable blockchain meant for decentralized finance, smart contracts, and NFTs. Ether is the currency used on the Ethereum network (usually called Ethereum). Even though these are commonly thought of as interchangeable, there is a stark difference in what these two were set out to do; although both are freely transferrable, purchased, and sold.
A relatively new development in the digital space is the rising popularity of Non-Fungible Tokens (NFTs) and the metaverse.
NFTs can be used to claim verifiable ownership of all things digital. At the moment, there is a hype about NFT usage for digital art. However, NFTs could be used for much more mundane but useful things like commercial contracts, real estate records, or in the metaverse, digital real estate or other digital property.
The metaverse is basically a virtual reality world where people can interact in a virtual 3D environment. Imagine, rather than shopping on the Amazon.com website, you can immerse yourself in a digital department store, where you can see and virtually try all articles before buying them.
This is the reason why real-world companies like JPMorgan and Ernst & Young are spending real dollars to buy virtual office space in the virtual reality world, as the metaverse will be a three-dimensional version of the internet we know today. Blockchain technology can play an essential role in developing this global metaverse as it will not be controlled by one company or country but by decentralized technology.
Crypto and blockchain have come a long way over the past decade with lasting implications for the future, but we have not addressed the underlying hurdles for widespread adoption.
Genuine issues are money laundering and theft. The takedown of the black-market site dubbed Silkroad used cryptocurrency as payment to maintain anonymity and illude authorities. Secondly, it is commonplace for theft and fraud. Some large crypto exchanges ( including Mt. Gox) were attacked by hackers, who made off with large sums of crypto that investors rightfully owned. With the rise in cybercrime globally, hackers have made off with large sums of crypto as their go-to payment medium for ransomware attacks. The good news is that major centralized crypto exchanges are beginning to require forms of Know Your Customer documentation to thwart those bad actors or at least keep track of them. Centralized exchanges have also been working to further protect their customers' holdings, in a variety of cyber security measures which hope to prevent or limit attacks on crypto held in “hot storage.”
While crypto was largely ignored in the early days by regulators across the globe, a recent reversal has put the digital assets in regulator’s crosshairs. The reason behind this is likely twofold. First is the sheer volume and value of these digital assets and the added complexity in governing this emerging investment offering. The complexity of these digital assets has expanded beyond buying and selling digital coins and into decentralized lending, use of leverage, and DeFi smart contracts. Secondly lies within this emerging asset class, a large opportunity to expand tax revenue leading most countries to tax digital assets. For example, the U.S. has rules on reporting the proceeds of digital asset sales, and cash reporting for large business transactions in digital assets. Additionally, the IRS considers crypto as property and treats it like other investable assets, taxing any gains at short-term or long-term capital gains rates. It’s not all bad – regulator intervention and policies are strengthening the idea of crypto as an asset class in ways, giving more weight to global adoption.
Price volatility and general acceptance are also giant hurdles. There has been a growing movement in the widespread acceptance as a medium for payment of goods/services for large multinational firms. Several large companies have already begun to accept cryptocurrency for their products and services. The main hurdle resides within the continued underlying volatility in crypto that has made it an untenable option for most businesses, especially once you consider the reporting and tax requirements. While volatility has been high, the good news lies within well-known financial pundits, who have reversed their views on the viability of asset class.
One key concern is power usage and carbon emission. While cryptocurrencies are revolutionary in decentralization and payment capabilities, the computing power to transact and mine remain an ongoing debate. At the heart of that debate lies energy usage and how that directly translates into actual carbon output. There is also a big difference in energy consumption between different coins themselves. While there has historically been a lot of crypto mining in places such as China, where energy costs are relatively lower, there has also been a sizeable shift away from carbon-generating sources to mine crypto. Focus on sustainability has led to the use of renewable energy sources to lower the impact of carbon output and to take advantage of the unused supply of renewables at particular times of the year. Compared to traditional banking, there is said to be less overall energy consumption used for digital assets, leading to favorable adoption in a growing sustainability-focused environment.
We find the most often asked question is “I’ve heard about crypto, now how do I invest?” In short, investors can gain exposure directly or indirectly to crypto in three main ways, each having its particular nuances, pros and cons:
This is done through the use of crypto exchange platforms and brokerage firms. Various types cater to new investors or sophisticated traders through names such as Coinbase, Binance, Gemini, Kraken, and OSL. When buying directly, one needs to be aware of centralized vs. decentralized exchanges, crypto wallets/custody, and transaction fees.
The U.S. SEC has till now, not allowed a cryptocurrency ETF vehicle that directly holds the underlying coin. Companies such as Grayscale have established private investment trusts to fill that void. These are tradable over the counter but entail higher ongoing fees and often trade at extreme premiums or discounts to underlying crypto prices. The U.S. has recently allowed a Bitcoin ETF of sorts, but the underlying asset relies on futures contracts of Bitcoin, ultimately a derivative investment. While the difference may seem minor, futures contracts can be costly to maintain as underlying contracts need to be rolled over and hence can entail more trading costs and disrupt tracking of actual Bitcoin prices. Several firms outside the U.S. have successfully listed ETPs, which have reasonable ongoing fees and more closely track the underlying investment. In short, non-U.S. investors have access to better options in this emerging asset class to date.
While not a direct exposure to an individual cryptocurrency, investing in publicly listed companies that closely invest in or cater to the broad crypto space allows one to get broad exposure. This alternative also allows investors to focus on the part of the digital asset space they find of interest (e.g., crypto mining, exchanges, hardware providers).
Holding direct cryptocurrency is an efficient method, but some trading platforms can be complicated and pose an ongoing concern regarding asset safety. Once a digital coin is purchased, consideration should be given custody in either hot or cold storage wallets. Hot wallets are essentially connected to the internet (risk of hacking) and cold wallets are not (they live on a private drive, with private access keys). Forgetting your private ‘keys’ to a wallet can lead to those coins being unrecoverable. Unlike traditional assets on centralized exchanges, cryptocurrency can be traded 24 hours a day, 365 days a year.
Direct exposure through investment products, ETF’s/ETPs, and funds, is just like buying another investment in your brokerage account and less consideration for storage. The downside is for the service of managing the investment one, in turn, pays additional fees. Depending on the product, the return can deviate substantially from the underlying crypto. However, a professionally managed fund can add value in navigating the digital asset space by reacting to changes in the market or by investing in new coins and tokens.
Indirect exposure, while providing investors the ability to be selective in what areas of the technology they’d like exposure, doesn’t necessarily closely track the underlying coin price movements.
Whether you are in the camp of considering digital assets as a “Ponzi scheme” or “‘the future of technology,” there is no denying that crypto and blockchain have begun to touch everyday lives. While crypto investing is not for the faint of heart, there are serious financial backers who view this as the next major advancement in technology and investing. The digital asset space is too big to ignore for investors, as it offers attractive opportunities, but it is also an area that requires careful consideration. The potential may be unlimited, as there have been large investments into payment technologies, digital coins, digital real estate, and the overarching metaverse. While volatility remains a top concern for investors, incorporating even a small allocation to digital assets will have an impact on portfolio diversification and capture part of the growth in these evolving investable asset classes. When considering the digital asset space, it would be worth considering using an active (digital) investment manager to get the most out of this emerging new asset class.
DISCLAIMERS & DEFINITIONS
This material represents an assessment of the market and economic environment at a specific point in time and is not intended to be a forecast of future events, or a guarantee of future results.
Forward-looking statements are subject to certain risks and uncertainties. Actual results, performance, or achievements may differ materially from those expressed or implied. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice meeting the particular investment needs of any investor. Past performance does not guarantee future results.
Cryptocurrency is a digital representation of value that functions as a medium of exchange, a unit of account, or a store of value, but it does not have legal tender status. Cryptocurrencies are sometimes exchanged for U.S. dollars or other currencies around the world, but they are not generally backed or supported by any government or central bank. Their value is completely derived by market forces of supply and demand, and they are more volatile than traditional currencies. Cryptocurrencies are not covered by either FDIC or SIPC insurance. Legislative and regulatory changes or actions at the state, federal, or international level may adversely affect the use, transfer, exchange, and value of cryptocurrency.
Diversification does not guarantee a profit or protect against a loss in a declining market. It is a method used to help manage investment risk.
Investing in alternative assets involves higher risks than traditional investments and is suitable only for sophisticated investors. Alternative investments are often sold by prospectus that discloses all risks, fees, and expenses. They are not tax efficient and an investor should consult with his/her tax advisor prior to investing. Alternative investments have higher fees than traditional investments and they may also be highly leveraged and engage in speculative investment techniques, which can magnify the potential for investment loss or gain and should not be deemed a complete investment program. The value of the investment may fall as well as rise and investors may get back less than they invested.
Trading futures involves the risk of loss and is not suitable for all investors. Please consider carefully whether futures are appropriate to your financial situation. Only risk capital should be used when trading futures. Investors could lose more than their initial investment. You must review customer account agreement prior to establishing an account. Past results are not necessarily indicative of future results. The risk of loss in trading can be substantial, carefully consider the inherent risks of such an investment in light of your financial condition.