Will traditional asset managers join the party?
These days in having conversations with institutional investors the subject often turns to crypto currencies. The question of whether there is an appetite from traditional asset managers to participate in the space and if so when will this happen is top of mind. It’s an interesting question from several different perspectives with the most pressing question being is there a genuine interest for this type of investment. I believe a majority of managers would welcome some exposure from a uncorrelated asset to the traditional ones. It also worth noting that sophisticated investors realize the changing dynamics proposed by ICOs and it's potential impact on capital markets.
A different asset class with a host of their own distinct issues
So what is the biggest hurdle when it comes to investing in crypto assets for these institutions? High on this list is the custodial ownership of the asset, a technological hurdle that remains as a key piece in the development of this asset class. When we speak of traditional assets, for example when you buy a stock or bond, there is a third party that holds the bearer bond or certificate in safe holding place and therefore assumes the risk of holding the asset. In fact, it is not only problematic but in many cases it's illegal for a investment advisor to have custodian responsibilities of the assets. Cryptos have a different level of security because they are digital keys and therefore have a vulnerability to online bad actors. What is needed to secure the asset is cold storage or a cold wallet, which is a secured , safe place like a hard drive or laptop that has never seen the light of day of the internet . The other pressing issue for institutions is hard forks, which is essentially a patch to the protocol which creates a new coin and perhaps a change in valuation. A clumsy example might be a company spinning of a new public division and leaving the equity holder with two separate traded equities with new valuations. Of course there is always the 800 lb gorilla in the room, the mighty SEC who have subpoenaed around 80 companies and have not come out with any definitive regulatory regime or guidance. There most definitive statements have said that ICOs look like securities per the Howey test leaving the onus on the issuer. (for more :https://www.coinist.io/the-howey-test-the-sec-and-ico/) Meanwhile the other regulatory arm, the CFTC, has claimed cryptos to be commodities, which only adds to the uncertainty. There will need to be regulatory clarity before many firms can even by participate according to their mandates or bylaws.
A community solving problems
While these hurdles seem challenging, the crypto community has already started to address this situation. The Swiss Financial Market Regulatory Authority (FINMA) in February announced a balanced approach to Crypto and ICO regulation where risk is mitigated while not hampering innovative potential. What really garnered the attention of investors and issuers was the willingness of FINMA to distinguish crypto assets into three categories of asset (security) coins, currency coins and utility coins. On the custody side Coinbase is planning on rolling out custodial services while crypto wallet firm Bitgo is merging with qualified custodian Kingdom Trust. Mike Belshe , CEO of Bitgo has said there is 20 bln pipeline that is committed to crypto assets as these custodial issues resolve. By the third quarter of this year the market could see a roll out of custodial services, expanded future contracts and clarification from regulators. Could this bring a funnel of new participants entering the asset class and while simultaneously ending the Crypto Haze of 2018?
I like the word digital-asset, It’s both simple and descriptive. It lays a stake in the ground that crypto or digital currencies merit the distinction of a separate asset class. Although I believe these tokens are indeed a separate asset class, they exhibit features of other assets—assets in the realm of technology, energy , base metals, stocks and currencies.
However, this burgeoning asset class is not uniform—it encompasses many types of technology and features tokens of different merit. Some coins or tokens provide access to their network and are commonly named utility coins. There are also coins/tokens that facilitate transactions and payments through their digital networks which we call crypto currency.
Another type of crypto-asset is the security token. Security tokens are the most similar to stocks because they usually feature a cash flow component. And to a lesser extent, there are tokens which represent a particular asset like a commodity as well as rewards tokens that promote use of a particular business or platform.
HOW DO WE VALUE CRYPTO?
So how do you peg a value to a crypto currency or "coin over internet protocol" (COIP) and it's potential for widespread use? To value crypto currency, we can look to the economic theory on the velocity of money to help understand the adoption and potential growth. In other words we can seek to determine how many people are using a particular coin as a form of barter. For instance, Venuzuela which experiences hyper inflation, has seen a growth of digital currency use which includes BTC, Monero and Zcash. Velocity is an important concept of economics where measuring the flow of money and can help determine inflation or economic growth and in the case of new crypto currencies a signal of acceptance. When considering the potential value of digital currencies, velocity might be even more important because of the inelastic supply of coins, as opposed to fiat which in theory can continue to print money. This gets into the quantity theory of money where monetarists believe velocity should be stable and money supply can be fluctuated—but that’s a different discussion.
THE VELOCITY OF MONEY
So what does velocity look like for a currency? The formula for velocity is such ; V= PQ/M where PQ is nominal GDP and M is the total amount of money in circulation. So how can we find GDP of a crypto currency? I would argue that total transactions seems to be the most innate number to use for this equation. We can replace money in circulation with the total supply of coins or as others some would argue from the float. So the new equation might look like V= TT/ICO where TT is total transactions and ICO is the total number of coins.
RELATIVE VALUE
After solving for velocity we now have a comparable way of finding relative value within digital currencies. However a vital component for a currency is a relative stability of the unit in order to transact or barter without huge fluctuations. We can measure this by using the volatility of the coin as measured by the standard deviations of the daily returns over a year multiplied by the square root of 250 (crypto doesn't seem to take weekends off so 365 days likely apply). We can therefore make a constant comparable number(lets call it a "Token Viability Ratio") between crypto currencies by dividing velocity by volatility, in essence having a number that measures usage and stability. I would note that for a utility or protocol coins there is sound reasoning that velocity would diminish as people would hold on to these coins to access growing networks. I would encourage reading Union Square Ventures paper by Joel Monegro titled "Fat Protocols" about this subject. ( https://www.usv.com/blog/fat-protocols )
CAN PAST PERFORMANCE PREDICT FUTURE RESULTS?
My thought is that perhaps as currency coins gain traction, one could argue that the numerator (velocity) increases while the denominator (volatility) of the underlying coin will decrease. To put this into daily context, transactions are growing while the underlying price remains somewhat stable. I think this concept will be interesting to look at not only with new crypto currency coins but may very well show a distinction between fiat currencies and their digital cousins as more sovereigns embrace a digital currency.
* note : This article is meant as a knowledge loop and I always encourage feedback of any kind.
The SEC and the CFTC are slowly but surely addressing the issue of ICO's and token sales. They have issued subpoenas and have broadly classified tokens as securities consistent with the Howey test. (for more see- consumer.findlaw.com/securities-law/what-is-the-howey-test )
While this shouldn't come as a surprise to anyone, it does resonate for many crypto currencies which are based upon decentralized ledger transactions. The burning question is how does a decentralized ledger and anonymous transactions comply with Anti money laundering(AML) policies and Know Your Customer (KYC) regulations.
Although these concepts of decentralization and regulation seem contrarian in nature, what is worth noting in regards of decentralization is the strength of community that supports them. Regulators at the SEC and CFTC have always relied on self-regulating organizations (SRO) in helping monitor markets. Could a community bridge the answers between regulation and decentralization. Gemini exchange and the Winklevoss brothers believe so and have recently submitted a proposal for a non profit SRO named the Virtual Commodity Association. This certainly seems like a step in the right direction as the market evolves and we add one more acronym (VCA) to the laundry list.
