How Traditional Asset Managers Can Start Investing in Crypto
If cryptocurrencies continue their trajectory, then traditional asset managers will need to learn how to invest in crypto.
Cryptocurrency has already been added to the CFA exam. That means the next generation of financial advisors will need to learn about crypto in order to launch their careers.
How do traditional asset managers invest in crypto? Does traditional investment wisdom apply in the crypto space? Or are cryptocurrencies a whole new category of asset class with whole new training required?
Gary Basin over at Hackernoon recently attempted to answer that question. In a post titled, “Crypto investing for traditional asset managers,” Hackernoon explained how traditional investors can begin investing in crypto.
The Biggest Selling Point is Diversification
One of the most important points made by Basin is that bitcoin is a valuable diversification tool. Put simply, bitcoin doesn’t track well with other asset classes. Bitcoin isn’t linked to the USD or the price of gold, for example. It’s a totally unrelated market. This might be the feature that convinces institutional investors and traditional firms to jump on board:
“This is crypto’s, specifically bitcoin’s, biggest selling point to institutions,” explains Basin. “Bitcoin returns are not very correlated with other asset classes. Even without a view on whether bitcoin will replace gold, or the fed, or whatever: smart money is interested in its uncorrelated returns.”
Where should institutional investors leave their money when markets are crashing? Bitcoin could be a safe haven.
Basin predicts that the diversity of bitcoin “will be the primary driver of new money flowing into bitcoin (and perhaps a few other top coins) over the next 12-24 months.”
What About Alpha and Beta Bets?
Alpha investing involves making predictions better than chance. Basin explains that the median asset manager “doesn’t have much hope for generating significant alpha” in the crypto industry, which is why these managers will aim for the diversification we explained above.
Meanwhile, large asset managers are hungry for low beta assets, which are assets uncorrelated with the rest of the portfolio. This is where the diversification of bitcoin could present significant value.
How Traditional Asset Managers Can Allocate Funds Across Cryptos
Institutional investors have major concerns when adding a new asset class to their portfolios. Some of their concerns include:
Staying Power: Is this new asset class here to stay? Or is it just a flash in the pan driven by short-term hype?
Custody: Can I securely hold and maintain ownership of this asset? Or is it subject to hacks, theft, and other types of losses.
Liquidity: If we need to exit our position, then how likely is it that we’ll get stuck holding the bag? How liquid are markets for this new asset class?
Based on all of these concerns, bitcoin is arguably the best bet. It was the first cryptocurrency and it may have the longest staying power. It’s also the most liquid cryptocurrency, as bitcoin has more trading volume on a given day than most other cryptocurrencies. Finally, there are more bitcoin custody services and bitcoin storage options than there are for any other cryptocurrency.
As evidence of bitcoin’s staying power, Basin cites the “lindy effect”:
“From a lindy effect perspective, Bitcoin has the longest track record and the most user support. Some institutions will still allocate along the top few coins to hedge their bets and may even place small speculative allocations on promising new projects that seem to be sufficiently different (e.g. using DAGs or new types of DLT).”
Bitcoin also has an advantage of terms of legal status. Sure, there are cryptocurrencies that grow faster than bitcoin and have more volatile swings, but they may not be declared legal as quickly as bitcoin is declared legal. A number of ICO coins are likely going to be considered unregistered securities by the SEC in the future, which could indicate a wave of lawsuits incoming. Bitcoin, as the best-known cryptocurrency in the space, may be one token that avoids regulation. Bitcoin is currently taxed like property in most jurisdictions. In the future, it could be treated like a currency or a commodity.
In 2018, for example, a judge ruled that bitcoin is a commodity. Judges don’t make rulings on smaller altcoins, and many smaller altcoins make risks that could attract attention from regulators – like paying dividends to token holders.
How Will Traditional Investors Trade In and Out of Crypto?
The next question to answer is how traditional investors will trade in and out of crypto.
Many institutions will want to get exposure to cryptocurrencies through a publicly-listed vehicle with low fees, like an exchange-traded fund or a closed-end fund – similar to Grayscale’s Bitcoin Investment Trust.
Today, these options are rare and expensive. Grayscale’s Bitcoin Investment Trust, for example, comes with fees of 2% and trades at a very high premium compared to its Net Asset Value (NAV) simply because bitcoin funds are so rare. Today, the fund trades at a 50% premium, indicating investors are willing to pay 50% more than the value of the assets currently held by the fund. At times, however, the NAV has been as high as 100%.
Ideally, more crypto funds will launch in the near future. Unfortunately, we don’t know when. The SEC just rejected the ETF application from the Winklevoss twins earlier this week. They’ve also postponed the decision on 5 more ETFs until September 2018. The SEC is denying these ETFs because of worries of price manipulation in bitcoin markets, among other concerns. Will these concerns really be solved in the near future?
Over the Counter (OTC) Trading
Alternatively, instead of investing in funds, firms could complete over the counter (OTC) trades.
This is how the vast majority of crypto trading is done today. This is how institutional investors are participating in crypto markets.
It’s widely suspected that many of the major over the counter (OTC) desks are developing their own dark pools. Some analysts suggest these OTC desks are already operating their own dark pools.
The idea of a dark pool is that it allows traders to execute hidden orders at prices that are relative to a liquid exchange’s prices at a midpoint. This allows institutional investors to complete large trades without revealing these large trades to the market.
Order Routing and Smart Execution Algorithms
Larger investors can also participate in the crypto space using order routing and smart execution algorithms. Smart order routing and smart execution algorithms essentially involve breaking your orders into smaller pieces and then spreading them across multiple exchanges. The algorithms account for small differences in price, liquidity, fees, and latency.
Basin of Hackernoon.com identifies several such services in the crypto space today, including TradeBlock, CoinRoutes, Coinigy, and SFOX. CoinRoutes and SFOX are custodial services, which means they hold capital on behalf of institution. Coinigy, meanwhile, just give users API wrappers with a unified user interface, which means you just interact with the exchange through the Coinigy dashboard.
The Pitfalls of Crypto Investing for Traditional Investors
It won’t all be smooth sailing for traditional investors seeking to dip their toes into the crypto space. Basin identifies a number of potential pitfalls they may encounter along the way, including:
- Exchanges are like the Wild West; they’re “risky, unregulated, and vertically integrated monoliths”, and many are incapable of securely handling institutional levels of money
- OTC trading costs are high, and all-in-costs of 2 to 5% are not unusual in the crypto space
- Coin provenance is not always known, and you may inadvertently take possession of a bitcoin that has previously been involved in criminal activity; this means the bitcoin you could might not be worth the same as another bitcoin – say, if that other bitcoin is totally clean and has no previous connection to criminal transactions
Overall, traditional asset managers will continue to be interested in crypto assets because the returns are not correlated with other asset classes. That makes crypto a potentially valuable addition to a portfolio.
However, there are certain serious problems that need to be solved if crypto is going to succeed among traditional investors.
Gary Basin dives even further into crypto investing for traditional asset managers in his article. You can read the entire piece here.