The Trouble with Crypto

We’ve long advised investors to approach the crypto space as they would venture capital. Yet now that some of the speculative froth has blown off, what’s the outlook from here?

For all the development and hype around crypto and blockchain, there are still limited ways to express a view on them as an investment theme. That’s a major issue for investors. But we expect that to change over time—perhaps more quickly than most anticipate.

Limited Options

An immature and uncertain regulatory environment explains much of the hindrance investors face in expressing their views. Consider the two main ways to invest in crypto (for the sake of simplicity, we’ll bundle blockchain technology under the same umbrella term). Investors can buy stakes in the firms operating in the ecosystem or they can buy tokens (aka “coins”) like bitcoin and ether.

Most of the interesting companies remain privately held, so their stocks aren’t accessible to many investors. A few companies such as Coinbase, Galaxy Digital, and Marathon Digital trade publicly. Yet, the ratio of investor appetite to the size of the publicly traded universe creates a significant imbalance.

What about tokens? Thousands exist, with a hundred or so most readily available for trading. The list meriting serious investment consideration is even shorter. And the SEC, CFTC, and other agencies are still determining appropriate regulation for most of these assets.

Regulatory Hurdles Abound

Investors who want to directly open an account at a crypto exchange, identify the tokens they find most attractive, and manage the risk have been able to do so for quite some time. Yet investors who would rather invest through a traditional financial institution or via an equity-like investment vehicle—or delegate the research and selection process—still have few good options.

Crypto tokens rely on a different infrastructure from conventional asset classes like stocks and bonds and most institutions still aren’t set up to offer them. Things we take for granted in the traditional investment world—such as custody and segregation of assets—pose more of a challenge when it comes to crypto.

Several equity-like vehicles for crypto tokens exist but tend to have drawbacks. In addition to being private, other disadvantages include illiquidity, hefty fees, and high tracking error (i.e., failure to closely replicate the moves of the underlying cryptoasset). What’s more, some own futures contracts instead of cryptoassets and the regular rolling to future months’ contracts creates a significant drag on performance.

Here again, regulatory issues resurface. Lacking comfort with trading market dynamics and the potential for market manipulation on crypto exchanges, the SEC has not allowed traditional investment funds to hold material positions in “spot” (or “cash”) cryptoassets. Besides creating portfolio constraints, these spot restrictions prevent passive index funds or actively managed mutual funds from managing crypto portfolios for investors. Instead, crypto funds only remain open to qualifying investors, and even then, many lack the scale to meet institutional investors’ criteria for investment.

More Regulation Will Improve Access

At some point, we expect the following key milestones to unfold:

• The SEC approves the first spot bitcoin ETF
• Other spot bitcoin ETFs launch in rapid succession
• Spot ETFs based on ether and other tokens come to market
• A reasonably designed token index is eventually created and commercialized in a spot crypto ETF

Each will represent an important juncture, with the final step opening the door to fairly simple, diversified crypto exposure (Display).

 

As time goes by, we also expect more privately traded companies in the ecosystem to go public and find a home in equity portfolios. We also foresee more active managers pursuing excess returns by launching strategies focused on tokens and allocating to them based on fundamental or quantitative metrics. In fact, given the present inefficiencies and difficulties in creating a broad, passive index like the S&P 500, the crypto ecosystem may be especially ripe for active investment management.

Tokenization, the Next Frontier?

Regulatory clarity will also benefit the tokenization of assets. In essence, this will create a more liquid and transparent market for assets that currently trade in private markets—real estate, real assets, and small- or medium-sized businesses.

Yet there are important reasons why these assets trade in private markets and remain difficult for most investors to access. To protect everyday investors, the SEC requires audited financials and other vital disclosures, which are costly. As more assets trade in tokenized form and interest in them grows, the SEC (or perhaps the CFTC in the case of the real assets) will also need to formalize the regulations for tokenized assets.

A Long Path Forward

While the crypto industry is developing at a rapid pace, it still has a long way to go—and it’s not going to get there overnight. As software developers and other industries employ blockchain technology to solve more problems—and regulators work with them to map out what is in- and out-of-bounds—we expect further access and transparency to bloom.

Like any nascent industry, there will be experimentation, which leads to both successes and failures. Investors approaching this theme with a long-term, venture capital mindset should be prepared for both ups and downs. One of the few things in the space that we can confidently predict is that there will be a lot of them.