Bitcoin—friend or foe?

The now infamous cryptocurrency is sparking interest among the institutional investor community but will its dark history, volatility and technological issues hold it back?

The never-ending rise of bitcoin has been both meteoric and frightening. The cryptocurrency price hit the fabled $10,000 mark in November, from just $1033 at the start of the year, while market capitalisation has surged tenfold to $160 billion leaving those who had the nerve to remain invested with some of the highest returns of any asset in the world.

The success, as can be expected, has led to burgeoning investor interest. Cryptocurrency-focused hedge funds have been springing up apace in the last twelve months. According to Autonomous NEXT, a financial technology research company, there were 104 crypto-hedge funds launched this year, taking the total to 130 with about $2.5 billion in assets. Many of these are banking on continued market growth and expansion. But despite all of the hype—or maybe because of it—bitcoin and its ilk are looked at suspiciously by the mainstream institutional investor community. Volatility, lack of track record and the fact that cyptocurrencies are seen to be used more for nefarious purposes than not, have cooled the appeal of the asset class for institutional investors.

So what chances of change?

Advocators of bitcoin, in fact, believe that mainstream adoption could be as little as a year away and are raising funds to prepare. In September, Mike Novogratz, former macro hedge fund manager at $36 billion Fortress Investment Group, announced he was launching a fund—the Galaxy Digital Assets Fund—with the aim is of raising over $500 million to invest in cryptocurrencies. Novogratz told participants at the Reuters Global 2018 Investment Outlook Summit that he expects major financial firms will soon start to offer bitcoin or similar products as an investment option that could be easily purchased over the phone which will make it easier to persuade institutional investors to join the fray. Other alternative funds are seeing a clamour from family offices and private banks to get into the cryptocurrency.

“The more bitcoin has climbed this year, the more family offices and high net worth individuals want access via their private banks,” says Lee Robinson, chief investment officer of $400 million London-based hedge fund Altana Wealth. “Clients remember how the banks told them to not invest in tech in the late 1990s and were wrong so they don’t take their biased views against bitcoin very seriously. Fear of missing out is real. All can see that holding digital global money will be the norm inside ten years.”

Undeveloped infrastructure

While bitcoin remains pre-mainstream, Robinson says that the institutional move to the asset will occur and investors like Altana are perfectly positioned to thrive on this.

“What is holding back a bigger tide is undeveloped infrastructure in the crypto capital markets, exchanges, trading pipes, and regulatory uncertainty around the whole sector,” says Lee Solokin, global director at financial technology research provider, Autonomous NEXT. “Once crypto custody is built and institutional trading can be done by FIX (Financial Information Exchange protocol) the path in will be much easier.”

It is essentially the need to connect traditional finance operational technology to the cryptocurrency operational stack. Getting the connection is not easy, however, as cryptocurrencies are built around very different concepts to traditional assets, with decentralized exchanges—the likes of Airswap—holding sway. Nonetheless, traditional participants have been eyeing the market and indeed working to create new instruments to broaden the market’s appeal. The most recent and significant of these is the Chicago Mercantile Exchange (CME) which announced proposals to launch bitcoin futures in October.

On the other side, product providers have been hitting the market with certificates and structured products to entice investors get into the business. Leonteq, a Swiss derivatives specialist, launched a short bitcoin certificate which allows investors to get exposure to downward movements of bitcoin with a conversion ratio of 0.1. The company says it has had numerous requests from clients to short bitcoin and is confident the product could appeal to institutions too.

The expansion ability to carry out risk mitigation are necessary if cryptocurrencies are to attract mainstream institutional investors. Unlike hedge funds, institutional investors have far greater scrutiny on an asset with no track record. And right now there are more questions than answers. 

Private cryptocurrency worries

“The starting point is the question of whether or not cryptocurrencies are actually currencies or rather an innovative yet highly speculative new asset class,” says Martin Hochstein, senior investment strategist at Allianz Global Investors. “Against the background of still extreme price volatility, a lack of recognition as legal tender and the sheer number of currently more than 1,000 different cryptocurrencies, these requirements are not met.”

Stephen Jen, chief executive of Eurizon SLJ Capital, says cryptocurrencies do serve a purpose as media of exchange which could function to help with the trade of goods. But they are not currently relevant as traditional currencies are to represent the value of goods simply because they are too volatile.

“I am unclear whether these assets will take a big market share from the traditional monies,” says Jen. “My hunch, for now, is negative given their extreme volatility. They do serve some purpose but cannot, at this point, replace the traditional currencies.”

The volatility aspect has been particularly notable this year. In November bitcoin lost almost a third of its value in less than four days after plans to upgrade the bitcoin network to improve speed of transactions—the so-called hard fork—were abandoned. Ethereum, the other major cryptocurrency, which makes up $41 billion of the market share, saw its price surge almost 50 times from the start of the year to June, before falling back by about a fifth.

The technological issues are compounded by cyber crime risks which few institutional investors understand, let alone have the ability to combat. Last year, Hong Kong-based Bitfinex lost more than $60 million worth of bitcoin to hackers and was fined by the US Commodity Futures Trading Commission ‘for offering illegal off-exchange financed retail commodity transactions in bitcoin and other cryptocurrencies’.

On top of all this institutional investors, who favour established currencies, are dissuaded by the lack of track record and the possibility that regulators may curb these private cryptocurrencies and introduce their own central bank currencies.

“Private cryptocurrencies open the door to the financing of illegal activities, money laundering and the circumvention of capital controls,” says Hochstein. “Ultimately, these could result in a ban of private cryptocurrencies and the creation of alternative digital central bank currencies.”

Whether these are teething problems or more fundamental issues remains to be seen.