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Virtual currencies become a mainstream investment, but investors and wealth managers must know the risks

In the winter of 1928, Joe Kennedy made a quip that became famous around the world: “You know it's time to sell when shoeshine boys give you stock tips.” This idiom articulates the risks that arise when a financial instrument becomes accessible to a mainstream audience who lack the sophistication to understand how to invest in it.

Whereas the shoeshine boy was providing an affluent and sophisticated investor with an equity tip, in today’s world, virtual currencies are following a similar path. Not merely another vehicle for mainstream investors and speculators, virtual currencies have established themselves as a de facto asset class, one increasingly becoming part of a diversified wealth portfolio.

In this blog post we explore some of the characteristics of these virtual currencies and assess the risks associated with them, as well as answer the question as to whether virtual currencies have truly reached terminal velocity. We will also explore how wealth managers must think about how to provide custody and management of this new alternative investment.

The Rise of Bitcoin, the Virtual Currency

In the past two years, virtual currencies have become a phenomenon that has reached a mainstream audience. They have become so ubiquitous that terms such as “bitcoin” and “ether” have been accepted into the popular vernacular of ordinary people across the world. The adoption rate is profound: Bitcoin was invented in 2008, languished as a niche currency with little adoption until 2013, and then exploded in value thereafter, up nearly 300 percent in the last two years.

Beware the ICO, Bitcoin’s Wilder Cousin

If Bitcoin took a long time to reach a popular audience, its cousin, the initial coin offering (ICO), has done so faster; since ICO came into existence in 20141 , $1.2 billion has been invested in this “asset class,” with two thirds of that investment ($800 million) having been made in the last thirty days. 2

An ICO is a form of raising money that is akin to crowdfunding, a share in the form of a virtual currency is created based on an underlying idea or business proposition that usually uses that virtual currency as its main method of transacting. These currencies can be traded in and out of and exchanged into fiat currency, much in the same way as casino chips represent a lien on a casino exchangeable for real cash.

Blockchain companies have used ICOs to go on a fundraising tear, the peak of which being the recent raise by a company called Tezos (TEZ), a husband and wife team who raised $232 million in 42 hours through their ICO, which demonstrated a controversial notion of a self-amending blockchain3. Equally large raises have recently been completed by many other organizations, such as block.one, which raised $185 million at a more leisurely pace of five days4, and Bancor, which raised $153 million5. Many of these raised these funds in an astonishingly short time: days, and in some cases, hours. The ICO market is currently growing at 800 percent a year6.

Contrast this with a more traditional fundraising approach taken by R3, the bank owned organization behind the "Wall Street-friendly" Corda distributed ledger, a blockchain-like platform that boasts more than 90 banks as members. R3 took nearly a year to raise funds through the time-consuming, but orderly and regulated, avenue of Series A funding, raising $107 million7.

What should we make of the contrast in terms of amount raised and the speed of funding? ICOs on the surface appear to be a process-light alternative approach to a Series A. However, a closer inspection demonstrates this asset class presents some significant dangers.

By claiming that they are crowdfunding vehicles, ICOs go around regulations designed to protect individuals and organizations against fraud. Crowdfunding a village church spire is one thing, raising funds to build a multimillion dollar organization based on a dubious business proposition is quite another – and is clearly not what crowdfunding was designed for. However, until recently there has been very little clarity from the regulatory authorities, and organizations participating in ICOs have used that to their advantage.

In July 2017, the Securities and Exchange Commission provided some clarity on the back of a ruling concerning a recent scandal involving a hack of a blockchain investment fund where mainstream investors lost millions: the infamous “DAO” hack. The SEC effectively stated that ICOs exhibit all the hallmarks of a regulated security, and therefore should be subject to the same issuance regulations. This has been tantamount to firing a warning shot over the bows of organizations aspiring to launch an ICO, but it has not provided the market with the level of clarity that it needs. It leaves many ICO investors in regulatory limbo with an asset considered and regulated as a security that has not gone through the necessary regulatory approvals to be issued and traded.

Not only is that a headache for investors but it also poses a dilemma for the regulators: Does the SEC protect the rights of consumers that bought into the ICOs before this most recent guidance, by providing some form of exemption? Alternatively, the SEC could adopt a laisse-faire approach and let these securities fail, which would akin to declaring over $1 billion 8 of assets effectively a worthless pyramid scheme.

Bitcoin, Too, Remains a Risky Asset Class

Bitcoin, the original virtual currency, also faces its own set of problems. Unlike ICOs, bitcoin doesn't have an intrinsic value, meaning that it is not tied to the ownership of a business model that can pay dividends or coupons (then again, neither does a unit of traditional currency, bitcoin proponents would argue). The bitcoin philosophy is one of a global currency that enables a peer-to-peer borderless transfer of value in a way that is agnostic to geography and regulation.

However, that's not to say it is not regulated at all. Local authorities have started to regulate aspects of the transactions that touch individuals and entities that reside in their geographic jurisdiction, specifically the interaction between the conversion of the bitcoin currency into the local fiat currency.

In the case of the U.S., that means dollars. Bitcoin transactions in the U.S. are subject to the Bank Secrecy Act, anti-money laundering regulations, and federal and state tax treatment on capital gains. The CTFC in the U.S. is starting to provide clarification concerning the treatment of bitcoin, recently declaring it a commodity9, which means that it can be governed under the Commodity Exchange Act (CEA).

However, that’s not to say that bitcoin is ready for prime time just yet. For example, the SEC recently rejected an application from Winklevoss twins (of Facebook fame)10, who proposed creating an exchange-traded fund to track the movement of bitcoin, on the basis that the counterparties involved in the underlying bitcoin transaction cannot be identified, and it therefore falls foul of BSA/AML and Patriot Act provisions.

We now have an interesting paradox whereby an individual buying bitcoin is legal under U.S. commodities law, but packaging bitcoin into a synthetic instrument that is bought and sold is an unlawful act, despite the underlying transaction performed being ultimately the same.

The lack of regulatory consistency makes bitcoin a risky investment for the mainstream investor, but so do the risks associated with bitcoin’s wild valuation fluctuations and the underlying technology that supports bitcoin itself.

Bitcoin Valuation and Underlying Technology Represent Risks

Bitcoin’s valuation has been on a wild ride, up nearly 200 percent since January 2017, driven by speculation and a massive influx of capital from countries such as China, Russia and Venezuela, whose citizens use bitcoin an avenue for capital to escape those countries’ authoritarian currency controls. With all this speculation, experts disagree as to whether there is a bitcoin bubble or if it has reached a fair valuation. Wild daily valuation swings of 5 to 10 percent add to the confusion. One thing for certain is that bitcoin remains too volatile an asset class for current consideration for mainstream investing. It is a punt, at best.

More concerning than the valuation is that the future of the Bitcoin as we know is in doubt, because the underlying technology is reaching capacity.

Bitcoin relies on a shared ledger of information that is added to in blocks of a certain size. When bitcoin was first conceived in early 2008, the inventor never predicted that so many people and institutions would use it. As a result, bitcoin has become a relatively slow mechanism for transacting, averaging 43 minutes to settle, which is still quick by international settlement standards11. Furthermore, the storage required to host a copy of the bitcoin ledger is becoming cumbersome and expensive. Added to this is bitcoin’s fixed supply of 21 million tokens, which will be reached some time in 204012. This may threaten the viability of the currency as it eliminates one of the incentive structures that keeps the currency going.

Fortunately for bitcoin, there are several proposals focusing on how to solve for some of the capacity constraints. These have very technical sounding names such as Segwit2 and BIP 14813. These proposals, however, need to be adopted in a democratic process whereby a majority of the main bitcoin participants (known as miners) are required to agree in order for the proposed changes to the underlying protocol be adopted.

This leaves some uncertainty about the future of bitcoin and introduces a real risk that Bitcoin could splinter into multiple currencies if mining groups decide to adopt different standards. In fact, this happened on August 1, when bitcoin split into two currencies, bitcoin and bitcoin cash. While this will need to play out before we understand the full implications, it is likely that this event will introduce confusion and then could potentially change the valuation of a currency that has, arguably, run above and beyond its true value. In the worst case, bitcoin holders may end up on the wrong side of a marginalized version of the technology, where their currency could become valueless.

Bitcoin cash, contrary to fears, appears to have held its value after the split. The new bitcoin cash instrument initially achieved a valuation of $12 billion overnight, then settled to $8 billion as of the next afternoon. However, some exchanges are deciding not to honor the trading of this currency, which is now resulting in lawsuits. Certainly, this presents a messy situation.14

The Impact for Wealth Managers

If this tumultuous environment appears puzzling for the layman investor, spare a thought for wealth managers, whose clients increasingly ask them to manage virtual currency investments on their behalf. Enlightened wealth managers must think about whether to include virtual currencies as part of a balanced portfolio. Those managers supporting clients already invested in virtual currencies must decide how to handle these investments, given that many may represent dubious investments that may not even be currently lawful.

The future of the virtual currencies remains uncertain, and we are only beginning to witness their impact on portfolios and investing. Whatever the future of these currencies, it will be an interesting one.

1Source: https://en.wikipedia.org/wiki/Initial_coin_offering
2Source: https://www.cryptocoinsnews.com/ico-mania-strikes-promising-to-transform-capital-infrastructures/
3Source: https://cointelegraph.com/news/tezos-232-mln-ico-sparks-fresh-fears-for-ethereum-sell-off
4Source: https://venturebeat.com/2017/07/01/185-million-in-5-days-block-one-sets-new-ico-record-with-its-eos-token/
5Source: https://www.cryptocoinsnews.com/bancor-sets-new-ico-record/
6Source: https://www.coindesk.com/ico-investments-pass-vc-funding-in-blockchain-market-first/
7Source: http://tinyurl.com/y9klbg2g
8Source: https://www.fastcompany.com/40446051/inside-the-ico-bubble-why-initial-coin-offerings-have-raised-more-than-1-billion-since-january
9Source: https://www.coindesk.com/cftc-ruling-defines-bitcoin-and-digital-currencies-as-commodities/
10Source: https://www.cnbc.com/2017/05/25/bitcoin-flying-as-etf-gets-second-shot.html
11Source: http://dodd-frank.com/limitations-on-blockchain-technology/
12Source: https://www.coindesk.com/top-10-bitcoin-myths-debunked/
13Source: https://www.theregister.co.uk/2017/07/13/bitcoins_might_just_vanish_into_the_ether/
14Source: http://fortune.com/2017/08/02/bitcoin-cash-lawsuit/

 
 
 
 

About the Author

Ben Jessel

Ben is a leader in Capco’s global distributed ledger practice and provides c-suite advice to organizations within the financial services domain. Ben’s expertise spans both the business domain as well as the technology architecture aspects of implementation.

Ben has led the development of distributed ledger strategies and proof of concepts for financial services institutions predominantly with U.S. tier 1 investment banks.

He is a vocal advocate of distributed ledger, having published thought leadership in a variety of journals and spoken at industry gathering such as private banking forums and the western hemisphere payments forum hosted by the world bank.

 
 
 

The content and opinions posted on this blog and any corresponding comments are the personal opinions of the original authors, not those of Capco.