Shining a Light on Bitcoin

By Ginger Szala

January 29, 2018 at 07:00 PM

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Bitcoin is drawing attention and drama.

J.P. Morgan's Jamie Dimon first saw it as another tulip bubble, but has since retreated from this assessment. Lloyd Blankfein, CEO of Goldman Sachs, reportedly is behind the start of a cryptocurrency desk. Blackrock's Larry Fink thinks Bitcoin is "an index for money laundering," while Peter Thiel's Founders Fund has invested in it full throttle.

Brokerage firms like Charles Schwab and Fidelity have taken a wait-and-see view, while TD Ameritrade began a pilot project in which some retail clients can trade CBOE Global Markets' Bitcoin futures. Kind of like the price of Bitcoin, the interest in it and other cryptocurrencies is all over the map.

Despite this range of acceptance and anxiety, cryptocurrencies have stormed the global stage, forcing investment professionals to, at the very least, explore what makes these products attractive beyond the speculative flurry and how they possibly could be used in investment portfolios.

There are only a few options today that provide financial advisors with the ability to invest in Bitcoin, but those may be out of their (and their clients') comfort zone. Still, there's also the investment that is attracting the "smart money": the underlying blockchain technology.

"We see potential benefits [of blockchain] for more efficient check-out settlement in the markets we currently trade, but are really excited about opportunities to unlock new markets where current transaction processes are simply not efficient enough for us to trade reliably," said Mike Harris, president of Baltimore-based investment management firm Campbell & Company.

"We think that's one of the most promising aspects associated with the development of cryptocurrencies. I don't know what will happen to Bitcoin in the future, but I'm optimistic something that looks like distributed ledger technology may be seen in our markets in the not too distant future," Harris explained.

What Is Bitcoin?

The simplest description of Bitcoin is that it is one of more than 1,500 cryptocurrencies traded globally, and it has the advantage of being one of the first to be developed and — reportedly — one of the safest in preventing fraud. These products are "mined" by people — instead of a cartel that may have commodity production restraints; and production is limited by an algorithm.

That said, people do control the amount of Bitcoin available to traders and investors. For example, the theoretical universe of Bitcoin is 21 million, whereas to date 16 million have been mined.

It also should be noted that a country can crack down on cryptocurrency users. For example, South Korea recently announced a ban on anonymous cryptocurrency accounts. This news pushed down the price of Bitcoin, which had been above $20,000 in December, to below $10,000 in mid-January.

Of course, other news can affect its price. Right after the first of the year, when Thiel's Founders Fund invested in Bitcoin, the price jumped above $16,000. But other than these types of events — believe it or not — there are relatively few fundamentals that determine (as of today) the true value of these products. What makes this area murkier is the unlimited number of cryptocurrencies, as well as their potential use on the dark web for drug and other illegal transactions.

Foliofn CEO Steve Wallman, a former commissioner with the Securities and Exchange Commission, questions what is behind the volatility of Bitcoin, stating that unlike orange juice, which has specific supply/demand fundamentals, or stocks that can be evaluated by a multitude of formulas on earnings, assets, etc., Bitcoin "is pegged to nothing."

"There is no math with Bitcoin. People have tried to make the argument that there is a limited amount of Bitcoin that can be mined, therefore some threshold at which people should pay for Bitcoin because of limited supply, but the problem is, who cares? There's a limited supply of sand in a sandbox, but you wouldn't pay $12,000 for each grain," Wallman explained.

He says that even if there is a theoretical value on Bitcoin, "the problem is there is no limit, theoretical or otherwise, on how many cryptocurrencies there can be….and therefore there is no inherent value of Bitcoin at all." (See "1,500 and Counting.")

Rules & Regulations

Along with all the excitement surrounding Bitcoin — and there is plenty — come the cautions, mainly from the regulators (examined further in "Be Careful Out There"). The Commodity Futures Trading Commission, which in late 2017 approved futures on these products for three exchanges it regulates, sees Bitcoin as a commodity and regulates it as such. The SEC, which is led by Chairman Jay Clayton — who has been vocal about precautions investors should take and adamant about taking actions against bad actors — recently issued a report stating that the regulator sees tokens as securities and therefore does and will regulate them. The IRS has ruled that cryptocurrencies are property, and the U.S. Treasury sees these products as currencies and money.

Norm Champ, former SEC director and now with Kirkland & Ellis, recently told CNBC that the regulatory view is "as clear as mud." He recommends regulators get together with practitioners to hammer out a single set of rules.

The issue of defining cryptocurrencies has even stumped Wall Street. "It doesn't quite fall in a [specific] bucket," said Ihor Dusaniwsky, managing director, prediction analytics, of S3 Partners, a New York-based financial analytics firm.

"I know of several firms that are sitting down and trying to figure out if this is a brand-new asset class, and [if so], creating an asset class they could refer clients to," Dusaniwsky explained. That's the first step in normalizing it as an investment vehicle."

This may be easier said than done, especially with regulation. Wallman says the regulatory issue really is twofold. One aspect of it is that "all regulators have seen some value in blockchain technology," he points out. The other "pure speculation" side is a problem that regulators and even countries have clamped down on, according to the former SEC commissioner.

"Some countries have already outlawed [Bitcoin and other cryptocurrencies] because they see it as a means to engage in the kinds of dark web activities or a way to evade currency transfer restrictions or a way to get around moving money out of country," he said. "For those reasons, some countries have already shuttered use of cryptocurrencies."

Time to Play?

With this much controversy swirling around Bitcoin and cryptocurrencies, should advisors pursue it as an investment for clients? Many don't have this option as several broker-dealers aren't allowing advisors to utilize the product at this point, such as Raymond James.

Merrill Lynch, for instance, stopped purchases of Greyscale Bitcoin Investment Trust on Dec. 8, stating in a memo, "The decision to close GBTC to new purchases is driven by concerns pertaining to suitability and eligibility standards of this product." Morgan Stanley, Wells Fargo and UBS also have banned sales of the Bitcoin-related products.

In addition, many wealth management firms question its usage. Joe Duran, CEO of United Capital, in Newport Beach, California, sees Bitcoin and cryptocurrencies as a currency, but one not backed by "the full faith and credit of any country, so cryptocurrencies don't have the backstop most traditional currencies have and will therefore be volatile."

Duran, though, says he is "bullish on cryptocurrencies as a product but not as an investor or asset class just yet." Still, he doesn't believe Bitcoin should be in most client portfolios now, as "no one knows the cross correlations or which currency will dominate just yet. And, few understand the liquidity constraints associated with cryptocurrencies."

There are other risks as well, says Omaha, Nebraska-based Carson Group Chief Investment Officer Scott Kubie. "Speculating on Bitcoin is an enormously risky exercise," he said in an interview. "Regulatory and taxation risk are extremely high. Competitors abound and the high-power usage attributed to Bitcoin makes it vulnerable. That's not even mentioning the additional risks like tax enforcement and market manipulation."

Wallman doesn't see any value in it for advisors at this point, mainly because more people are "wondering if there is no underlying foundational value for it, is there a reason for it to be? Or if in fact most people are using it [in ways] that are not necessarily for purposes [an advisor] would like [to be associated with], or for pure speculation." For a hedge fund or family office to put money into the product is one thing, "but if you are an advisor acting as a fiduciary" it's probably not the place for them to put their client money, he added.

Other Games to Play

Thus far, Bitcoin isn't for the faint-hearted, however, there are options beyond the cash marketplace. In early December, CBOE launched a futures contract (XBT) based on the Gemini Exchange, a group launched by the Winklevoss brothers Cameron and Tyler (of Facebook fame). A week later, the CME Group launched its Bitcoin futures (BTC) contract based on an index of multiple Bitcoin exchanges and tethered to the Bitcoin Reference Rate.

The CME considers the product an index, not a currency. The CBOE's XBT's unit/multiplier is one Bitcoin, one-fifth the size of CME's contract. Both contracts are cash settled. Although these contracts have been launched, the CFTC, which regulates futures markets, announced it is holding more meetings in January with industry participants to discuss procedural and operational controls for cryptocurrencies.

Despite all the ballyhoo associated with the launch of these Bitcoin products — in fact, the Bitcoin price almost doubled in price from the time of the contract announcements to the time the products were launched in December — the interest has been tenuous to date, even allowing for the holidays. For example, from Dec. 10, 2017, through Jan. 16, 2018, average daily volume at CBOE was just over 4,500 contracts. For the CME, which launched Dec. 18 (and is five times the size of the XBT), the average daily volume through Jan. 16 was slightly above 1,100 contracts.

Several Bitcoin ETF submissions linked to futures products and set to list on CBOE and other exchanges were withdrawn in January due to SEC concerns of illiquidity in the underlying products. One product that still showed signs of life as of press time is Evolve Bitcoin ETF, according to ETFTrends.com; the fund is based in Canada but did not have regulatory approval as of Jan. 16.

If Bitcoin ETFs ever are approved, they would have advantages over the futures and GBTC products, according to Dusaniwsky: "In general, for a person looking for pure Bitcoin exposure, it's an easier way to get it to trade than opening a physical bitcoin wallet or opening up a true futures trading account."

Furthermore, the ETFs "could trade in their brokers' accounts. It's just operationally easier to do, … more readily available to them, and easier to understand in trading an ETF," he said.

Beyond these products are Bitcoin funds investing in actual cryptocurrencies, such as GBTC or through Ark Investment Management. Several other private funds are available that invest in initial coin offerings and other aspects of cryptocurrencies.

Whatever the reticence of Bitcoin investment, the reaction is opposite with its underlying technology, blockchain, which is described as a distributed ledger with open architecture.

"[Blockchain] is the next big thing for settlements," says Dusaniwsky. "It's an open ledger that allows people to see all transactions, and it could theoretically speed up transactions. It probably is the next big thing for transactional efficiency. In that way, [Bitcoin] is sitting on a process that is really cutting edge."

United Capital's Duran is equally as enthusiastic. "Blockchain will be one of the single most important developments in the history of money. It will eventually allow us to receive and invest money with complete transparency and give consumers more power than ever. It will streamline business and make most traditional software obsolete," he says.

With this distributed ledger technology, there wouldn't need to be a central registrar or recorder, Wallman says. "Everything in a filing cabinet, let's say the DMV, housing mortgages…that all rely on somebody or something to keep track of or maintain them, blockchain technology theoretically can replace any and all that. So blockchain is powerful, and one [of its] application[s] is in the context of currency."

He adds that blockchain would be the best investment route, akin to advisors investing in biotechnology, AI or driverless car companies. Of course, "We don't know what small or technology companies will succeed, but we think placing investment dollars behind [this technology] makes sense." He cautions though, "One needs to remember that it's speculative like those other [emerging market] areas."

Venture capital fund, Blockchain Capital, launched in 2013, is one example of a fund that invests in companies that utilize the blockchain technology. One of its investments is in LedgerX, which was early in getting CFTC approval to be a swaps execution facility and derivatives clearing organization. Another firm, TMT Investments, also launched with a focus to invest in blockchain-based firms.

Overstock.com also has launched an ICO through its subsidiary tZERO, which has already raised more than $100 million. Companies like Google or Japan's SBI also are big investors in blockchain technology. (In fact, Bitcoin is a legal currency in Japan).

Mixed Bag?

Despite its promising technology, blockchain can't handle the type of transaction speed or scale currently needed to deal with, for example, credit cards, Wallman points out. "Blockchain at the moment is relatively slow in what we normally think of as high volumes of transactions, so it doesn't have, for the moment, the capability to replace your credit card, and just become something that can be used in any transaction. It simply doesn't scale enough right now," he says, adding that if it does get to that point, it certainly could put pressure on credit and debit card companies.

Though caution should be used, the excitement around these new products and the related technologies isn't just hype, experts say, and eventually they may help the end investor. Carson Group's Kubie, although bearish on Bitcoin in the short term, is optimistic about blockchain in the long term, and he sees many future advances for advisors tied to blockchain technology as it relates to their business.

"Think about the time it takes to move money out of a 401(k) and get it invested, or costs mutual funds pay for fund administration," he explained. "These and many other frictions could be removed to the benefit of financial participants."

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