Cryptocurrencies Can Become a Mainstream Asset Class, but Hurdles Remain

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After Bitcoin rose 2,090% YoY to a peak of $17,060.55 on December 11, 2017 and subsequently fell by 80% to about $3,400 at present, cryptocurrencies are mainly attracting attention for their volatility. Investors, however, might be overlooking that cryptocurrencies are still a relatively new class of assets. While high yield bonds now account for around USD1.9 trillion or roughly twenty percent of USD9.9 trillion in outstanding corporate bonds, these bonds did not become standard investment assets in portfolios for several decades until the 1970s and 1980s. Similarly, once a few hurdles are overcome, the top twenty cryptocurrencies, which currently have a total market capitalization of close to USD95 billion, could become commonplace assets for investors’ portfolios in coming years. Following are some of the hurdles that cryptocurrencies will need to overcome:

Regulatory framework. The most obvious hurdle for cryptocurrencies to overcome are regulatory. It is not always clear when cryptocurrencies are subject to the rules of the Securities and Exchange Commission in the United States, or not. As the SEC recently created the new positions of Associate Director of the Division of Corporation Finance for Valerie Szczepanik and Senior Advisor for Digital Assets and Innovation for Bill Hinman, the SEC may soon provide some clarity to this. Though other countries are also developing rules for cryptocurrencies, they will most likely fall in line with ones developed in the US, which has the deepest capital markets and most extensive regulations.

Price transparency. Trading in cryptocurrencies is not yet widespread enough for prices on such assets to be efficiently established in transparent markets. To the contrary, prices can be quite different for the same assets on different exchanges, and such arbitrage opportunities can remain available for lengthy periods of time.

Security concerns. With estimates as high as USD1.1 billion for thefts of cryptocurrencies during the first half of 2018, security will need to be significantly improved. While thefts have been through “hot wallets”, or segregated accounts that store cryptocurrencies within exchanges for investors, “cold wallets” that store cryptocurrencies offline on investors’ personal devices are far from optimal. Personal devices can be stolen, lost, or subject to faulty hardware, which could result in losing cryptocurrency assets.

Insurance products. Along with better security, expanding the market for cryptocurrencies could benefit from insurance products that cover thefts or losses of cryptocurrencies.

Fund administration. While a few fund administrators, such as Northern Trust, Apex Fund Services, Trident Trust and Stonegate Fund Services, are providing administrative services for cryptocurrency funds, this appears to currently be for select funds only, rather than a full embrace of cryptocurrencies. Moreover, the fund administrators only cover a limited number of cryptocurrencies, such as Bitcoin and Ethereum in the case of Northern Trust. Once the fund administrators provide their services for a broader range of funds and cryptocurrencies, more investors will become comfortable trading them.

Increase awareness and education. For cryptocurrencies to become more mainstream, it is critical that investors become more knowledgeable about them. As media cannot be relied on to provide a clear framework for investing in cryptocurrencies, schools will need to play a role in educating their students about cryptocurrencies.

Uses for cryptocurrencies. While common shares represent equity interests, and bonds debt interest in companies, it is not yet clear what role cryptocurrencies will serve in the economy. Cryptocurrencies could serve as means of exchange for other goods, similar to traditional fiat money, or potentially as ownership interests in businesses. Until the use of cryptocurrencies is better defined, it will be difficult to fundamentally assess their value.

Convertibility. Cryptocurrencies will need to become more efficiently convertible into other cryptocurrencies, as well as into hard currencies, such as USD, for them to become more used. Efficiently converting cryptocurrencies means paying minimal spreads on trading them with arbitrage opportunities not being readily available.

Hedging instruments. At present, CME Group and CBOE have futures contracts available for Bitcoin, which allow investors to hedge investing in this cryptocurrency. Trading is available three months out from the present month, though traded volumes drop off considerably beyond one month. Since basis risk would be quite significant for using the Bitcoin futures to hedge other cryptocurrencies, hedging instruments for other cryptocurrencies will also need to be created.

New technologies and investment assets can take years to be adopted. It took decades for high yield bonds to become standard investments. With cryptocurrencies, it is important to keep in perspective that they are technology based investment assets that the world is still developing a framework for using. As the above hurdles are gradually overcome, cryptocurrencies could ultimately become a mainstream asset class for investors.

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HUT Consulting is transforming one business at a time. harumi@hutconsulting.com

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Harumi Urata-Thompson

Harumi Urata-Thompson

HUT Consulting is transforming one business at a time. harumi@hutconsulting.com

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