What makes a really smart Cryptocurrency Index Funds (CIF)

By Ksenia Beloglazova on The Capital

Ksenia Beloglazova
Nov 21, 2019 · 11 min read

Why the current CIFs do not work and how to fix it. Is it possible to mine some Microsoft shares?

Cryptocurrency Index Funds (CIF) appeared immediately after cryptocurrencies and cryptocurrency exchanges. The general idea sounds good: “If you want to invest in cryptocurrencies, you should minimize your risks. Index funds provide an opportunity to invest not in specific crypto assets, but in the cryptocurrency market as a whole, which should reduce the volatility of investments. ”

Before we dive into the detailed discussion about CIFs, let’s answer a couple of simple questions. Why do people invest in the cryptocurrency market? And who are these people investing in the cryptocurrency market?

In fact, there are many reasons for investing in crypto assets. For some investors, cryptocurrencies are the only way to preserve their savings, for the others it is the opportunity to invest small amounts in highly profitable assets. Someone is looking for a future star like Bitcoin , Ethereum or Binance coin that can bring thousands of percent of revenue. I can clearly identify several large groups of investors with different goals — citizens of developing countries, residents of developed countries, ICO investors and institutional investors . I wrote about them in detail in my article “Assets on the blockchain — creating new markets” and now I will not repeat it.

Anyway, currently, investments in crypto assets have a rather high risk level. So why do people, especially when we are talking about the residents of developed countries, like the US or the EU, are ready to tolerate such risk levels? The problem is that the current market offers limited investment opportunities. What are the options for investments?

The money can be deposited in the bank? But currently, the interests are extremely low. Moreover, fiat currencies constantly devaluate, and it’s not a secret that the USD purchasing power now and 20 years ago are completely different.

The investor can buy shares. But it is questionable, which investments are more risky today — in cryptocurrencies or in shares of companies. Besides, income from stocks is often taxed.

So what’s about Hedge Funds? Well, yes, this is a great option if you are willing to invest at least a million dollars. But what if you do not have millions?

What about a Real Estate investment? It is quite controversial — firstly, liquidity problems, and secondly, real estate investments need permanent maintenance if you intend to rent out your property and receive income from your investments.

Finally, it may be concluded that investing in crypto assets today is a great solution under the circumstances. Therefore, a number of Cryptocurrency Index Funds (CIF) appeared; and, it seems, all these funds should work as good as their counterparts on stock exchanges. But something went wrong. Often, investors suffer significant losses. Why does it happen?

To answer this question, I will start from the beginning, from the very beginning, as my personal experience says that not all players in the cryptocurrency market know what index funds are. This is amazing, isn’t it?

· A classic index fund is a type of investment or exchange-traded fund organized in such a way as to follow a predetermined set of stocks according to predetermined rules.

· The Fund buys this set of shares and issues its securities secured by the purchased shares, and, as a result, having a price equal to the price of this set of shares.

· According to a previously described algorithm, the fund periodically conducts a rebalance procedure, maintaining the structure of its stock portfolio within a certain framework. This procedure is necessary, as stocks change their value over time, and, accordingly, their share in the fund’s portfolio changes. As part of the rebalance, the fund sells some shares, buys some other shares, returning the portfolio structure to the specified parameters.

The benefits of index funds are well known:

· Low management costs (there is no need to pay for expensive managers who will manage the fund’s portfolio)

· Ease of management (portfolio composition and its rebalance rules are completely determined by the initial conditions)

· Low turnover (volumes of resale of securities), since customers invest for a long time, index funds themselves are passive investments, and investors receive an average of 87% of total profit (versus 47% for active funds).

· The mismanagement is impossible. For example, when the managers take on unreasonable risk, go beyond their powers, and jeopardize the well-being of investors.

It seems like we can replace the shares with crypto assets, add the word “cryptocurrency” to the name and launch our CIF. No, unfortunately, that’s not the case and I wouldn’t recommend doing it. And there are at least two reasons why: firstly, Token ≠ Share, secondly, Shares, unlike cryptocurrency, cannot be “mined”. Let’s elaborate on that.

Token ≠ Share

Most of the tokens, which are usually included in CIFs are cryptocurrencies. Also CIFs are comprised of stablecoins, some types of security tokens, and some utility tokens. I will take a look at all these types of tokens for the feasibility of including them in the index fund.

A monetary asset is built into any blockchain and needs no mandatory functionality outside the network. This asset existence is a necessary condition for the proper blockchain functioning, it guarantees its security and minimizes the necessity of trust in third parties.

This monetary asset, the basis of any blockchain, is essentially a cryptocurrency. Trust in this cryptocurrency directly depends on trust in its blockchain. Trust in the blockchain depends on multiple factors:

· whether the source code is open

· what are the rules of inflation

· whether there are constant payments in favor of developers

· Some other factors.

The growth potential and prospects of the cryptocurrency depend on the prospects and usefulness in the application of its parent blockchain. Given the fact that the cryptocurrency market and the blockchain technologies usage are at a very early stage, it can be expected that some blockchains (both existing ones and those that are just about to appear) have huge growth potential, which can also be projected on the corresponding cryptocurrencies. In general, cryptocurrencies of the most promising blockchains, from my point of view, can be considered as a basic asset for index funds.

Also, in some cases, it makes sense to include stablecoins in the underlying assets of the cryptocurrency fund. This is actually very reasonable when complex rebalance algorithms are utilized. For example, before the expected cryptocurrency market fall, the assets of the fund are transferred to stablecoin (in fact, to the fiat cache). Subsequently, before the expected cryptocurrency market growth, the funds are returned to cryptocurrencies again.

It brings no benefits to include the bond tokens in the underlying assets of fund. There are several reasons for that. Firstly, their potential profitability is very limited. It is definitely too low for rather high-risk investments in the cryptocurrency market. Secondly, the liquidity in most cases is also in question. Indeed, most bond tokens are not traded on cryptocurrency exchanges. The issuers of these bond tokens usually prefer not to list them on cryptocurrency exchanges, since listing fees can significantly reduce all the benefits that tokenization provides for them. And finally, the most important facet is that investment in token bonds is not an investment in the cryptocurrency market, but rather an investment in the company that issues these tokens.

The same applies to tokens secured by any goods — gold, diamonds, hemp, any mineral resources. By investing in these tokens, you are not investing in the cryptocurrency market, but rather in the underlying asset. This reason alone is enough to not include such tokens in the underlying assets of cryptocurrency funds. Indeed, the purpose of investments in CIF is investment in the cryptocurrency market as a whole.

Share tokens look a little different. They, just like the shares of any company, can have great growth potential, but the risk associated with them cannot be estimated by an investor who does not profess to be an expert in the company’s industry. Investing in stock tokens is, on the one hand, investing in a specific company, and not in the cryptocurrency market. But, on the other hand, it is companies that form the market. Therefore, I think it is reasonable to include the tokens of companies that operate in the cryptocurrency market, in the index fund portfolio. However, I mean only shares of stable companies, and not startups. Currently, I cannot name even a single company whose shares would be tokenized, and the company itself would be at a fairly mature stage.

Eventually, let’s talk about the most interesting topic — about utility tokens. This, of course, is an absolutely enchanting invention, which, through ICO, has pumped a huge amount of money from unwary and not very deep into subject investors. Indeed, in most cases, what is utility token (please do not confuse it with cryptocurrency, which is a monetary asset of the blockchain)? It is an internal product token, which can be used to pay for services provided to one degree or another by this future product. Let’s leave aside the issues of product readiness, the fairness of team rewards before the product starts to make a profit, and all the rest. Suppose everything is OK, the product is released. You can pay with a token. What does a regular utility token look like in this case? It looks very much like frequent flyer miles. Indeed, you can buy a ticket for your miles. Alternatively, you can pay with your miles for some goods from the airline’s catalog. You can even pay with your miles for services and goods in organizations that are friendly to the airline. This is a utility token, isn’t it? But nobody trades with airline miles on stock exchanges and nobody includes them in index funds. In this case, why it happens with utility tokens? Indeed, investment in utility tokens is a double risk: risk in a risky market, even by the standards of this risky market. What made the ICO investors to buy them in the hope of price hike? Who are the people who subsequently bought them on crypto exchanges and invested very serious money in these actives? I am puzzled.

However, the utility tokens shouldn’t be dismissed apriori, because there is one exception that brings utility tokens into a completely different category. This happens when the utility token becomes the internal crypto currency of a large ecosystem, for example, Binance Coin. Once it was an ordinary utility token, but Binance has grown and today Binance has turned into a large ecosystem, which is likely to grow over many years. Currently, Binance Coin is not just a utility token. It is an internal Binance ecosystem cryptocurrency. Binance Coin’s capitalization is already measured in billions of dollars, and it will grow with Binance. All this can lead to a very significant price increase for the Binance Coin token (very liquid token). So, large ecosystems cryptocurrencies definitely can be among the underlying assets of CIFs. And I hope that we will still see Libra and Gram among them.

The interim results:

Token ≠ Stock, therefore, I would take only the cryptocurrencies, reliable stablecoins and internal cryptocurrencies of large ecosystems as the underlying assets of the cryptocurrency fund. In the future, it will be possible to add tokenized shares of large companies from the cryptocurrency market. Let’s compare this list with what is included in the CIFs today and we will be very surprised indeed.

It is impossible to “mine” stock shares, unlike cryptocurrencies

Another very important difference between cryptocurrencies and shares is that the issue of shares is entirely in the hands of the issuing company. No one except Apple can issue Apple shares. With cryptocurrencies, the situation is quite different. There are a large number of crypto assets that can be mined (issued) by virtually anyone.

The usual mining income model involves the following sequence of actions: (1) investments are made in fiat currency (for example, in US dollars) — (2) cryptocurrency mining — (3) sale of mined cryptocurrency for fiat currency — (4) profit or loss fixing, depending on the rate of the mined cryptocurrency to the fiat currency at the time of sale.

This model contains two key risks:

· The risk of the mining complexity increase is significant for new cryptocurrencies, but insignificant or predictable for the most established cryptocurrencies on the market. We are almost always able to accurately calculate how much cryptocurrency can be mined over a certain period of time.

· The risk of cryptocurrency price fluctuations is significant for all cryptocurrencies. We never know at what price we are going to sell the mined cryptocurrency.

The main risk of mining is a cryptocurrency price fluctuation. The Prepaid Mining Model (PMM) offers a mechanism for complete elimination of this risk! Now watch closely:

1. Suppose we have a cryptocurrency fund that comprises cryptocurrencies with available mining (e.g., Ethereum )

2. We allocate ETH (for example, 10% of all ETH available from the fund underlying assets), for the process, which I call “prepaid mining”.

3. We know exactly what is the current price in USD of the pre-paid ETH mining and how much mining capacity (for example, using cloud mining) we can currently purchase with this money.

4. We know (this is not difficult to calculate) how much ETH we will receive as a result of investing the received amount of US dollars (p. 3) at the end of the mining cycle.

5. If the total amount of ETH exceeds the allocated amount of ETH (p. 2), the entire operation of the prepaid Mining makes sense. The resulting profit goes to the underlying assets of the fund, increasing the funds of all cryptocurrency fund token holders.

How is this possible?

When mining, everybody lives in the Fiat — Cryptocurrency — Fiat investment cycle, in which the phase of exchanging cryptocurrency for fiat currency is in the future, which brings inevitable exchange rate risks in the future.

We have moved on to the investment cycle Cryptocurrency — Fiat — Cryptocurrency, in which the phase of exchanging Cryptocurrency for Fiat is in the present. Prepaid mining neutralizes the exchange rate risks in the future, neutralizes the risk of price changes.

That means that unlike a conventional index fund, a CIF, under a certain composition of basic assets and under certain conditions, is able to independently generate its underlying assets without new investments In such a way, the underlying assets can be continuously increased.

Who needs CIFs tokens?

If the fund is built correctly, then the smart contract allows any of the fund token holders to exchange their tokens for the cryptocurrency of the blockchain at any time. And I am talking about the blockchain on which this fund is created. Currently the most common assets are built on Ethereum. So, if the investor returns the fund token, he will receive the equivalent ETH value on his personal wallet.

I see three main groups of private investors in crypto assets:

· Citizens of developing countries seeking to avoid their savings depreciation

· Citizens of developed countries seeking to invest with a high level of reliability

· ICO investors

CIF is a unique financial instrument. Indeed, CIFs are suitable for all three major groups of private investors.

Customers from developing countries, protecting their savings, invest only in absolutely liquid and reliable crypto assets, which comprise the main cryptocurrencies, stablecoins and correctly made CIFs. The funds, in this case, is a quick liquid investment in the cryptocurrency market as a whole — the constant rebalance procedure makes these funds potentially more reliable than any particular cryptocurrency included in it.

Clients from developed countries invest both in tokenized assets and in the cryptocurrency market as a whole. The latter include CIFs.

ICO investors keep part of their assets in cryptocurrencies. For them, a high liquidity CIF is also a smart solution.

When choosing a fund, I recommend looking at everything: the composition of underlying assets, the presence of a smart contract that allows you to get out at any time, the exit cost, the annual maintenance cost, the audit of underlying assets and the use of the fund’s assets, etc.

Index funds in traditional financial markets are, in my opinion, one of the best human inventions. Cryptocurrency funds will also take their place of honor in the cryptocurrency market. They just need to be done correctly.

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