The U.S. Department of Labor recently (March 10) issued a release on the investment of 401(k) plans in cryptocurrencies. It is a sign of how new the subject still seems to much of officialdom that, in the headline of the release, there are quotation marks around the word “cryptocurrencies.”
The Labor Department is offering a sternly worded warning to fiduciaries under ERISA that they must act “in the financial interests of plan participants and adhere to an exacting standard of professional care.” That is of course true, and the other reminders in the document are well-taken. Certainly, a fiduciary willing to put plan participants’ money into cryptos are well-advised to watch their step and document their decision making process.
The Labor Department’s warning, coming immediately after an executive order about cryptocurrencies and related technologies from the White House, should perhaps trigger us all to look at this space: where is it in its development? Is this 1999 again, and are the investors in cryptos in the position of investors in the fashionable dotcom companies that were riding high until March of the following year? Or is this a market that is about to be mainstreamed, so that the quotation marks will fade away from references to cryptocurrencies as investments.
What follows suggests one plausible answer to that question.
The Crypto Sorting Begins
Consider this hypothesis; the various components of this complicated asset class are headed in very different directions. The remaining three quarters of 2022, and likely all of 2023 as well, will be a time neither of a simple boom nor of a simple bust, but of a sorting out, among the 17 thousand coins now extant.
The cryptos on the top tier are very likely here to stay. This tier may consist of as few as three coins: Bitcoin itself, Litecoin, and Ether. The coming months will see them adopted by major institutions and continuing to find themselves mainstreamed into hedge funds, sovereign wealth funds, and over time other institutions. With their acceptance will come high value and lower volatility.
Beneath that is a tier of cryptos that are boutique or, less flatteringly, niche. They will remain boutique, though the nature of their niches may well change. Dash, Cardano, Ripple, and USD Coin are all examples. They serve no pressing function for broad demographics that is not better served by the top tier, but they will likely remain in play.
Beneath that there is a third tier that consists of wild creatures that will likely be weeded out by the ruthless workings of survival of the fittest in the market jungle. One might count Dogecoin, Steem, and Golem among the likely victims of obsolescence, like the victims of the March 2000 bursting of the dotcom bubble, going the way of those ‘90s champions of the new economy, Netscape and GeoCities.
Top Tier Cryptos
Bitcoin is of course the matriarch of the field, and a household word. It has grown to maturity in a world where 1.7 billion people have no bank account. Many people live in countries with extremely volatile currencies. Bitcoin, which can be accessed through the internet and without a bank account, is becoming a taken-for-granted bearer of value in that international context.
More importantly, perhaps, it has just (on March 14) survived an attempt to ban its mining nodes, computer operations that stand behind the whole proof-of-work mining mechanism, in Europe.
Thirty-two members of the European Parliament voted against, to only 24 voting in favor, of such a plan (there were six abstentions). This was in the face, first, of a strong political “green” constituency that is concerned that the mining creates excessive carbon emissions and, second, of a geopolitical climate in which the pressure that economic sanctions can bring to bear against the government of Russia is a pressing issue, and the fear that Bitcoin in particular is a way of circumventing such sanctions is a prominent component of that broader issue. In the face of even such storms, the establishment’s acceptance of Bitcoin remains intact.
Our second top tier coin is Litecoin. Litecoin (LTC) was an early Bitcoin (BTC) progeny. LTC can be traced back to 2011. Its differences from BTC? A higher maximum number of coins, a different hashing algorithm, and a decreased block generation time. As a deliberate consequence of these differences, LTC is much less expensive than BTC. [As of this writing, BTC is worth roughly $40,500, while LTC is at $107. This means 1 LTC equals 0.00265 BTC.]
Litecoin has outlasted most of its peers among the early Bitcoin progeny. It is traded on almost every crypto exchange, and it is accepted by tens of thousands of merchants.
Ether (ETH) is the native currency of the Ethereum blockchain. It was first described, by Vitalik Buterin, in a white paper in December 2013, and announced at the North American Bitcoin Conference in Miami, in January 2014. Both Ethereum and Ether have the names they do because 19th century physicists believed that an invisible medium they called the “ether” permeated the whole universe. Lightwaves were understood as undulations within this ether. The analogy struck Buterin as promising: his “ethereum/ether” would become the unseen but pervasive medium for smart contracts and in time for real-world assets like real estate titles and corporate stocks.
It has kept much of that promise. It has become the preferred platform for two great growth areas, both NFTs and DeFi.
Nearly a year ago now, JP Morgan Chase, UBS, and MasterCard became major investors in a software development firm named ConsenSys, precisely with the goal of developing Ethereum-related infrastructure.
Middle Tier Cryptos
It is possible that, by limiting the top tier of today’s cryptos to the three I have, I have grievously underestimated one or more of the other contenders. But in general, this schema seems right.
It is natural to consider the Cardano blockchain, and its native currency ADA, as first among the middle tier, because Cardano’s origin was so closely bound up with that of Ethereum. Cardano’s founder, Charles Hoskinson, was closely associated with Buterin in the creation of Ether, and for a time was the chief executive at Ethereum.
After a disagreement between the two men, Hoskinson teamed up with another Ethereum veteran, Jeremy Wood, and they created IOHK (Input Output Hong Kong), an engineering and research company. Cardano became IOHK’s chief project, and ADA is the host currency of Cardano.
Cardano has received praise for certain features. For example, the Cardano blockchain is well adapted to the settlement of block trades. Admirers of this system have contended for example that Cardano could have avoided the now-infamous restrictions that the Robinhood app placed on GameStop (NYSE:GME) in early 2021.
But the positives of Cardano, as an example of the blockchain technology, do not necessarily translate to positives for ADA as a coin, beyond its limited use as a native currency for that blockchain. They certainly don’t put it on our first tier. ADA has of late been trapped in a narrow valuation range between $0.75 and $0.90.
One must say much the same of Ripple. Ripple is a currency exchange and remittance network, with blockchain features. Its native coin is XRP, and its value in U.S. dollars at this writing is not far from ADA’s.
In December 2020, the U.S. Securities and Exchange Commission sued Ripple Labs and two of its associates alleging that they had traded XRP as a security without registering it as such. Is this lawsuit an attack upon all of the cryptocurrencies as an asset class? Apparently not: The SEC says that Ethereum operates in a decentralized manner, so that Ether is not a security. RippleLabs claims that it operates in all pertinent respects in the same way that Ethereum does.
There has been no resolution or settlement: but on March 11, 2022, the judge in the case denied the SEC’s motion to strike Ripple Lab’s “fair notice” defense. This means that the defendant is free to press the argument that it had not been given a fair notice that it was in violation of any law or regulation. That is not decisive: it merely keeps a specific defense in play. But it is an indication that things are not as of now going the government’s way.
Leaving the litigation aside for now, though: what is distinctive about XRP’s design is that it is not intended to disintermediate banks (as the first-tier coins mentioned above all are) but to assist banks — it aims to help their payment processing. It has had years to make this case to them, but most banks continue to say “thanks but no thanks.” XRP will never be a big player unless that changes.
As Vince Martin, of InvestorPlace, put it years ago, XRP is the crypto of a financial evolution (and one in which traditional banks retain their central importance), whereas most of the other cryptos are betting on a financial revolution. Frankly in this context revolution seems the better bet.
Bottom Tier Cryptos
Now we come to the most likely victims of obsolescence.
In the case of DOGE, the “joke” has already worn quite thin. DOGE began life in 2013 because designers Billy Markus and Jackson Palmer found the proliferation of altcoins amusing and wanted to add one of their own to the number. They gave it a name that sounds like a mispronunciation of “dog” and gave it as a logo the face of a Shibu Inu.
The following year, the Jamaican bobsled team qualified for the Olympics but could not afford to spend the money necessary to participate. On Reddit it was Palmer who raised Dogecoin donations for the Jamaicans worth $25,000, and they got to Sochi, in Russia, to compete.
Both the cuteness of the Shibu Inu and the bobsled-created warm-and-fuzzy feelings may by now have faded. They may have left behind a realization that Dogecoin notably lacks one of the key elements that allowed Bitcoin to make a splash in 2008: there is no limit to how many of them may be created. Part of the original appeal of the whole asset class was the analogy to old-fashioned gold-backed money. The amount of gold available is limited and, though miners may discover more tomorrow, the amount inside the planet is surely finite as well. Likewise with Bitcoin, or many other members of this class: the miners may discover more, by providing “proof of work” or through whatever substitute mechanism is devised. But the amount that can be brought into circulation is finite.
With Dogecoin: no. And this oddity will limit its appeal. Even a bullish writer like Analyst Insight observes that in the months to come “its growth will significantly depend on whether the influential figures will continue to support the meme coin.” Yet that is what is always true about “greater fool” investments. Somebody always ends up being the greatest fool at the end of the chain.
Our final example is GLM, the native currency of Golem. Golem is a blockchain platform named after a dangerous anthropomorphic being in Jewish folklore. The point of the platform is to allow users to draw upon the computing power of others and to share their own. When it was first created, the related coin, used for paying for the computing power of those others, was called GNT and existed on a dedicated blockchain.
Now, though, the token has been renamed GLM, and it exists on an Ethereum blockchain, ERC-20.
Golem, and GLM, are useful for institutions that have computers that stand idle, and for those who find it more convenient to rent computing power than to buy a new computer. But those two parties have never had a lot of difficulty finding each other: their ability to do so is precisely what created “the cloud.” Even as a niche operation, then, this golem may not have long to live or much disruption to create.
Crypto Hedge Fund Use
On the hypothesis that a sorting-out is underway, roughly along the lines outlined above: what can we say about the hedge funds that involve themselves in the crypto space?
We can, I think, divide these hedge funds into three categories of their own (although these are not tiers! — the division is horizontal, not vertical). There are hedge funds that are specifically about cryptocurrencies: a thesis about crypto is what they offer as their alpha-creating ‘secret sauce.’ There are also hedge funds for whom cryptos serve only as one part of a broader portfolio: as a hedge, perhaps, against finding oneself on the wrong side of a disruptive revolution in finance if the cryptos ‘win.’ Thirdly, there are hedge funds that are looking for, and finding, ways to invest in the blockchain technology, rather than in the coins.
The Secret Sauce
The secret sauce category now includes a division within the Brevan Howard family, BH Digital. The $16 billion UK based hedge fund manager Brevan Howard Asset Management put Colleen Sullivan in charge.
Ms Sullivan co-founded CMT Digital, in Chicago, in 2017 and served as its CEO until August 2021. She is interested both in crypto asset trading and in investments in the underlying blockchain technology.
Her new team, BH Digital, has more than $250 million in assets under management and has 12 portfolio managers. It launched its inaugural vehicle, the first Brevan Howard cryptocurrency hedge fund, in January. That fund is making directional bets on the cryptos while also looking for opportunities for arbitrage. It began trading in January with internal capital, but has plans to open itself up to external capital in the second quarter.
A fund family like Brevan Howard is in a position to cross-sell. And that is what is going on, according to media reports: calls are going out to the large allocators that already have a Brevan Howard product, getting a sense of the extent of interest in cryptos.
One of the co-founders of Brevan Howard, Alan Howard, has also invested personally in crypto, blockchains, and digital tokens.
The Eurekahedge Crypto-Currency Hedge Fund Index, though, indicates that globally the AUM of fund managers focusing on cryptocurrencies declined 19.31% in January. These are their deepest losses since November 2018. The index’ figures for February are not available at this writing.
Cryptos as a Hedge
There is a feeling through much of today’s investment world that the U.S. dollar, long regarded as the world’s reserve currency, its numeraire, is at or very near the end of its time as such. This end will have tremendous consequences, which is why, above, we referred to “revolution” as a safer bet than “evolution,” and it is why the top tier coins attract the whales that they do.
Cryptos are, from one perspective, a hedge against this revolution. This could and likely will draw to the crypto space hedge funds that are uninterested in attempting arbitrage, and even less interested in making directional bets. They are interested in protecting themselves and their investors from disruptions.
Blockchain as a Technology
It is bitcoin as a technology, more perhaps than the issues raised by the crypto-assets themselves, that underlies much of the recent (March 9, 2022) executive order from President Biden.
Early on, the order says for example, “Digital asset issuers, exchanges and trading platforms, and intermediaries whose activities may increase risks to financial stability, should, as appropriate, be subject to and in compliance with regulatory and supervisory standards that govern traditional market infrastructures and financial firms, in line with the general principle of ‘same business, same risks, same rules.’ The new and unique uses and functions that digital assets can facilitate may create additional economic and financial risks requiring an evolution to a regulatory approach that adequately addresses those risks.”
As noted above in the discussion of Golem, cloud computing as executed through blockchains is the same business, with much the same risk, as is the cloud computing already executed in a more traditional fashion. So, the general principle the President cited, “same business, same risks, same rules,” likely applies there.
Likewise, among investors. Blockchain is a new technology but must be approached with the same risks and opportunities in mind with which one approaches other new technologies: from an alleged blood-testing breakthrough to quantum computing or fusion energy.
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