facebook twitter instagram linkedin google youtube vimeo tumblr yelp rss email podcast phone blog search brokercheck brokercheck Play Pause
Introduction to Cryptoassets Thumbnail

Introduction to Cryptoassets

By Simon Tryzna, Chief Investment Officer

One of the bigger investing storylines of 2021 has been the continual appreciation of Bitcoin and other Cryptoassets. Since the beginning of the year, Bitcoin is up over 70%. Over the last six months, it's up just under 330%. With fears over global Central Banks continually printing fiat money and inflationary concerns, investors have been allocating to Bitcoin and other cryptocurrencies to hedge against inflationary risks and use these assets as a way to store value. What originally started with a select few computer scientists buying coins has now turned into a significant asset class. Today, some of the most prominent institutions worldwide are starting to allocate to the asset class. These include financial institutions, large university endowments, and big multinational corporations like Tesla. Because of those listed reasons, I wanted to put together a quick intro guide to the asset class.

To best understand Cryptoassets, the easiest place to start is with Bitcoin itself. Bitcoin, blockchain, and cryptocurrencies began in 2008 when a pseudonymous white paper, written by "Satoshi Nakamoto," was posted on the internet. Nakamoto envisioned a new way to transfer value over the internet and devised the technology to do so. Since then, the crypto asset market has gone through a complete transformation, innovation, volatility, euphoria, and moments of despair. Bitcoin was the first crypto asset and was the one that allowed other crypto assets to emerge.

To start to understand Bitcoin and its popularity, one first should understand the problem it's attempting to solve. For example, if I wanted to invest in a stock, I'd need to move money from my checking account at Bank A to my brokerage account at Firm B. At Firm B, I would submit the request to transfer $100. Firm B has a database of all its account holders and knows everything about them. Bank A has a similar database for all of its account holders. However, Firm B can't directly see the database of Bank A, so to move my $100 over, they need to ask permission to see the database, verify that I have the $100 I want to transfer, and then process the transaction where they move the $100 from Bank A to Firm B. This process takes 2-3 days, but sometimes it could be a lot longer. If these types of asset transfers are done internationally, the time delay can be even more impactful.

The solution by Nakamoto was to create a decentralized database that is accessible to anyone - where anyone in the world can view balances and submit transactions - and have that transaction ledger not be controlled by any single entity. In my example, Bank A and Firm B would share a database alongside User C and Company D. This is called a "distributed ledger." The idea is that if everyone is plugged into this database, there is no need for the delay. My brokerage account will quickly tell that I have the assets I want to move in my checking account and be able to finalize the transfer in a few minutes, not a few days.

While conceptually, this idea is relatively simple to visualize, this process is challenging to execute in reality. That is truly where the benefit of this technological innovation comes into play. While the databases are wide open, there still needs to be a set way to conduct and validate transactions – otherwise, the system would be useless. To help facilitate and secure transactions, there exists a group of "bitcoin miners." Miners are computers scattered around the world whose job is to aggregate groups of valid new transactions and propose them for settlement. They aggregate these transactions in "blocks," which is where the term "blockchain" comes from.

Because the work of validating transactions and ensuring that only valid transactions settle is trivially easy for network participants and attempting to settle transactions is costly, there is minimal incentive to try to defraud the system. This "consensus algorithm" is the heart of a blockchain network and arguably the most ingenious part of Satoshi Nakamoto's breakthrough.

By having a global system verify someone's ownership of an asset (as opposed to just a bank or a brokerage firm), asset holders can quickly and efficiently transact wherever they are in the world. This blockchain technology is now being studied (and hopefully applied) to non-financial areas, such as medicine. Imagine the possibility of having all of your medical history on one token and not needing to keep paper copies of all your doctor visits and surgeries. You could take it wherever you are without any hassle. This blockchain technology originally made Bitcoin a possible alternative to currency, and from its creation in 2008 to the early part of the 2010s, coin holders viewed it as such. However, over the last few years, it has become more adapted as "digital gold."

The idea behind gold is quite simple. It's a scarce resource that our ancestors used as a way to store value. There were many regional banks in each city-state and country with their own banknotes; gold was the only globally accepted piece of value. Aside from jewelry, it had minimal usage – it is just a shiny object that isn't readily available. It was, and is, worth what others are/were willing to trade for it. In the case of Bitcoin, the underlying software has guaranteed that there will never be more than 21 million Bitcoins created. The finite amount gives Bitcoin holders the assurance that no other coins will be made (unlike currency being printed), and thus, it will protect against currency inflation.

In addition to Bitcoin, there are several other crypto coins out there, most notably Ethereum. The most significant difference amongst coins is that their underlying blockchain is optimized for different uses. While Bitcoin is focused on basic transactions, Ethereum can be programmed more complex transactions. Users have replicated everything from collateralized loans to IPO-style fundraising efforts using Ethereum-based "smart contacts." The problem, and why many "alternative coins" are viewed negatively, is that Ethereum (and the other coins) are more complex; in crypto/blockchain space, the simpler the technology is, the harder it is to hack. Bitcoin's simplicity makes it a more attractive digital coin. From my conversations with those active in the crypto asset market, there is a feeling that multiple coins will become "winners," with each having different functionality. The best way to think of this is by looking at how we utilize social media – we (generally) use Facebook for personal use and LinkedIn for professional. Another example is software – Android is built to power cellphones while Windows powers computers. Different coins have different purposes.

The issue from the portfolio management side is how to best view and value this emerging asset class. It has high volatility levels, high return potential, and minimal correlation with other asset classes. If we compare this asset to gold, then it has an incredible return potential. As of 2.24.21, the market cap of gold was approximately $11.512 Trillion. The market cap of Bitcoin was $908 Billion – just under 8% of the value of gold. Currently, the price of Bitcoin is driven by market adoption, network security, liquidity, inflation risks, supply changes, regulatory developments, technological developments, and other factors. The more investors allocate to it and put faith into the asset class, the higher the price will go (due to finite supply). The value of Bitcoin comes from its network - the more people who are using it, the higher the value. The way to picture it is in the case of Facebook. Facebook's value comes from its user base - if only 100 people were using it, it really wouldn't be worth anything. Bitcoin, and crypto-assets in general, function the same way, which is why the recent rapid adoption of it is impactful, and it's only going to increase. This passage is from Walden Bridge Capital's most recent letter to its clients:

"It appears as if the two leading governments in the world, the United States and China, are laying the foundations to facilitate the global adoption of crypto and public blockchain systems. The US Office of the Comptroller of the Currency published three interpretative letters this past year that gave guidance around national banks custodying crypto assets, engaging in stablecoin related businesses, and being able to settle transactions on a public blockchain while also running validator nodes. These interpretive letters essentially lay a path for existing financial institutions to fully engage with the crypto space. The Chinese government, on the other hand, launched the Blockchain Service Network and the Digital Yuan.

While still in its infancy, ongoing Digital Yuan trials show that the Chinese are highly committed to being a leader in the digital currency space."

All of these factors are beneficial for Bitcoin and the crypto-asset space as a whole. But, volatility aside, there are risks associated to the asset class. Here are some that have been identified:

  • Some bugs were and could be found and exploited in the code – it's improbable for bitcoin, but not for more complex coins.
  • There are some technical issues with handling transactions, as Bitcoin can only handle a few transactions per second (although efforts are being made to speed it up).
  • There also are competitive risks - Bitcoin and other assets could lose out to rising competition from other technological solutions. If there is a rapid adaptation of this technology by central banks and governments, and clearly, it's underway, there could no longer be a need for crypto.
  • There could be entities (like foreign governments) that could attempt to corner the bitcoin miner market and look to allow fraudulent transactions.
  • Regulatory threats - governments could ban crypto-assets' ownership, especially those with untraceable transactions because they could be used for money laundering. Governments could also change the tax legislation to discourage investors from owning crypto coins (much like how there is a tobacco tax to deter consumers from smoking). If coins are forced to be listed as securities instead of property, that could affect the ecosystem's current liquidity.
  • Crypto-assets in general, are more susceptible to market manipulation since there is no oversight.
  • Fraudulent entities – there have been many instances where entities stole investors' assets due to investor incompetence or malicious intent.
  • Valuation risk – similar to a competitive threat, if enough crypto owners decide to move away from the asset class, the value will inherently drop. While highly unlikely given the commentary and indications from "Crypto-bulls," it is still a risk.

The last and probably most important question is that of ownership – how can an individual invest into crypto-assets? Right now, there are three primary options available to individual investors.

The first is through Crypto exchanges or brokerage platforms. These platforms allow users to buy and sell crypto coins like they would buy and sell stocks. The biggest advantage is convenience – opening and funding an account takes minutes. The biggest risk is that, while unlikely, exchanges could be hacked. They also have relatively high fees on transactions and have non-competitive trade execution (you can only trade on one exchange vs. a global one). Many large crypto coin holders use multiple exchanges to buy and sell coins and then store them "off-line" in "cold storage" where they can't get hacked. It's the equivalent to taking possession of gold bars and hiding them in a vault or burying them in your backyard. Once they are taken off-line, the coin holder has a "key" – a password – that gives them the ability to unlock and use their coins. There have been numerous articles written about early adopters of bitcoins who have since forgotten their "keys" and are now locked out of millions of dollars.

The second option, and one that could be slightly easier, is to invest in crypto assets via private placement funds. In this instance, an investor can become a limited partner in a fund which then invests in coins on the investors' behalf. These funds have high-quality custodians to ensure asset safety and handle custody, trading, reporting, taxes, and are subject to annual audits. The issue with these is that there is a fair amount of paperwork to review and sign, and only accredited investors can invest.

The last option is to invest via publicly traded shares of seasoned private placement funds. After a specific time frame (either 6 or 12 months), an investor in a private placement fund can sell their shares on the OTCQX, an "over the counter" exchange. The largest and most well-known fund is the Grayscale Bitcoin Trust (Ticker: GBTC). While investors can access Bitcoin (or other crypto coins) with ease, these publicly traded shares are often trading at a premium to their net worth due to the limited supply of shares available. While there is a situation where they could trade a discount, that is a rare occurrence. Per research done by Bitwise, GBTC has historically experienced premiums and discounts ranging from approximately +140% to –1%. In other words, by purchasing publicly traded shares, an investor could be paying a significant premium to get exposure to bitcoin and could end up with any bitcoin appreciation being negated by the fall in premium.

This introduction has just scraped the emerging asset class's surface, but hopefully, it was informative enough. If you have any questions or comments, please don't hesitate to reach out to me.