The Path to a Multi-Trillion Asset Class Part 1: What’s Holding Crypto Down?
As I fundraise for Circuit Capital, several high-net worth individuals (HNW), family offices, and funds have asked, “Why is the crypto market not rallying despite all the good news?”. Contrasted with late 2017 when almost every (or any) headline on cryptocurrency drove the market higher, it now seems that the correlation between positive developments and crypto prices have broken down. After several investor meetings, I decided to make this the subject of my inaugural blog post.
In my view, the following fundamental drivers could explain why crypto has not been able to react to any positive headlines for the past six months.
1. Fund redemptions
2. Retail community not participating
3. Funds buying via equity not ICO
4. Institution-grade market infrastructure not ready for institutions to FOMO
5. Potential rehypothecation issue (#FakeGoodNews)
6. Smart money shorting
A brief history on headlines and prices
The most compelling market narrative for the next bullish cycle is that institutions will be the main catalyst driving the market. For these traditional entities to gain direct exposure to crypto, they have to be able to trade, settle and store assets in an institutional-grade environment.
With consensus seemingly fixated on this “Institutional FOMO”, I wanted to understand how positive headlines impact the price of crypto assets. To do so, I collated the eleven most positive market-moving developments that happened in the past six months and tracked the change in price of Bitcoin (as a proxy of the broader crypto market) from announcement to the close on the day, to gauge the market impact of these headlines. These headlines tend to signal either development in an institution-ready investment solution or evidence that large institutions are starting to invest in crypto.
Any investor would have expected a strong positive correlation between these headlines and the price of Bitcoin. Instead, it appears that the crypto market seemed almost unfazed with any constructive news. In some cases, the market even closed lower. While it is easy to dismiss the above with the bearish market being the root cause, there are a myriad of driving forces that are worth looking at. It is only through understanding and anticipating these forces that would allow us to better position for the coming cycles.
Fund redemptions
Broadly speaking, there are currently two types of funds; venture and hedge funds. Venture funds, invest with a long-term “buy and hold” strategy with capital typically being locked between five to ten years. In comparison, hedge funds’ strategies are diverse, ranging from Initial coin offering (ICO) to systematic strategies. Given the current illiquidity of crypto and the open-ended structure of hedgies, these funds tend to have a 1-year lockup on capital.
Last year was a banner year for crypto funds with 175 launched. The lack of market infrastructure also helped spur direct investing from traditional players, most HNWs and institutions as they sought exposure through crypto funds. This is also supported by signs that an increasing number of HNWs, U.S. college endowments, and traditional entities were investing in these funds. Anecdotally, there would now be an increasing number of crypto funds reaching the end of their 1-year lock up.
With an average fund performance of more than 50% year-to-date decline, most investors will be redeeming their capital, which means force selling in the market. ICO is one of the most popular investment strategies and recent data has shown that median returns were -55%; most funds are likely to be struggling even more.
Q4 2017 marked a bullish run up on solid volume, and most of these inflows were likely driven by deployment from funds. Therefore, I expect further forced liquidation from funds to suppress the market for the next few months (and potentially in greater magnitudes) until the broader market gets to an inflexion point where capital inflow exceeds capital outflow. Recent findings have shown that funds with less than $25M will struggle unless this year miraculously outperforms. 2018 has already seen a number of crypto funds shutting down. This domino effect can result in a further sell-off and a more prolonged winter should funds choose to shut down completely rather than ride out this cycle. This is a scenario that could play out especially when the vast majority of crypto funds are small and were probably launched in late 2017 and Q1 of 2018.
Retail community not participating
Numerous experts have attributed the enormous run up in late 2017 to retail and Asian-based investors. Most retail are now feeling the heat especially when billions were poured into ICOs since mid last year with median returns returning less than half their capital invested. The losses are staggering especially when more than $18B were raised through ICO in less than 18 months since May 2017. Unsurprisingly, they are not participating partly from increased sophistication and fear. Depressed trading volumes from the retail sector is clear evidence that they are becoming less interested in Bitcoin.
Funds are buying via equity not ICO
Another reason why ICO activity is lackluster is likely because most investing has returned to the private markets. The traditional way of investing via equity has picked up significantly in the last six months driven by the following; first, regulatory uncertainty around public crowdfunding practices that increases complexity in raising and investing in tokens. Second, more countries such as China are starting to take a harder stance such as banning of ICO this year. Third, an increasing number of fintech companies are pivoting into crypto such as Overstock, Robinhood and etc. Fourth, large crypto infrastructure businesses are raising capital via equity offering. For example, the largest Bitcoin miner, Bitmain is seeking to raise $18B for its IPO that could make it the largest IPO in history. Another example will be Bithumb being sold in equity for close to $2B in valuation. Fifth, there is a growing trend of projects giving tokens for “free” when they sell equity. Sixth, security token offerings have recently taken some limelight given the recent scrutiny on ICO. Taken together, the slowdown of capital ploughing into ICOs has drastically reduced direct demand for tokens.
One important difference in investing in ICO is that there is a direct impact on crypto asset prices via demand for Ethereum as a funding currency. The positive feedback loop usually kicks off with current investors re-investing their capital gains as well as new investors entering. Simply, forces of demand and supply determine the price of a token. In this feedback loop, capital inflow drives demand for more token investments in the form of ICOs, thereby driving the price of these tokens once they are released. Investors then re-invest (or “flip”) their capital gains into more ICOs, reinforcing this feedback loop. This loop generally distorts the natural state of things (i.e. the demand-supply balance equilibrium). With more capital investing shifting towards equity form, this direct price transmission has gradually became more subdued.
Institution-grade market infrastructure not ready for institutions to FOMO
Institutions remain by far the largest investors across all asset classes, and with their involvement in the crypto asset there will be greater legitimacy. However, the current structures for investing in crypto poses far more disadvantages than upsides (and more career or firm reputation risk), and it is clear that the imperative in most traditional fund management space is operating with the highest of accountability, clarity in regulations and institutional-grade infrastructures. Without the principle of conservatism in best-practises (yet to be established) for such a nascent space, it is almost dangerous for any traditional entities to dabble in crypto.
It is the inability for most traditional institutions to directly invest in this space that hinders large deployments of capital. Further, this asset class is still relatively foreign with the lack of talent, and may be overly technical for the average fund managers to operate. Institutions clearly do not possess the necessary tools, support and infrastructure (i.e. banking channels, custody, and etc) to directly participate yet. Until Fidelity’s digital assets services officially launch their custody service, institutions will stand on the sidelines.
Potential rehypothecation issue (#FakeGoodNews)
While seemingly positive headlines on the surface, there are potential negative implications from the launch of Bakkt and ErisX. These firms are trying to issue “physically-settled” crypto ETFs and there will be little transparency as these assets are managed out from an omnibus account. The result? A rehypothecation problem that results in unaccounted leverage-based financialization, which would potentially have dire consequences on the current development of crypto assets.
While this argument can be perceived as circular especially when infrastructure (i.e. supply) is required for institutions (i.e. demand) to invest, most critics argued that these infrastructure developments are generally “supply-side” enablements, and does not represent any form of genuine demand.
Smart money shorting
ICO projects were not the main culprits for crashing Ethereum prices this year, instead many funds have been reported to be shorting crypto, and they continue to add to their positions last month. Bearish bets have never been higher with short interest from both Bitcoin and Ethereum making record highs this year. Unless the broader market materially trends higher, short interest should continue to stay at elevated levels.
Market dynamics has downplayed good news for the past six months
The above contributing downward pressures are likely to persist in the near future, especially when other forces are coming into the mix. First, the upcoming potential tax loss harvesting, which is the act of selling of crypto assets at a loss to offset potential capital gain tax liability, could add further selling pressures towards the end of the year. Second, the fund management industry tends to reduce their capital deployment towards year-end. Third, there are a number of critical events round the corner, and any disappointment will aggravate the fragility of the market.
The path to a multi-trillion dollar asset class isn’t a straight line
Notwithstanding the above, I am excited for 2019 because the foundations for a marketplace will be laid. The buildout of this infrastructure will grow alongside clarity in regulations and regulated investment product offerings that will bring massive inflows of capital.
From exchanging handwritten pieces of paper in coffee shops to virtually the most important exchange in the world, the U.S. stock market has lived through four major devastating recessions and yet we are seeing record levels made this year by S&P 500, Nasdaq and Dow Jones Industrial Average. Accordingly, I believe that short-term market dynamics will not alter the path towards a censorship-resistant peer-to-peer society, unstoppable killer dApps used by billions around the world, and a multi-trillion dollar asset class.
We (at Circuit Capital) believe that blockchain technologies will disrupt global socio-economic foundations to create trillions of dollars in value in the long term. This realignment of our socio-economic infrastructure for the adoption of blockchain will be a slow and gradual process, not dramatic, as waves of mass adoption, institutional change and technological innovation gather momentum.
In my second thematic thought piece, I will argue that institutional market infrastructure will likely follow the sequence of three stages starting with an initial period of chaotic fragmentation, followed by consolidation in market practices and then global standard and mass acceptance.
Thanks to Dr. BK Kim, Guo Jie and Tiantian Kullander for their feedback on this blog post.
