Many readers will be old enough to remember the likes of Donnie, Jordan, Joey, John and Danny, one of the original boy bands, New Kids on the Block. As their career was in full swing, another phenomenon was beginning to take off: the internet bubble.
Readers may also recall the (probably apocryphal) stories from the late 1990s/early 2000s of cab drivers recommending tech stocks before the dot com crash. Fast forward to today and not only does my Uber (no tech pun intended) driver recommend the next best cryptocurrency, it seems all my friends have become capital markets experts, given the amount of advice I’ve received on the next best ICO[1] to get involved in.
The meteoric rise of these new kids on the block such as Bitcoin – the posterchild of ‘crypto-mania’ – follows a pattern consistent with other major asset bubbles of recent decades. A recent article on Bloomberg cited analyst comments from Barclays likening the rise of Bitcoin to the spread of a contagious infection like the flu[2].
Another Bubble or “Hangin’ Tough”? Bitcoin price at peak relative to other asset bubbles over the last 10 years
Source: AMP Capital citing Thomson Reuters and Bloomberg[3]
Whilst one may be sceptical regarding one of the most discussed stories of 2017, one facet of cryptocurrencies inspires more optimism, and no, it is not an inverse ETF on a basket of cryptos. Rather it is the concept that underpins cryptocurrency technology: blockchain. But what is blockchain exactly? What are the mechanisms or vehicles through which investment can be made? What should allocators consider before venturing into this space?
Blockchain – “The Right Stuff"
Blockchain can be thought of as a decentralised ledger system; multiple participants write entries into a record of information, and a community of users controls how the record of information is amended, updated and validated. All the transaction record information is stored in blocks, which are validated and/or approved by the network community and then ‘chained’ onto previously approved blocks. Why is this useful? For starters, no single entity – such as a bank, for example – controls the information. The ledger itself should be incorruptible and transparent. This could have many applications: preventing election fraud by creating a ‘hacker-proof’ electronic vote counting system, making medical records more secure, tracking ownership of assets (both digital and physical e.g. Kodak’s attempt at tracking image ownership rights), and processing commercial transactions, for example. The potential for the technology is vast.
Perhaps the best way to describe an application of blockchain technology is by using an analogy. William Mougayar, author of The Business Blockchain: Promise, Practice, and Application of the Next Internet Technology, makes a comparison of blockchain to Google docs that gets the point across in a very simple yet effective manner:
“The traditional way of sharing documents with collaboration is to send a Microsoft Word document to another recipient, and ask them to make revisions to it. The problem with that scenario is that you need to wait until receiving a return copy before you can see or make other changes, because you are locked out of editing it until the other person is done with it. That’s how databases work today. Two owners can’t be messing with the same record at once. That’s how banks maintain money balances and transfers; they briefly lock access (or decrease the balance) while they make a transfer, then update the other side, then re-open access (or update again).
With Google Docs (or Google Sheets), both parties have access to the same document at the same time, and the single version of that document is always visible to both of them. It is like a shared ledger, but it is a shared document. The distributed part comes into play when sharing involves a number of people." [4]
Cryptocurrencies vs Blockchain – “Step by Step”
It is important to distinguish between the cryptocurrency phenomenon and blockchain. This point was recently discussed in an article in City A.M. by Laura Bailey, founder of Qadre, a blockchain services company that, along with a consortium of other firms, recently raised over $65m to develop its framework.[5]. Ms Bailey made a point of separating misconceptions surrounding Blockchain technology from some of the “unsavoury topics” that Bitcoin has been associated with such as “human trafficking, money laundering and most recently indecent image transfer”[6], highlighting the fact that this “dark side” of cryptocurrencies has led to a tarnished view of blockchain in the public eye, which threatens to overshadow the potential benefits of the technology. From an investment point of view, such perceptions are not necessarily negative, as they may lead to a more interesting entry point for investors in firms that heavily incorporate blockchain technology.
To date, from an investor’s point of view, the blockchain theme has primarily been played by investing in cryptocurrencies such as Bitcoin, Ether, Ripple and many more. However, we are yet to see a particular blockchain company establish itself as a “market leader” in monetising the technology. Several companies have attempted to profit from the cryptocraze by adding “blockchain” to their names, such as Long Island Iced Tea Corp., which rebranded as Long Blockchain Corp. in December 2017 and saw its share price rise by more than 280%. This practice is reminiscent of the dot com bubble days when companies included “.com” in their names and experienced incredible gains. Theglobe.com, for example, is one of the poster children for the dot com bubble as it saw share prices rise over 600% on the day of its IPO with its CEO, Stephan Paternot, famously quoted as saying “Got the girl. Got the money. Now I’m ready to live a disgusting, frivolous life”[7].
Whilst scepticism is understandable, we should also remember that Amazon.com emerged from the dot com bubble to become one of the largest companies in the world today. So, in the world of blockchain, how can the next ‘Amazon’ be distinguished from the next ‘globe.com’?
The blockchain industry is in its nascent stage and, as such, separating the winners from the losers feels more akin to a lottery than fundamental investing. To continue the dot com analogy, however, Jeff Bezos poured every single dollar of revenue from Amazon back into the company in order to develop brand recognition, improve, and fundamentally transform and evolve the product. Similarly, when evaluating emerging blockchain ventures, one should look for strong management with long-term vision and a will to build brand recognition and strong technology over time. Investors should also look for companies positioned to deliver “off the shelf” blockchain solutions to firms, as they will have first mover advantage.
“Since You Walked into My Life” – What are the investment options from an allocator’s point of view?
It’s no secret that most of the capital flowing into blockchain is via cryptocurrencies. Cryptocurrency investing is overwhelmingly dominated by the long only option: one can either choose to own cryptocurrencies or not. But are there any ‘true’ cryptocurrency hedge funds out there? In theory, if Ether, for example, ends up as the ‘one crypto to rule them all’ and others fail, there should be some kind of relative value opportunity. Unfortunately, options for shorting cryptocurrency directly and in size, are currently limited to using Bitcoin futures or shorting the Bitcoin Investment Trust (GBTC), an investment trust that holds Bitcoins and is traded as an equity. Until crypto markets become more liquid and shortable, there is no satisfactory way to hedge investments without taking significant basis risk. However, we have seen some hedge funds placing bets against the ‘crypto-phenomenon’ in other creative ways, such as shorting companies that are heavily correlated to the performance of cryptocurrencies.
Investing in crypto-vehicles and funds also raises many operational due diligence considerations, not least the question of custody. This arises because cryptocurrency assets are, by design, not in the custody of a bank or other custodian. They are held through a key, which is unique and represents the only way to retrieve assets. Therefore, any fund that is responsible for investors’ capital will need to have measures in place to mitigate hacking risk, as well as keyholder risk, in order to protect client assets.
We are also seeing other creative ways to play the cryptocurrency phenomenon. For example, Mike Novogratz, former macro hedge fund CIO at Fortress Investment Group, is launching a firm that he hopes will become ‘the world’s first cryptocurrency bank’, generating revenue from handling digital assets and related services. Such ventures carry significant risk, yet Novogratz is reported to have raised ~$250m for his venture, Galaxy Digital LP[8].
Beyond the hype – “Baby, I Believe in You”
It is likely that blockchain will become a very important aspect of TMT[9]-focused equity trading and that, as with most disruptive technologies, some stock-pickers in both the equity hedge fund and long-only spaces will capitalise. Simultaneously, we are witnessing the continuing rise of another ‘disruptor’ technology, quantum computing; this will also have significant implications for blockchain technology. Quantum computers will have the ability to solve problems that were previously intractable, which could have devastating implications for decryption and encryption, processes that are fundamentally interwoven with blockchain. Traditional computers may take a theoretical billion years to decrypt a key-cipher, whereas quantum computing technology could solve the same problem in a second. Ensuring that blockchain and cryptocurrencies remain resilient to the rise of quantum computing will be a critical factor in the coming years. Quantum computing itself will inevitably be part of the solution.
The issuance of cryptocurrencies by governments could represent a significant ‘game-changer’ in how cryptocurrencies are used and perceived. One could argue that cryptocurrencies are, by definition, non-governmental, but the blockchain technology itself does not preclude centralisation. Theoretically a government could exercise more control on a virtual currency than a traditional one, as it could monitor everything on the blockchain ledger. A nationally issued cryptocurrency would represent a threat to bank revenues, as the blockchain technology would lead to the clearing process provided by banks becoming redundant.
There are numerous applications of blockchain technology and, as with any disruptor, there will be winners and losers. There is a bigger picture beyond Bitcoin and it represents an exciting new opportunity set for investors.
Conclusion – “Where do I go from here?”
As allocators, we are always looking for the ‘new kids’ and opportunities in the hedge fund world. From a hedge fund point of view, until these assets are easy to short and as liquid as other markets, it will be hard to make an investment case for a cryptocurrency hedge fund versus investing directly. Some vehicles may provide access that investors could not otherwise obtain, but this remains very much a long-only arena. We are still in the early adoption stage of blockchain technology and there are likely to be many opportunities to generate revenue by betting on blockchain companies, once the nascent industry consolidates.
“We’re the New Kids on the Block and we’re here to stay!”[10]
