Cryptocurrency is down, so why are sophisticated investors buying?
Do they know something you don't? Not really. It basically just makes sense.
- Sophisticated and institutional investors are putting (i.e. losing) a lot of money in cryptocurrency.
- Cryptocurrencies remain tempting on their own merits regardless of price performance.
- A lot of the capital invested in blockchain as a technology ends up in bitcoin as an asset.
The value of its investments are down as much as 70% in the year to date, crypto investment fund Grayscale announced midway through 2018. Many of the institutional investors who bought into it are losing money hand over fist, blowing through countless millions of dollars.
And things couldn't be better.
Things go faster downhill
Money just kept pouring in throughout 2018, and by the end of June, Grayscale clients had invested about $250 million into crypto through the firm. This trend continued throughout the remainder of the year. Millions of dollars have gone up in smoke, and impropriety, opacity and outright criminality continue to riddle the ill-regulated crypto markets. Everywhere you turn, there are red flags and cautionary tales of people who lost everything to crypto.
And by all measures, the ostensibly "smart" money is loving it.
More than half of Grayscale's continuing investment returns come from institutional investors. Average daily volumes in Chicago Mercantile Exchange's (CME's) bitcoin futures market grew by 119% between Q1 and Q4 of 2018 despite it being introduced at the peak of the hype cycle. And in an effort to match ongoing demand, big-volume block trading platforms started raising their minimum trade sizes almost across the board.
Two things are clear:
- Cryptocurrency prices got utterly smoked in 2018.
- Sophisticated and institutional investors are keener on crypto than ever.
So what gives?
Jeff Dorman, an 18-year Wall Street veteran who's now a partner at crypto asset management firm Arca Funds, put forward a few ideas in a guest piece for CoinDesk.
"Through meetings with over 100 institutional investors over the past four months from California to New York, one thing has stood out most − an overwhelmingly positive response. These endowments, family offices, pensions and other institutions are enthusiastic about crypto assets despite an overall pullback in crypto valuations upwards of 75 percent from their all-time highs," he explains. "This is remarkable."
Cryptocurrency is impossible to ignore
The heart of the problem, as it were, is that cryptocurrency is impossible to ignore. This forced market-watchers into a decision between getting involved or writing it off entirely, Dorman said.
Basically, cryptocurrency is banging around the place, and then when investors go and see what's making all that racket, they get sucked down a rabbit hole.
The three stages for an entrant as Dorman describes it are "scepticism" at first, followed by "optimistic but confused" around six months later. Then "you spend the next 12 months going deeper down the rabbit hole until you want to dedicate the next 20 years to this new technology," he says.
You might be able to relate to that.
In this respect, cryptocurrency is an extremely magnetic asset class, which helps account for the seemingly outsized interest from well-heeled investors.
What people want
Of the institutional investors exploring cryptocurrency, Dorman says, there are two key points which seem to resonate with absolutely all of them. The level of buy-in and pace with which an investor races down the crypto rabbit hole might depend on how closely they relate to these two points.
The first point is that cryptocurrencies allow for hedging beyond the existing financial system. The second point is that cryptocurrency investments are an exploration of an emerging technology.
Investors are 100% long on the existing financial system
Without cryptocurrency, someone is 100% invested in the existing financial system.
This has traditionally been dandy for investors in the USA and other (previously) stable countries, but the ability to implicitly trust the existing financial system is a luxury that many millionaires and investment firms don't have.
Capgemini noticed this last year in its World Wealth Report, which found that while most millionaires around the world were interested in buying cryptocurrency, interest levels varied dramatically by country. A quick glance clearly shows a correlation between general faith in the financial system of a region and interest in cryptocurrency.
But these geographical differences don't represent the total interest in cryptocurrencies. Rather, they just show which region's investors tend to have the most reasons to plunge down the crypto rabbit hole as quickly as possible, and the places where people are more likely to already be somewhere in crypto-land even before it reached peak hype in late 2017.
These numbers are from Q1 2018, and interest in cryptocurrency has likely shifted upwards and started equalising across geographies since then. We'll just have to wait for the next World Wealth Report to find out.
As Dorman makes clear, you don't need to be some kind of doomsday prepper to be moved by this argument. No matter where on the planet you are, there are systemic risks that would be nice to hedge against.
Plus, statistically speaking, based on previous price correlations (or the lack thereof) between cryptocurrency and other asset classes, it makes mathematical sense to have a cryptocurrency allocation as long as you think it has some kind of merit. And remember, due to its sheer loudness, investors have been forced to address cryptocurrency. This naturally leads institutional investors to the fact that buying cryptocurrency simply makes sense from a risk perspective as long as you have a reasonable amount of faith in what you're buying.
It's not surprising that big money is buying big crypto even as markets plunge. It would be surprising if they weren't buying.
Familiarising yourself with emerging technology is just common sense, and that means crypto
Dismissing cryptocurrency as an asset class just because bitcoin prices are falling would be like dismissing the Internet just because Pets.com flopped, and investors know it. By buying cryptocurrency today, investors are participating in the growth of emerging technologies.
"The pie is growing even as prices collapse and, with enough research, you can figure out which slices of the pie to grab," Dorman says. "Viewing the utility of cryptocurrencies through price alone misses the fundamental revolution. Cryptocurrency and blockchain have uses far beyond price."
If the cost of staying abreast of emerging technology is ten million dollars, then that's eight digits well spent.
The key factor, though, might be that investments in blockchain as a technology will often still mean investments in cryptocurrency as an asset class. There are three reasons for this:
- Getting access to a wide range of crypto-assets is still easier when using bitcoin or Ether as a bridge. Token sales and purchase agreements are a common part of venture capital investments in blockchain tech itself, and actually interacting with these tokens (buying, selling, using as a utility, etc) is made easier with bitcoin or Ether holdings.
- Despite a lack of mainstream uptake, bitcoin and Ether are still widely accepted in the blockchain industry. These crypto assets can be a volatile yet practical currency for someone who wants to invest in emerging blockchain companies.
- The industry is still relatively small and all money tends to flow towards crypto-assets either directly or indirectly.
Western Union's $50 million cryptocurrency investment
Western Union does not do cryptocurrency as an asset class.
It's been underwhelmed by Ripple tests, and its spokespeople have repeatedly emphasised that they don't see any reason to use cryptocurrency because no one actually wants to use it. Of course, Western Union's view is quite understandable because one of the points of crypto is that with it you don't have to use Western Union or any other third party, but that's beside the point.
The point is that Western Union wanted to invest in an exploration of blockchain technology to see how it could improve its business operations, without any involvement in cryptocurrencies.
"Our position is to be on the inside track... [but] we're not going to get sidetracked," as Western Union's country director in Australia said of blockchain.
This investment in blockchain sans crypto took the form of a US$50 million investment in the Digital Currency Group.
That money would have then been an indirect contributor to the Digital Currency Group's own investments, which include hearty positions in cryptocurrencies themselves, bitcoin developers like Blockstream and so on.
Investments in blockchain as a technology still contribute directly to the purchase and development of bitcoin and other crypto-assets, whether the investor wants them to or not.
Institutional investors and businesses are interested in emerging technologies like blockchain and are eager to invest in it to the extent that they believe they should prudently invest in upcoming technologies. It's simply common sense.
Sometimes the deliberate direct purchase of bitcoin or other cryptocurrencies is simply one of the most practical choices for these tech investments, but even without actually touching crypto-assets, many of the funds put into the blockchain space run that way anyway. Plus, in many cases, these investments are a means to an end regardless of current cryptocurrency prices.
This doesn't mean savvy investors are blind to the obvious risks and flaws associated with cryptocurrencies and other digital assets.
On the contrary, Dorman says, there are a lot of very real concerns around how to measure the value of a novel asset class, especially when so much of it is best known for not having any intrinsic value. That the space is so full of fraudulent-looking cryptocurrencies, and that figures like market caps so often seem to exceed the actual value or usage of a cryptocurrency, are also common objections.
But these tend to fade a bit when you take a closer look at the rest of the world, Dorman notes.
"There are hundreds of penny stocks that retain market cap value and trade, despite no underlying value. And there are plenty of 'stub bonds' in the corporate bond and distressed market that have no value but remain priced and trading for decades," he points out.
And then there's that time established financial institutions trashed the global economy by banking on subprime mortgages during an obvious housing bubble. And it's happening again right now with subprime car loans, and everyone knows it's happening. It's a sad state of affairs when cryptocurrency has to be the voice of sanity, but here we are.
Objections to cryptocurrency tend not to stand up to scrutiny of the real world. And at the same time, this scrutiny serves to highlight the real-world applications of blockchain technology. As CFTC Commissioner Christopher Giancarlo said, blockchain might have prevented the 2008 global financial crisis. And if you want to go long on blockchain, that leads to cryptocurrency.
It's no surprise that big money is entering cryptocurrency despite poor price performance over the last year. It's all going exactly as you should expect it to go.
Disclosure: At the time of writing, the author holds ETH.