The case for digital assets
At the mere mention of the word cryptocurrency, eyes roll.
“I bought Bitcoin and lost 60% before I could blink!”
“Three weeks ago I bought 2 Bitcoins on the dip and now I’ve doubled my money!”
In fairness, these outcomes can happen. It’s usually how bubbles work, and the bubble de jour permeates popular media, and the emotional FOMO of the average person prompts buying hysteria in which Uber drivers et al get in on the act. The market goes up faster and faster, until one day there is no one left to buy. Then it unwinds.
What goes up must come down right? Well, not if you ask those in the midst of the hysterical buying phase of Tesla right now (at the time of writing). The thing about bubbles is that they are often prescient, but just early for their time. The tech bubble of the late 90s/early 00s presaged the boom that came over the past decade or so for example. Who can remember Amazon falling from $106 down to $6 dollars?
Great expectations.
Proponents of digital assets (the “institutional” rebranding of “cryptocurrencies”) say we are in the early innings, and that the space is where the internet was in the 90s. If one looks at the sheer amount of graduates who have entered into the industry as a career, the development activity taking place on the various protocols, or even the performance of bitcoin as an investment over the past decade or so since its creation, we can postulate that this may very well prove to be true.
Our objective is not to determine whether digital assets will be a fully blown asset class or how many times our money we can make. We simply try to see if there is an asymmetric return opportunity relative to risk, and for that, we examine some of the factors both for and against being involved.
There are thousands of digital assets. The vast majority of them are worth close to zero and highly illiquid, but nestled amongst this ocean of mediocrity there are (possibly) the beginnings of enormous opportunity. The nature of the beast is that one is buying an incredibly early stage instrument, more akin to a listed venture capital bet. What interests us is that digital assets appear to have the return profile of a VC opportunity but similar trading characteristics to equities, in particular, emerging market equities. The legal framework for these instruments is still gestating, and that may be why transparency is still lacking in many places. The question we must ask is whether the opportunity is so big that it is worth the risk at this early stage.
The importance of edge.
As an investor there are a number of ways one can have an edge, the way we see it:
Be early – swim in a pool with very few others in it.
Be better – better research, an ability to piece together disparate information to gain an understanding of an opportunity which results in an outcome not currently predicted by the investment value.
Be disciplined – a repeatable trading approach with rigorous self discipline that cuts losses early and lets winners run.
In a world where traditional public markets are saturated with the most sophisticated professional investors and machines, digital assets appear to be a fairly untapped area, given that they have only recently popped onto most people’s radars (arguably helped by the 2017 spike).
The institutional angle.
Institutional ownership of digital assets is very low – let us call it zero or near zero. The majority of “institutional” assets are managed by a host of specialist “crypto” hedge fund managers, which in turn are funded by investors who are educated in and have a particular risk tolerance for digital assets. The level of sophistication of this grouping of people is exceptional.
There is a small but growing group of what we would call traditional managers (people with expertise trading established asset classes and markets), which is seeking to transplant its skills to the emerging digital asset landscape and the level of interaction particularly with Twitter as the playground for the exchange of ideas is rapidly climbing. Despite this emerging pool of talented managers, the pool of participants in the digital landscape is overwhelmingly retail, as the volatile price action would suggest. For us this means OPPORTUNITY – the pool is empty and the water is warm.
There are currently very real barriers to entry for institutional investors. In particular, the security risk around custody of assets is a major risk. Even if managed with the utmost competence, left uninsured (a growing industry in itself), even a small chance of a loss of assets to malicious actors is a risk many institutions are simply unwilling to take. There are a number of solutions to this, depending on how deep into the digital asset space one wishes to delve, but to really extend deep into the opportunity set one would need full blown custody and security solutions. The complexity of appointing multiple custodians across a diversified mandate is also not to be laughed at.
Indeed the service providers who offer custody and even prime brokerage for digital assets are all fairly new institutions themselves and however good these services may be, there is still a question as to whether they will be around in the years to come. So far, none of the major traditional investment banks have shown any interest in bridging the gap from traditional to digital, but one would imagine that if the sector shows signs of success they will act on the research they have already done into this.
In terms of quantitative and algorithmic strategies, there are of course many who are already very successful in the digital space, however for the types of strategies that have brought success to the more famous names in traditional asset classes, one requires decades of tick-by-tick data and deep liquidity. Bitcoin itself has only just recently celebrated its 11th anniversary, nevermind the rest of the digital asset universe, which is far younger.
An emerging art.
Furthermore, the key question being asked by traditional investors is how to value these digital assets. Some excellent valuation work has been done by many of the best managers however this is an emerging art. We have no doubt that in the years to come these valuation methodologies will be articulated and become more mainstream as the best minds in the world converge in this space, but we are not there yet. Perhaps that is a sign of the opportunity?
In terms of legal frameworks, there is simply grey everywhere. The markets themselves are not actually regulated. This means that things like insider trading, price manipulation and all the oldest tricks in the book are not actually illegal. So for many assets, it's a case of knowing what is fair game and what is not, and this comes with time and experience.
So, despite all of these apparent headwinds, why is it that we believe there is such an opportunity staring at us? It's quite simple. As these questions become answered the institutionalisation of the asset class will be rapid. Now is the time to strike and capitalise. Let's go back to how we define edge:
Be early – we believe we are still incredibly early as evidenced by the predominantly retail investor base.
Be better – we use our narrative-driven research process, cultivated and built for more than a decade in the toughest emerging markets to identify structural opportunities in the digital space. Our experience shorting structurally broken companies on the equity side is also particularly applicable.
Be disciplined – we use charts to identify key breakout and breakdown levels, with identifiable stop losses on each position. Risk management is everything. Due to the large return opportunities, if one can avoid large drawdowns the upside should take care of itself.
The opportunity.
We believe we can succeed because in our careers we have never seen an asset class that marries the opportunity to earn such outsized gains with an excellent ability to control losses. Digital assets trade 24 hours a day, 7 days a week. This is crucial, as it means that there is little gap risk, barring a global shutdown of all exchanges. Risky? Stocks trade on exchanges that can shut down too - in case anyone forgets, stock exchanges shut for hours at a time everyday. In the 2009 crisis the Russians shut down their exchange and just this week the Chinese extended the Chinese New Year break to help mitigate any panic resulting from the coronavirus outbreak. They did this because they could and we have definitely not seen the last of this.
Let's give an example. If we are long Mercadolibre shares in the US and something happens pre or post market, we are subject to gap risk. Let's say the stock opens down by 25%. It doesn't matter where our stop level is because we will miss the chance to trade at that level. With digital assets we will almost always hit our stop (within reason of course). This assumes liquidity is readily available and we can control this by being very selective as to which instruments we trade given the liquidity criteria.
Furthermore, because of the binary nature of many of these instruments, there are many (in our view) that add zero value to the world and will be classified as failed projects. This means there are a number of opportunities to make gains on the short side. It naturally provides opportunities to construct a balanced portfolio and manage risk similar (but most definitely not the same) to how one would manage a hedge fund equities book, albeit with a completely different book structure.
A brief word on Bitcoin.
Let’s turn briefly to Bitcoin which is most definitely the first real use case in the digital space. We always start with the search for truth and as such, we have no preconceived ideas about Bitcoin. Any investment opportunity will have multiple paths that it can take over time and we are open to them all (especially the ones we can't think of). But some of our condensed thoughts are as follows. There are lots more, and this is not a full research piece into Bitcoin.
Bitcoin seems to be emerging as a supporting safe haven asset to gold. The jury is still very much out on this and it is incredibly early to start thinking about comparing it to gold’s market cap, its stock-to-flow ratio etc although these indicators are certainly worth monitoring. Our key insight is that if one looks at the owners of Bitcoin and who trades it the most, one can see that the younger investor generations are more prevalent as a concentration of the activity than they are in any other asset class. Do they dominate the flow? We have no idea, but what we see from the price action is almost a naivete in the way it trades. Like a teenager, to use an annoying and patronising analogy!
In recent times of global disharmony (US/China trade war acceleration in 2019, Iranian strike a few weeks back, and the coronavirus panic just this week) Bitcoin has traded very similarly to gold for short periods of time. It has, however, not replicated gold’s slower grind higher, which we attribute to a number of more “complex” factors (see our newsletter on gold from a few weeks back). Could it be that a newer generation of trader, who has not really known global uncertainty, is stretching its legs using Bitcoin as its newest tool? That is not to say that the most sophisticated macro investors in the world are not involved. Believe us, they are. The correlation of Bitcoin to other global traditional assets is still very low, but it is changing every day as it increasingly becomes part of the macro investor’s toolkit. It is important not to embed one’s view of what Bitcoin is correlated to but rather to monitor and watch how fast things are changing.
Bitcoin is often hailed for being the best performing asset since its inception, as this chart indicates (note the chart is to mid 2018 but it still applies today):
On the one hand this is incredibly impressive given we have seen one of the best 11 year sequences in terms of financial asset returns in history. On the other, it can be argued that Bitcoin’s returns have been possible only due to the proliferation of “easy money” and low cost of borrowing. We have yet to see what would happen to the Bitcoin price if we go into a sustained global bear market. As with gold, it is all about the narrative. Gold itself has no real intrinsic value other than it is what everyone believes everyone else believes in as a safe haven instrument. Such behaviour has been built generation after generation. Bitcoin is eleven years old. So how on earth do we know what is going to unfold?
Well, we don’t.
As ever for us we use the charts to help us see. We have an idea what the best case scenario is. If the bulls are proved correct, the price has material upside and buying at $8,000 or $9,000 or even $10,000 likely won’t really matter on the way to a far higher price. Then again, if the bears are proven right, we set our sell levels based on where the breakdown is on the charts and we move on while keeping a close eye to reenter should the facts change again. The asymmetry is where the opportunity is for us. If Bitcoin goes to $50,000 we will be there and if it breaks down we will be gone. It may sound ridiculous to say and it probably is but the most one can lose is where the stop loss is set and the upside (wherever the stop is) is many multiples of that.
Too compelling to ignore.
There are numerous other opportunities in digital assets - too many to mention in detail in this piece and every day, we are incredibly excited to research deeper. The DeFi (decentralised finance) space is in its infancy and 2020 is a big year for many nascent token projects and possibly for Ethereum which is considered the key ingredients to most of these growing ecosystems. There are some innovative projects we are monitoring closely. Binance, the largest exchange (though in fairness today it is already becoming more of an emerging fintech challenger) continues to grow its ecosystem with its token, BNB, at the forefront.
The nature of the structural upside opportunity in many of these assets is simply too compelling to ignore, and when combined with (what we think) is the best ability to control price risk of any asset class, we believe it's an excellent area to target.
Digital assets are what we call an emerging opportunity and we hope to be earlier, better and more disciplined in how we approach investing. This may prove to be a generational opportunity. If it isn’t, we will simply cut our losses and move on.
We would welcome any feedback on this piece and as ever would love to engage. Digital assets are still a bit of a mystery, even to the most successful traditional investors, so please feel free to get in touch.