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LIFE AFTER A BUBBLE - From the Financial Post Magazine

November 4, 2019

 One of my first experiences with cryptocurrency and Bitcoin was in May 2017 and I had just come off of a TV interview at the SALT Conference (the largest hedge fund conference in the world, with attendees from all over the globe) held at the Bellagio hotel in Las Vegas. Two of the serving staff walked up to me and asked “what do you think about Bitcoin? We are thinking about buying some.” At the time the price of BTC was in the $2,000 USD range. Given experience with investment bubbles and having worked in the industry through the run up of technology stocks in 1999 and early 2000, there seemed to be some eerie parallels.   

 

I told them “while I have not invested any of my own or client capital into this sector, some of my friends who have been in it since the $100 range, have been selling on a regular basis to reduce the position size since $1,500. I can’t give you more advice than that”.

 

We all now know that the bubble burst on the price of BTC which peaked at $19,900 on December 15th, 2017 and went into free fall with the price of BTC vs the USD declining 83% over the next 12 months before bottoming at just under $3,200.

 

Bitcoin is open source software and is more akin to the internet, and it’s a mistake to compare it to a company or a stock.


While many investors don’t remember the tech bubble which ended in March of 2000, we are all now familiar with names like Amazon and Google (which were alive before), and Facebook and Twitter which were born after the crash. The question becomes, is Bitcoin like Amazon and Google of this new era? Or like Pets.com. The truth is that Bitcoin is open source software and is more akin to the internet, and it’s a mistake to compare it to a company or a stock.  In fact, the Chairman of the SEC has publicly said that Bitcoin is not a security.  

 

With prices as of this writing above $8,000 USD, is Bitcoin an asset class to consider as part of a diversified portfolio? What are the risks? What is the potential? More importantly, what is Bitcoin?

 

Without going into a deep dive about the technology, Bitcoin is a consensus network that enables a new payment system and completely digital money. It is the first decentralized peer-to-peer payment network that is powered by its users, with no central bank, authority or middlemen. From a user perspective, Bitcoin has been compared to digital gold, in that it is global, immutable and a store or value.

 

Bitcoin is an asset class which is uncorrelated to other asset classes and thus can provide diversification and the potential to improve portfolio returns for a given level of volatility.

 

In a world awash in liquidity provided by central banks, and the potential for things like Modern Monetary Theory to be enacted in some form, the devaluation of fiat currencies can become significant over time. It’s why hard asset classes such as gold, real estate and to a degree public stocks, are invested in; to preserve the value of one’s savings against inflation.  Bitcoin is an asset class which is uncorrelated to other asset classes and thus can provide diversification and the potential to improve portfolio returns for a given level of volatility.

 

While the 2017 and previous bull markets were primarily fueled by retail investors, it is likely that the next wave will be led by institutions. Sophisticated institutional investors such as the endowment plans of Yale and Harvard have begun allocations to the crypto asset class through fund offerings which tend to have Bitcoin as a core holding along with exposure to private equity investments.

 

Through this price decline in what is affectionately known as the ‘Crypto Winter’ to industry insiders, important progress has occurred in areas such as custody, possibly scalability, and other key infrastructure related projects. Over the past year we have seen dedicated funds launch which invest in underlying cryptocurrencies, there was the launch of Bitcoin futures on the Chicago Mercantile Exchange and custodial giants such as Fidelity created Fidelity Digital Assets to offer custody and trading solutions for institutional clients and family offices. In contrast, the regulatory environment has been slow to develop, as witnessed by the continued delays of the SEC approving the listing of a Bitcoin ETF.

 

THERE ARE TWO AVENUES TO INVEST IN THIS ASSET CLASS: DIRECT INVESTING IN BITCOIN, AND EQUITY INVESTING.

 

Direct Investing: Investors can directly purchase Bitcoin, which is highly liquid, as it is traded through various exchanges 24 hours a day, 365 days a year. From a pricing perspective, large order sizes can move the market, as significant market volatility with moves greater than 5% in a day are not uncommon. Serious investors in Bitcoin have a term-“HODL”-which referred to a typo in a chat room in 2013; the term means holding or being long Bitcoin despite the price fluctuations.

 

Investors can purchase and have custody directly through “hot wallets” which are connected to the internet and allow the funds to be highly accessible but are more vulnerable to phishing or hacking. Alternatively, “cold”, or “paper wallets” are not connected to the internet and therefore are highly secure, although the funds are less accessible.

 

With regard to holding Bitcoin for a long-term investment at an exchange, Caveat Emptor is not to be forgotten, as there have been hacks of exchanges such at Mt. Gox, as well as the recent scandal of QuadrigaCX, a Canadian crypto exchange which is currently in creditor protection due to what could be a fraud, or the operation of a fractional reserve system.

 

Equity and Debt Investing: Accredited Investors can make investments in companies whose returns are connected to the growth of the asset class and who maintain traditional capital structures. These investments are similar to venture capital and should be considered longterm, illiquid investments which are held at cost and marked up or down depending on funding rounds. Private debt would likely be accessed typically through a fund structure as this is a relatively new area. 


Funds: Accredited Investors can invest with asset managers who may employ a variety of strategies to gain crypto asset exposure. There are typically two approaches; a public index approach, a public active approach (similar to a hedge fund structure which has an initial lock up), or a private approach which utilizes an illiquid private partnership structure. Investors need to understand that regardless of the approach, investment should be thought of as investing in early stage venture investing, with the commensurate risks and potential returns. 

 

The Bitcoin network has worked for 10 years without interruption, has more than 32 million wallet addresses and is adding more than 1 million new holders per month and trading more than $1 billion per day. With the bubble burst, and what appears to be the end of the Crypto Winter, now may be the time for investors to research how to add this new asset class to their portfolios in a prudent manner.

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