Bitcoin and other cryptocurrencies have captured the imagination of many investors. This most press-hungry of asset classes always seems to be in the news. Just a few days ago, El Salvador became the first country to make Bitcoin its official currency.
And let’s not forget capital appreciation. One Bitcoin is worth a little more than $46,000 at the time of this writing, an obscene amount compared to its value of $0.0008 in 2010. While some say it’s the wave of the future, others have deemed the one of the biggest scams in financial history.
Amidst all these disparate opinions, clients are eager to learn about cryptocurrencies and the blockchain, and it’s our role as advisors to supply them with information. Consider this three-point cheat sheet a first pass at broaching the subject.
Blockchain is (probably) inevitable
Proponents of blockchain view traditional intermediaries as old tech, with companies like Visa and American Express getting richer with every swipe at the expense of consumers and retailers. Blockchain is a recordkeeping technology that allows for efficient transactions between two parties.
The transactional data (or ledger) is decentralized, meaning that all users have access. According to Matthew Sigel, head of Digital Assets Research at New York-based Van Eck Advisors, blockchain allows for “faster, cheaper, and more open transactions – and those are all better attributes.”
In Sigel’s view, payments processors will see continued spread compression and threats to their franchise value as blockchain transactions enjoy increased acceptance. He expects 5% of banking industry revenues will move to blockchain in the next few years, from 0.50% as of April 2021.
Sigel also sees companies like Solana, which offers the fastest blockchain in the world and the fastest-growing ecosystem in crypto, to eventually upend traditional stock exchanges. “The Nasdaq is a perfect example of a trusted but unequal financial intermediary. Transactional data is expensive to acquire, and there are hundreds of pages of rules for listing, and they can do that because such an enormous amount of liquidity is being created. These exchanges have a huge regulatory moat that won’t disappear overnight, but blockchain will eventually match them on speed and be a much more cost-effective solution.”
It’ll be a minute for crypto
Physical bitcoin exchange-traded funds and other products seem like the next logical step in the evolution of cryptocurrency as an asset class, but there are considerable jurisdictional issues, according to Sigel. “The SEC wants Congress to provide legislative guidance, which has not been forthcoming, and until then the agency is taking a regulation by enforcement strategy,” he says.
And though SEC chairman Gary Gensler has invited product developers to develop 1940-Act wrappers around bitcoin futures, Sigel doesn’t see this as an ideal solution. “Additional cost and complexity due to having to roll futures contracts, and the dramatic underperformance of bitcoin futures versus the spot price, are a few reasons why futures-based products are suboptimal.
There are also issues with income from commodities having to be captured by an offshore subsidiary, and the requirement of leverage and borrowing, which ends up contributing to the performance drag of futures-based funds,” he says. Even so, the timeframe for a true U.S. bitcoin-based product is uncertain.
Interestingly, the rest of the world has much less reticence on cryptocurrency. Van Eck owns a piece of the Canadian Bitcoin issuer BTCQ and offers several crypto-based funds on the EuroNext platform, with roughly $350 million in assets.
Tax-deferred havens are a must
The taxation morass that could envelop cryptocurrencies makes investing in such funds best in tax-deferred accounts like 401k plans, either outright via crypto-based funds (when they become available) or as part of a glidepath strategy. Cryptocurrencies are taxed as an investment by the IRS. Using them to buy something is the same as selling stock to buy another stock and should be reported to the IRS.
Every federal tax filer that uses a 1040 form is required to disclose whether they received, sold, sent, exchanged, or otherwise acquired any financial interest in any virtual currency during the tax year. And as part of the proposed Infrastructure Investment and Jobs Act, crypto exchanges other non-broker entities like miners and software developers will be required to report all transactions to the IRS.
Regardless of where the regulatory dust settles, Sigel is quick to point out that cryptocurrencies are an asset class that fully diversified investors need to own. “The success of cryptocurrencies reflects technological breakthroughs in cryptography and software design that are fundamentally disrupting how businesses and consumers transact online. Thanks to their lower cost and programmability, these fast-growing and collaborative ecosystems present a fundamental threat to both Wall Street and Web 2.0 profits. They also broaden financial inclusion and provide a direct path to market for individual creators and small businesses. Yes, I am bullish!”
Ben Warwick is Chief Investment Officer of Denver-based Aveo Capital Management.
Ben Warwick founded Quantitative Equity Strategies (QES) in 2002 as a platform for implementing his quantitative investment strategies. The firm advises on assets with traditional long-only equity and fixed income, private equity, managed futures, and alternative investment mandates. Warwick is the author or editor of six books on investing, including Searching for Alpha: The Quest for Exceptional Investment Performance (Wiley, 2000).
