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New kids on the blockchain - why you should watch this space

New kids on the blockchain - why you should watch this space

30 Jan 2024

Simeon Willis explores developments in cryptocurrency and blockchain and considers whether the US Securities and Exchange Commission’s (SEC’s) decision to permit Bitcoin Exchange Traded Funds (ETFs) marks a turning point for institutional investors.

Following a turbulent 3 years since I last wrote on this subject, Bitcoin is back in the press. On 10 January 2024, the US financial regulator, the SEC, officially announced that spot market Bitcoin ETFs could be traded in the US. This opened the door to a whole world of retail and institutional investors who might previously have been put off given the practicalities of investing directly. It is interesting therefore to have observed a 10% fall in its price since the announcement.

There is something of an irony that a trail-blazing digital currency, such as Bitcoin, is now seen to be more accessible when wrapped by something as comparatively archaic as an ETF. I thought the whole point was independence from the shackles of centralised financial systems? Understandably though, people are naturally suspicious of cryptocurrency exchanges and platforms given the tattered reputations of the collapsed FTX and Mt Gox and therefore value the seal of approval of a regulated instrument, one less thing to go wrong. That said, I would think of the additional protections that a Bitcoin ETF offers above the Bitcoin itself to be akin to the addition of a seat belt on a motorbike.

You’ve been contangoed

Bitcoin ETFs have actually been permitted in the US since October 2021, when the SEC approved the use of Bitcoin futures ETFs. The drawback of these “futures” based funds, versus “spot” ETFs, is that they don’t invest directly in the cryptocurrency, they instead use futures to track the price.  Unlike other developed futures markets which are extremely cost effective and liquid, crypto futures tend to underperform the spot market. With a futures contract, you only make money if the spot price rises to more than the forward price by the expiry of the futures contract. But the forward price for Bitcoin is typically higher than the spot price, a situation known as ‘contango’.  Which unfortunately in this instance means on average you expect to be left out of pocket.

So are spot market Bitcoin ETFs the answer we’ve been waiting for?

Crypto under the mattress

In over 20 years of advising institutional investors, I do not recall anyone investing in physical currency. Sure, people invest in deposits at a bank, but this is lending to a bank; they invest in foreign exchange contracts, but this is a contract for differences in the value of one currency versus another and doesn’t involve investing capital; they invest in cash funds, but as anyone who invested in one of these during the financial crisis of 2008 knows, these do not actually invest in cash. Investing in currency ultimately involves lending money to someone who will pay an interest rate in return. Nowhere has anyone ever bought a stack of £50 notes and called that a cash investment. It’s not an investment because it earns no interest. Investing in the spot market of Bitcoin is equivalent to investing in £50 notes, and stuffing them under the mattress. This would not be a great investment strategy for a developed market currency, let alone a currency that has questionable fundamental value.

This all means that following the interest rate rises of the last two years, with a current UK Bank Rate of 5.25%, there is now a huge opportunity cost for holding Bitcoin.

Never a (crypto) borrower or lender be

To address this return drag, what Bitcoin needs is a lending market. Interestingly, several platforms now offer deposit and lending of Bitcoin. The lender receives an interest rate and the borrower pays a higher one, with the difference paying the platform’s fees. Interest rates vary considerably depending on the platform, seemingly ranging from 1% to 30% according to Google. However, if you are lending on these platforms you’ve got to cross your fingers that the platform has some sort of credit control measures and is still going to be around when you want to withdraw your assets - because you are exposed to their credit risk. This is the wild west of decentralised finance, aka DeFi, so there are no credit checks to protect the platform; nor are there protections such as the Financial Services Compensation Scheme to protect you, the depositor. This type of lending can be likened to picking up pennies in front of a bulldozer. Frankly, given the unquantifiable risks, you’re better off forgoing the interest.

Also, you may be somewhat concerned that your lending is being used by criminals. After all, these unsavoury financiers favour the anonymity that crypto offers. You’ve also got to bear in mind that, even when you’ve got your principal back, you’ve still got to convert it back into your base currency. In 3 out of the last 10 calendar years, you would have got less than 35p back from a 1-year £1 Bitcoin investment.

New kids on the blockchain

That all said, the shortcomings of crypto should be kept distinct from the developments in the blockchain technology that sits behind it. Blockchain is simply a means to record what you own using tokenisation. A token refers to a digital unit of value that can be owned and recorded on the blockchain. Innovators are looking to create an alternative way of accessing traditional investments through tokenisation. This is where the ownership of the underlying asset is determined by who owns the token. Blockchain technology has huge potential to rival traditional platforms and investment vehicles.

In the same way that a digital token such as Bitcoin can be wrapped up in a traditional investment vehicle like a Bitcoin ETF, similarly, a traditional investment such as equity can be wrapped up in a blockchain token. Using blockchain could make it potentially even easier to trade in a new market. People don’t tend to associate blockchain with ease of trading because the industry is nascent. But there’s no reason why that won’t change with time, with the scope for lower transaction costs and smaller trade sizes involving partial shares. There are companies currently busy building these platforms in anticipation of future demand.

The scope for mass adoption of this new tech isn’t so difficult to get your head around. These days technology can achieve rapid adoption within a staggeringly short space of time. Chat GPT achieved the adoption of 1 million users within 5 days of being released. Also, it’s not like many people think about the specific instrument that they are accessing investments with. For example, ETFs have become very popular over the last 15 years, but many different fund instruments are used by different investors, such as unit trusts, open-ended investment companies, etc. What matters most when it comes to the investment wrapper is security and liquidity along with sensible ongoing costs. Ultimately, the performance of the underlying asset will do the rest.

Summing up

Bitcoin is no more a sensible investment than it was 3 years ago, and it’s difficult to see that changing for the time being. However, the blockchain technology that drives it is showing signs of real promise, with an exciting future full of potential.

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Steve Leake

Simeon Willis
Chief Investment Officer

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