Mapping a responsible development of digital assets
by Dr. Richard SmithDr. Smith, known as ‘The Doctor Of Uncertainty, is a Berkeley Mathematician and PhD in System Science, is the founder and CEO of RiskSmith, a risk analytics platform for independent investors. Visit https://drrichardsmith.com/.
Traditional financial markets remain skeptical about crypto, and rightfully so. The endless hype and marketing promise of “all reward and no risk” should give any financially literate person pause. The recent Super Bowl crypto commercials, for example, were far from sober. Financial advisors have a fiduciary duty to act responsibly on behalf of their clients and they are more than justified in encouraging caution in the face of such endless hype.
There’s no doubt, however, that Bitcoin and other cryptocurrencies have become impossible to ignore and are here to stay. President Biden’s recent executive order on the “responsible development of digital assets” should put any serious doubts of viability to rest. Family offices are also driving institutional interest and adoption in crypto as family wealth migrates from older investors to younger digital-native investors.
The Future Of Crypto As An Investable Asset
So, let’s take a deeper dive and see if we can arrive at a more balanced approach to the future of crypto as an investable asset class and its potential to diversify existing portfolios.
The first and most important thing to understand is that crypto really does represent a new asset class. The title of the original Bitcoin whitepaper was “Bitcoin: A Peer-to-Peer Electronic Cash System.” The very first sentence of the Bitcoin whitepaper says, “A purely peer-to-peer version of electronic cash would allow online payments to be sent directly from one party to another without going through a financial institution.”
Bitcoin, the original cryptocurrency, truly ushered in a new era – the era of digital scarcity and digital custody. Before Bitcoin, the only way to control a digital asset was to secure it and make sure no one could ever get a copy of it who shouldn’t get a copy of it. Bitcoin was the first technology that allowed for a digital asset to be shared publicly while still controlled privately and to allow for peer-to-peer exchange of digital assets without a third-party intermediary to guarantee the transaction.
This is a major revolution, the significance of which cannot be overstated. Bitcoin has literally opened up a new digital economy and that fact can’t be ignored.
Bitcoin showed us the way, but Bitcoin was just the beginning. Any digital asset can now be “tokenized” and if there is a buyer and a seller, an exchange of value can take place digitally.
At a minimum, we can look at Bitcoin as the reserve currency of this new digital-exchange economy. Just like the U.S. dollar has value because of its role as a medium of exchange in the global economy, Bitcoin has value as a medium of exchange in the still-nascent digital assets economy.
While there’s no doubt that Bitcoin has authentic value, the ability to assign a stable value to digital assets like Bitcoin is still a work in progress. However, it is important that we acknowledge and agree that Bitcoin really does represent a new asset class and that this new asset class does indeed have authentic and, more than likely, enduring value.
The challenge of valuing digital assets like Bitcoin is directly responsible for the underlying volatility of such assets. Looking at a simple histogram of daily percentage returns of Bitcoin over the past year, we can see that Bitcoin’s daily returns are not exactly normally distributed.
The distribution of its daily returns doesn’t look like a classic bell curve. Yes, it has some height in the middle and slopes downward from the middle, but Bitcoin has fat-tails. These particular fat tails are telling us that Bitcoin regularly is up or down by 5% or more in a single day and that over the past year it has had more big down days (the red tail) than it has had big up days (the green tail).
We can contrast the volatility of Bitcoin with something like the S&P 500.
The S&P 500 has a much tighter distribution of daily returns. Almost all of its daily returns are within the range of plus or minus 2%. It is more normal. There is less uncertainty about how to price the assets represented by the S&P 500. There is more consensus about the future value of these assets.
The greater uncertainty about the future value of Bitcoin is something that investors need to understand, and they need help to understand it. This inherent uncertainty is what allows for all the promotional hype that unethical marketers use to draw people into get-rich-quick/FOMO pitches about Bitcoin. Bitcoin is risky. Other cryptos are even riskier. Here, for example, is the histogram for Dogecoin. Dogecoin is all tail. The tail is truly wagging the Doge.
Financial advisors understand the relationship between risk and reward, and advisors can and should play a constructive role in helping the public better understand that relationship.
Financial advisors also understand that just because an asset is volatile doesn’t mean that it can’t play a constructive role in a diversified portfolio of assets. One of the most interesting things about Bitcoin is how uncorrelated it has been to equities over the past year. This table shows the correlation of Bitcoin with each of the 10 sector ETFs of the S&P 500. The brighter the green the higher the correlation.
Not surprisingly, Bitcoin is most correlated with technology (XLK) and health care (XLY), but even those correlations are surprisingly low at just +33.5% and +29.8% respectively. Bitcoin is completely uncorrelated with both consumer staples (XLP) and utilities (XLU). The bottom line is that Bitcoin, in small doses, can add constructive diversification to an equity portfolio.
While both the White House and the SEC are making lots of noises about the need to regulate crypto, neither one of them are saying that crypto has got to go. Unlike China, which declared all crypto transactions illegal, the U.S. is taking a more constructive approach to this new technology.
Gary Gensler, the head of the SEC, has once again recently stated the obvious that many cryptos are indeed securities. In an interview with Andy Serwer on Yahoo, Gensler said, “If you’re raising money from the public and the public is anticipating some profit based on the efforts of those folks raising the money, that comes within the definitions of a security and the securities laws.”
Gensler was making these comments in the context of encouraging crypto exchanges like Coinbase to voluntarily register with the SEC because “a platform that has securities on it is an exchange.”
For the record, Bitcoin is the only cryptocurrency that the SEC has officially declared is not a security. On the other hand, in December 2020, the SEC charged Ripple and its two founders with conducting a $1.3B unregistered securities offering. Ripple is currently the sixth-largest cryptocurrency by market cap.
Gensler himself has been famously coy about whether or not Ethereum, the second-largest cryptocurrency, is a security or not. Ethereum was launched via an Initial Coin Offering (ICO) and it’s hard to see how Ethereum wasn’t raising money from a public who was anticipating profit based on the efforts of Ethereum’s founder Vitalik Buterin. At least one former SEC official, however, is on record as saying that Ethereum, since its sale, has become “sufficiently decentralized” to no longer be regarded as a security.
It’s a testament to the commitment of the United States to technological innovation that cryptocurrencies have been allowed to evolve as much as they have with a relatively light regulatory touch. With the total market capitalization of cryptocurrencies hovering around $2T today, however, that regulatory touch is clearly starting to get heavier.
With legitimate questions about whether many cryptocurrencies are unregistered securities coupled with justifiable skepticism of the all-reward-no-risk marketing hype, traditional capital markets and financial advisors have rightly kept crypto at arm’s length.
The highest levels of the U.S. government have now made it clear, however, that crypto is here to stay and the SEC is on record as saying that Bitcoin is not a security. Bitcoin was the start of a new asset class of peer-to-peer exchange of digitally native assets, and we are still just beginning to understand the potential of this new digital landscape. Moreover, with its low correlation with many equities, Bitcoin can, in moderation, add diversification to equity portfolios.
While continued caution remains warranted, crypto clearly can no longer be ignored.