Guest Post By Kaila Krayewski
One of the things about digital currencies that makes it so appealing to investors is its highly volatile nature, comparable to the Wild West minus the good sheriff. Described as a “volatility swing,” investing in cryptocurrencies is highly speculative due to the unregulation of the market as well as fluctuation based on new events such as security breaches and large movement of tokens based on the overall outstanding float. Unlike regulated fiat currency stock exchanges, cryptocurrency has no circuit breakers in place to soften the blow of said swings (also known as flash crashes), which can make investors pay a hefty price.
Take Bitcoin Cash for example: it had an uncertain future from the beginning, but no one imagined the extent to which the numbers would rise and fall. Doubling within the first 24 hours of its release, it rose from $394 to $757 USD, then down to $300 in a matter of hours, before declining further still. Come Aug. 8 and Bitcoin Cash was valued at $386, $1091.97 by Aug. 19, but by the end of the month it was back down to $557.26. “It has been crazy since its introduction,” explains Tim Enneking, managing director of Crypto Asset Management on the topic of Bitcoin Cash’s price volatility, simply “because no one knows what it’s really worth.”
The varying perceptions of the intrinsic value of Bitcoin and other cryptocurrencies correlate to properties similar to gold in the sense of there being a fixed amount to go around — 21 million BTC — and its perceived amount seesaws significantly, though it promises nearly frictionless value transfer. This volatility is a relatively minor risk to countries with high inflation. These countries can easily obtain and receive a higher return in a Bitcoin-denominated fund than debt instruments in their home currency, potentially offsetting the risk of high inflation in its market.
Poor Interfaces of Crypto-Exchanges
Cryptocurrency exchanges allows users to swap fiat money such as dollars, euros, pound sterling, etc., for cryptocurrencies or trade cryptocurrencies for others. However, as simple as it might sound, users are losing money as a result of poor interfaces, far from any industry standard platforms. It’s crazy to think that in the ripe ol’ tech age of 2017, some websites are still difficult to navigate due to non-intuitive user interfaces. As if it wasn’t challenging enough for new digital-dabblers to take on the world of cryptocurrency, they are now under pressure to navigate alien sites and seek support through forums and chatrooms.
Coinbase is one of the few crypto-exchanges with a clean, easy purchasing interface boasting a good entry point for newbies. Here, Bitcoin, Litecoin and Ethereum can be purchased and/or exchanged. Some exchanges are totally transparent about deposits, buying and selling digital currencies and also storing them. However, others are sly in their approach to extracting fees due to their complicated interfaces and users being new to the system. “Monthly wallet fees,” for example, are in place though there is no cost to managing a Bitcoin account and large Bitcoin withdrawal fees due to “transaction backlogs” or “mempool overload.”
Risk of Tech-Interruptions and Hacker Attacks
According to Fortune, there have been at least three dozen heists of cryptocurrency exchanges since 2011 and more than 980,000 Bitcoins have been stolen, which in relation to today’s exchange rate, would be worth around $4 billion. More often than not, these investors are left without any form of compensation. Japan’s Mt. Gox was one the world’s largest Bitcoin exchange, but after three years of waiting for compensation (as well as its 25,000 customers) for its loss of around 650,000 Bitcoins ($400 million), it collapsed into bankruptcy.
On the May 7, the U.S. exchange service Kraken lost more than $5 million after coming under attack, and its exchange price of Ether fell by more than 70 percent — they received no compensation. As a consumer, there is nothing in place to protect you, unlike the more regulated financial markets. Poor security and investor protection has led to news such as Chinese investors falsely inflating their trading volume to lure in customers. “A deceptive market is not a healthy market,” notes Xiaoyu Hang, co-founder of BTCChina.
Yet it is not the blockchain/Bitcoin protocol that is prone to being hacked; it’s the exchanges that are. For security, look out for things such as, proof of coins in storage, verification of identity and location before depositing. Also look for encouragement to use two-factor authentication. Indicators of a security breach include a backlog of Bitcoin withdrawals often stretching two days, a large difference between quoted price of Bitcoin in comparison to other exchanges, media allegations (check coindesk.com for reputable advice and news) and the most alarming: silence from operators who stop responding to community questions and allegations.
The Role of Crypto Funds in Dealing With These Challenges
Crypto funds are just the digitalisation of hedge funds. Instead of directly purchasing and trading cryptocurrencies, the responsibility is passed onto portfolio managers and traders who decide which ICOs to avoid and which to participate in. These managers and traders promise to produce investment gains in return for a percentage of the overall profit. According to Autonomous Next, there are now 124 crypto funds, of which 90 have launched this year alone. Their total assets under management currently stands at $2.3 billion, but why would you want to hand over your crypto assets?
It seems the whole point of cryptocurrencies — namely cutting out the middleman and pulling back the curtains for transparency — is falling by the wayside. Now the market has ballooned enough that the first funds-of-funds are emerging with the launch of Protocol Ventures by venture capitalist Rick Marini, who invested $1 million of his own capital.
“The goal is to provide diversification for investors,” Marini says in an interview. “With this volatility you want to invest enough that the upside is meaningful, but not so much that it would hurt your portfolio in the case of a loss.”
Major Players in the Field
Metastable Capital launched in 2014, and was founded by Naval Ravikant, the co-founder and CEO of AngelList. He now manages more than $45 million in digital assets, but that’s nothing in comparison to PolyChain Capital. Olaf Carlson-Wee first made a name for himself by being a Coinbase employee who lived on Bitcoin for three years, then launched his own crypto fund in 2016 with $4 million. Now with $200 million in digital assets, PolyChain Capital rivals one of the newest and biggest players in the field: Galaxy Digital Assets Fund, funded by 52-year-old Mike Novagratz. Well, technically he’s a bit of a veteran as he was former hedge fund investor at Fortress Investment Group — until suffering some significant losses and a self-imposed two-year exile from Wall Street — but with goals to raise $350 million by January, it could potentially be the largest crypto hedge fund.
Downsides of Crypto Funds
Although Crypto Funds are the newest, shiniest toy on the trading block, there are some concerning downsides to consider.
First is cost: All crypto hedge fund managers are paid through fees — that is true for crypto and traditional markets. What’s unclear is the setup of their pricing structure and how much it’s actually taking away from an investor’s wallet. To illustrate, Coindesk.com obtained a copy of a real fee structure in a product now actively available on the crypto market, and greatly simplified the structure for easier understanding. What they found is that a $100,000 USD investment in a crypto hedge fund with a 10 percent gross return yields just $78 per $1,000 investment dollars. Why? Because of this little thing called the “2 and 20 rule,” which is a 2 percent management fee pulled from the initial investment, and 20 percent in incentive fees taken from returns.
The second problem is the chance of cryptocurrency risks affecting the larger financial industry. With every creation of crypto funds — 124 at the time of publication — a new bridge is built between the crypto island and the mainland financial system. Defenders argue that crypto funds won’t cause risk to the larger market because of their relatively small size. Yet recent studies point out that size doesn’t matter in this case because the liquidity provided by cryptocurrency inflate the assets’ price bubbles, while the simultaneous withdrawals can quickly deflate those prices. Furthermore, as Angela Walch, a research fellow at the Centre for Blockchain Technologies at University College London, argues, “They also bring risk from the cryptocurrencies into the financial system, as shocks in cryptocurrency prices could affect obligations that hedge funds owe to other actors within the financial system, potentially sending ripples of broken promises far and wide.
Further criticism argues that the complex system itself, vulnerability to bugs and hacks (51 percent at the time of publication) should be a larger cause for concern than it currently is. The lack of education and awareness surrounding these bridges to the larger financial system, Walch cautions, is the same need-to-know lack of education between banks and consumers that, as we all know, brought the housing market to its knees in 2008.
Alternatives to Crypto Funds: Autonomous Crypto Fund Ecosystems
If we’ve sufficiently scared you out of the crypto fund sphere, allow us to offer potential alternatives. Tokenbox, for example, a platform that leverages blockchain to provide the necessary tools to create, manage and invest in crypto funds. Investments include cryptocurrencies and project-specific tokens. Tokenbox ensures transparency and independence by running on the Ethereum blockchain without application servers. It also implements know your customer and anti-money laundering processes to prevent scams.
Another option is Iconomi, which allows for the creation of Digital Asset Arrays (DAA), comparable to EFT. Both of these platforms remove the technical barriers for creating and managing crypto funds, which allows more organizations to enter the space.
The moral of this story is to caution investors to research prior to opening their wallets. Although this seems like simplistic advice, consider the Coindesk.com example. A $100,000 investment in a “boring,” static index fund such as Schwab U.S. Broad Market ETF (SCHB) would yield the investor all but 0.03 percent, which is the fund’s annual expense ratio. It doesn’t take a calculator to figure out the better option in this example.
“Costs still matter in a big way.” writes John Wasik, a best-selling author and financial expert. “Invest broadly at bargain prices. No matter how alluring a new investment looks, you still have to know how much you’re going to pocket at the end of the day.”