Since the 2017 bubble, significant fundraising has gone into crypto asset and blockchain infrastructure projects. We have seen a constant rise in investments in traditional financial vehicles, such as exchanges, funds and payment methods for solutions in the crypto ecosystem, in particular the compliance and regulatory solutions sector. Venture capitalists, incubators and family offices remain a major source of capital for crypto-driven companies, but there has also been a rise in funding from established corporates and banks; a natural consequence of the institutionalisation of the industry.
With the emergence of each new technology, governments and other established institutions feel the threat of losing control over their market position, before eventually regulation and innovation come together. For the technology to be useful it has to comply with regulations; after which point it is seen more as a challenge and an opportunity instead of purely a threat. As recent market turmoil has emphasised further, there is a clear global trend towards digital currencies among governments and central banks. At the same time, we see a private crypto assets sector that is experimenting with this new technology and successfully implementing and testing the infrastructure needed to support its effective usage in a neutral free market internet economy.
Without cash flow you can’t value crypto, so it must be worthless?
The emergence of decentralised distributed ledger protocols, combined with the invention of smart contracts, enables a system of account, exchange and store of value. The legitimacy of the technology comes from the transparent mechanics of open source, cryptographically secured code. In essence, it is a novel form of bookkeeping and it’s a first in the history of mankind.
A new form of bookkeeping might seem like a grey accomplishment. Yet for thousands of years, going back to Hammurabi’s Babylon, ledgers have been the bedrock of civilisation. That’s because the exchange and ownership of value, upon which society is founded, require us to trust each other’s claims about what we own, what we’re owed, and what we owe. The development and actual application of this novel technology requires us to give serious thought to neutral economies on the internet.
What typically happens with the emergence of a new technology is that we tend to overestimate its value in the short run and underestimate its value in the long run. However, we would be mistaken to assume that crypto assets will replace all existing currency regimes. Their legitimacy is rooted in fundamentally different concepts, such as trust through government backing and the value of assets providing collateral for a currency.
In corporate circles, especially in financial institutions, it has become fashionable to say, “I am interested in the blockchain but not in crypto”, which is the same as saying “I am interested in the web but not interested in the internet”. This reminds us of previous discussions on ‘intranet vs. internet’ during the dot-com era. These have been replaced by ‘centralised vs. decentralised’ or ‘permissioned vs. permission-less’ blockchain discussions. These repetitive dynamics ultimately come down to the fact that established institutions want to embrace novel technology through centralised implementations (intranet and permissioned) so as to not risk the loss of their current market power. This is especially the case with crypto assets, since the decentralised technology seems to directly threaten the base of control by some of our legacy institutions.
Emergence of decentralised finance – ‘open finance’
The economic benefits of decentralised crypto asset systems are proving to be an important financial evolutionary step, as opposed to a pure threat to the existing systems. From a high-over economic perspective, the combination of decentralised distributed ledger technology with a crypto asset affects at least two key costs:
- Cost of verification – This sees to the ability to securely record and time-stamp information on a blockchain, which is extremely valuable when issues arise with a transaction.
- Cost of networking – In our current financial system we need intermediaries to transfer value across the globe (e.g. SWIFT, ACH), which is both a capital- and labour-intensive approach in terms of maintaining security. As we currently have to invest in maintaining ‘trusted nodes’ to validate transactions, crypto assets use a clever mix of cryptography and game theory to deliver the same results.
By adding a crypto asset to a distributed ledger, you can bootstrap an entire marketplace that can achieve trustless internet-level consensus about the state and authenticity of its market participants as well as transactions providing for security through decentralisation.
A leading example of the actual application is Decentralised Finance (DeFi), a movement in the crypto asset ecosystem that has gained increased traction over the years. This term generally refers to open financial infrastructures built upon public smart contract platforms, such as the Ethereum blockchain. In contrast to the traditional financial sector, DeFi does not rely on intermediaries and centralised institutions. Instead, it is based on open protocols, decentralised applications (DApps), and the timeless economics of supply and demand. Agreements are enforced with specifically incentivised smart contracts and transactions are executed in a secure, automated way that have their legitimacy reflected on a decentralised blockchain. The development of DeFi has created an immutable and highly interoperable financial system with unprecedented transparency, equal access rights and little need for custodians, central clearing houses or escrow services, as most of these roles can be assumed by smart contracts.
While this nascent technology has great potential, there are still certain risks involved. The main problem is the scalability issue that has proven to be a barrier to mass adoption. Smart contracts can have security issues that may allow for unintended usage. Moreover, the term ‘decentralised’ is deceptive in some cases. Many of the protocols and applications use external data sources and special admin keys to manage the system, conduct smart contract upgrades or even perform emergency shutdowns. However, as these issues will be solved going forward, DeFi has the potential to lead a paradigm shift in the financial industry and potentially contribute towards more robust and transparent financial infrastructure.
Operational risks for institutional investors
Custody, counterparty risk and prime brokerage
In the traditional fund management space, using an independent third-party custodian is expected and there is a large number of established players, from licensed custodians to prime brokers, who can take custody of fund assets. Given the reality of public and private keys, this is not as straightforward in the cryptocurrency space, which is why many crypto fund managers often use self-custody solutions through multi-signatory wallets, deep cold storage, different security levels of hot/cold wallet set-ups, and the use of external custodians – either third party or exchange custodians. We are seeing the rise of institutions stepping into the market for custodian and prime brokerage solutions, such as Bitcoin Suisse, Bakkt and Fidelity. Their services are specifically designed for institutional investors and crypto fund managers, resulting in optimised security, and market liquidity through best execution and custody services.
The investment strategy of a crypto fund manager is the main deciding factor in the level of sophistication in their custody process related to counterparty risk. A long-only fund that invests in crypto assets for the long term based on fundamentals requires a secure deep cold storage custody solution as it seeks to buy and hold these assets, significantly decreasing the counterparty risk. Alternatively, a quantitative or actively traded fund, which trades at higher frequencies and requires increased liquidity, might have no need for a cold storage solution because its strategy requires it to keep all crypto assets on an exchange. In such instances, monitoring the counterparty risk of such crypto exchanges becomes fundamentally important as these exchanges are sensitive to single points of failure due to breaches of cyber security.
For fundamental and discretionary fund managers, custody is a very important part of the operational due diligence process for investors. Having clearly defined cold storage or third party custodian solutions with clear internal guidelines on its governance and controls becomes fundamental.
Track record and team
Most cryptocurrency funds were established in 2018, and thus have a short track record of crypto asset investment experience. The size of the average crypto fund team is seven or eight people, with an average investment management experience of 20+ years. This indicates that experienced investment professionals are moving into the crypto asset space as teams are looking for the optimal balance between ‘traditional’ asset management experience and ‘crypto-native’ expertise in order to assess an asset’s long-term viability.
Corporate governance is an important issue and most traditional funds today have independent directors. Having independent directors on the board of the fund is seen as an accepted fund expense. The majority of crypto funds do not have independent directors on their boards, mainly due to costs. However, we expect crypto fund managers to focus increasingly on fund governance as they look to raise capital from institutional investors.
Independent valuation is key in order to verify fund performance and to give investors, particularly institutional investors, peace of mind that their assets are being properly valued. Investors expect a monthly NAV to be available and verified by an independent, reputable fund administrator. Today we are starting to see a diversified number of fund administrators servicing the crypto space as the industry matures. Some of the more established players have become more comfortable with crypto assets, leading them to move into this space. The strategic partnership between Cyber Capital and IQ-EQ is a good example of this.
Being able to accurately value a crypto fund remains a novel exercise that requires an alternative approach and clear communication with the investor. Important nuances, such as the cut-off time for valuation (crypto markets never sleep) or which and how many price source(s) to use (the same crypto asset may be priced differently at different exchanges globally), need to be clear upfront. As an independently verified NAV is crucial information for the fund auditor as well as investors, we expect to see continued developments in this area as these functions ‘institutionalise’ further.
Most institutional investors will raise the above issues as part of their operational due diligence, and it is important for a crypto fund manager to have thought through these issues and have proper controls and risk frameworks in place.
Sizing the opportunity in an investor’s portfolio
As with the dot-com bubble, we think something similar is happening behind the volatility and stratospheric hype of the crypto asset and blockchain boom. We can’t yet predict what the blue-chip industries and unicorns built on blockchain technology will be, but we are confident that they will exist, because the technology itself is all about creating one priceless asset: trust.
Let’s be clear. This could all go substantially to zero for various reasons, however the elements providing comfort that it certainly won’t are definitely materialising. Being ‘right’ in an investment with a high risk of failure, but a highly positively-skewed distribution of potential outcomes, is about getting the a-priori probabilities right (and adjusted for new information as it arises) and getting position sizing right. Provided that we accept that crypto assets’ net expected future value is positive, even marginally so, the right answer on position sizing isn’t zero. Nor of course is it 100% of one’s investment assets. For those stuck at the step of whether or not to invest, the logical thing to do is to move past that point and focus on position sizing supported by a specified investment policy.
About Cyber Capital
With its investment funds, Cyber Capital B.V. allows investors to participate in this emerging asset class with professional, secure, liquid and transparent exposure. Cyber Capital approaches crypto asset management with the same professional mindset and standards as the traditional financial industry. Because Cyber Capital's investment products meet the due diligence requirements of a collective investment fund, investors benefit from several unique advantages. These include easy and secure access, an institutional-grade custody service and funds administered by reputable service providers.
Cyber Capital is a fund manager based in the Netherlands, founded in 2016. Cyber Capital is fully registered by the Dutch Authority for the Financial Markets under the AIFM light regime and the Dutch Central Bank. Cyber Capital manages a range of alternative investment funds focused on crypto assets.