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Rehashed - #27 Cryptoassets: Risk On or Risk Off?

Estimated reading: 6 mins

Rehashed - #27 Cryptoassets: Risk-On or Risk-Off?

Taking cues from Howard Marks

Howard Marks from Oaktree Capital (USD $100 billion AUM)  is well known in the investment community for his quarterly memos to clients which detail investment strategies and various market insights. Although Marks is not yet crypto’s biggest advocate, his commentary on the global economy is widely respected and has implications for crypto as an asset class. In his most recent memo which came out this week, Marks referred to a current market environment of irrational high-risk tolerance and excessive optimism, which has led public and private debt levels to balloon.

“Enough time has passed for the trauma of the Crisis to have worn off; memories of those terrible times to have grown dim; and the reasons for stringent credit standards to have receded into the past.”

Marks aggregates compelling evidence that investors are not exercising appropriate levels of discipline, scepticism and risk aversion in current markets. In light of this, Marks warns investors to proceed with caution, citing that although today's risky behaviour won’t result in immediate catastrophe, a prudent investor should favour strategies that emphasize limiting losses above ensuring full participating in gains.

“Frothiness” across the investment stack

The general market environment is incredibly frothy, exemplified by elevated asset prices and an excess of capital chasing high returns. If we look across the investment stack (venture capital (VC), private equity (PE), equities market), there is ‘too much money, chasing too few deals.’ The number of PE funds, up 25% since last year, has reached all time highs with over 2000 PE funds in fundraising mode, seeking (USD) $744 billion of equity capital. Last year, Softbank announced the formation of the biggest VC pool in history; the Vision Fund, a staggeringly large (USD) $92 billion fund, investing no less than (USD) $100 million per deal into promising tech companies. Several indicators: deal multiples, leverage ratios, and the amount of dry powder (uninvested capital) are at historically high levels, and new entrants continue to flood into the market.

The overcapitalised environment that we find ourselves in today is largely a result of heavy quantitative easing (QE) implemented by central banks around the globe attempting to re-stimulate the economy. Since the 2008 GFC, the world, particularly the U.S., has seen roughly ten years of artificially low interest rates and other forms of stimulus. As the low yield environment continues to persevere (NZ Reserve announced this week that they will not be raising the official cash rate (OCR) and intend to keep rates at an expansionary level for a longer period than initially projected), investors have been more willing to move further out the risk curve in the hopes of generating high returns. This excessive optimism and environment of high-risk tolerance likely bolstered the crypto run-up in Dec/Jan.

Risk on vs. risk off

“Risk-on, risk-off” is a classification of market sentiment, where prices are shaped by changes in investor risk appetite. For example, the 2008 global financial crisis was considered a risk-off event, where investors scrambled to de-risk their portfolios by selling existing risky positions (e.g. equities, high yield bonds) and move money to extremely low-risk positions, such as U.S. Treasury bonds or good old cash. In contrast, over the past decade, we’ve observed a risk on environment, whereby, as Marks has described, investors are more likely to invest in high-risk instruments.

Not all asset classes carry the same risk and are traded according to their risk properties depending on the overall perceived risk in the markets. For example, stocks are generally seen as riskier assets than bonds so in the event of a market crisis, will be sold for ‘safer’ assets such as U.S. Treasury bonds or simply cash.

As cryptocurrencies are emerging as their own unique asset class, it is important to consider how crypto may behave in an environment of dramatically shifting risk sentiment. This becomes even more relevant as Howard Marks’ memo suggests that such a shift in risk sentiment (risk off event) may not be too far off the horizon.

Is crypto a risk-on or risk-off trade?

Because we have been in a prolonged bull market for roughly the past decade, the price action of bitcoin has not yet been truly tested. In the face of a serious catalyst that causes a macro sell-off (think subprime mortgage collapse in 2008), how might the price of bitcoin react?

From a risk perspective, there are two ways to look at bitcoin: a highly volatile tech asset (risk on) or an uncorrelated ‘flight-to-safety’ asset (risk off). From the risk-off perspective, there is a strong argument that bitcoin acts as a ‘flight-to-safety’ asset. Bitcoin’s emerging utility as a store of value, boasting certain properties that are favoured over physical gold, has led to Bitcoin’s designation as digital gold. As gold typically performs well in risk-off environments, many believe that bitcoin will also behave as a safe haven asset. The limited data we have suggests that Bitcoin has performed well under past geopolitical chaos and conflict, doubling in price in response to the Greece fiasco 5 years ago. After all, the whole value proposition of bitcoin is its independence from the influence of centralized parties, namely central banks and corrupt governments. In fact, many are confident that the next bitcoin bull run will be catalyzed by a global risk-off event (e.g EU credit crisis, large pension fund collapse etc.)

Although crypto is rapidly maturing as an asset class, the effects of a global risk-off event are just as likely to send crypto prices diving. In liquidity squeezes, a market sell-off has a cascading effect where people generally sell everything in a panic; in 2008 gold lost a lot of market value before showing a strong recovery. Additionally, Bitcoin and the wider crypto asset class is still perceived to be highly risky. Although bitcoin has shown impressive stability over the past couple of months, the asset class is highly volatile relative to traditional asset classes.

Bitcoin is on the precipice of becoming a trusted store of value, but is still inherently a speculative asset and lacks market maturity. Crypto has only existed in a liquidity-driven, bull market, particularly in its more “mature” state. If the environment switches to risk off, I think that it is most probable that crypto will suffer along with everything else. However, the risk-off argument should not be dismissed. As the market ecosystem continues to mature (developed custodial solutions, healthy derivatives markets, approval of an ETF etc.) and cryptoassets become more widely owned, perhaps bitcoin will be able to establish its foothold as a true risk-off asset.

In the News

A recent report from the New Zealand Law Foundation says that the government should support the country’s transition to a blockchain and fintech hub.

A Bitcoin Core bug was detected that would enable rogue miners to perform duplicate transactions and burn block rewards, forcing nodes off the network in the process. Fortunately, the bug, which was around since early 2017, hasn't been exploited.

A Wall Street Journal investigation identified nearly $90 million in suspected criminal proceeds that flowed through intermediaries such as Shapeshift over two years. In the case of Shapeshift, money launderers used the platform to convert bitcoin into the untraceable cryptocurrency Monero.

The stablecoin frenzy continues with Circle joining Gemini and Paxos in announcing their own stablecoin “USDC.” A comprehensive report, on the state of stablecoins was just released by Blockchain.com and Cambridge University and covers 57 identified stablecoins in the crypto ecosystem, 39% of which are live products.

Cofound.it, intended to be a decentralized crowdfunding platform, is calling it quits and redistributing its assets to token holders. As we alluded to previously, token holders have no residual rights to a project’s treasury assets, however, this is likely to become more contentious down the line as we see more token “bankruptcies” assume different shapes and forms. In an honourable fashion, Cofound's plan is to return their net assets to token holders after liquidation. Luckily token holders will not have to stomach too much of a loss; the company still has ~$14 million on the balance sheet, close to what it initially raised in June 2017. This is interesting as Cofound token holders are effectively getting shareholder-like treatment despite ICO legal agreements in their current form not requiring the project to do so. Although this is setting a great precedent, other “ICO unwindings” that are inevitable over the next couple of years are unlikely to be so generous.

Coinbase has made a series of announcement this week. Firstly, they announced that they will be taking submissions for token listings from projects as they start to ramp up the number of tokens they are listing. Despite being ridiculed on Twitter for issuing a google form for such submissions, hopefully, Coinbase will provide feedback for approval/rejection of tokens, ultimately encouraging higher standards from token issuers. Coinbase also introduced a new product which bundles its five core assets into one investable vehicle. Such a product is likely to onboard new users to the crypto space in a low commitment, user-friendly manner.

Baidu, a China-based search engine and web services company has released a whitepaper outlining the Baidu ‘Super Chain’ network system, apparently a more efficient blockchain that performs with a higher degree of hardware utilization.

 

Upcoming Dates

Oct 12 - Blockworks Conference, Auckland

29 December - Deadline for VanEck SolidX ETF (can be extended to final deadline of Feb 27, 2019)

 

As always, thanks for joining - see you next week for Rehashed.

Freddie Archibald

 

View previous issue: Rehashed - #26 "Crypto as Money" Driving Initial Adoption

View next issue: Rehashed #28 Yale Endowment Paves Way for Institutional Allocators


About the author:

Capital markets to crypto convert. From Christchurch →  Boston → New York, Freddie became intrigued by the potential of the digital asset economy after plucking a book on Bitcoin off a New York library bookshelf in 2016. Her parents are thrilled that she is chasing magic money on the internet.

 

Disclaimer:  The above references an opinion and is for informational purposes only. The opinions expressed by the author do not represent the opinion of BitPrime.

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