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In the quest for an enhanced portfolio return, investment management firms have been exploring newer and hitherto non-conventional investment avenues in recent years.
With an aggressive shift away from a passive indexed-based investment strategy to actively managed strategies – more so focus on emerging markets, alternatives and others (real-estate, commodities and private equity) – investment managers are now left with few unexplored investment territories.
Propelled with a sudden growth and promising an ultra-attractive return profile, the popularity of cryptocurrency (Bitcoin, Ether, XRP, Dash, Litecoin and other similar virtual currency genre) as an investment product has grown manifold in recent times. Some of the available analysis indicates that cryptocurrency has emerged as the world’s best performing asset class[i] since its inception in 2009 – with an annualized return astronomically exceeding its traditional peers. There is another market estimate suggesting that the entire cryptocurrency market will continue to grow rapidly and reach a total value of $1 trillion by end of 2018 (from currently estimated value of $350 – 400 billion).
Of course, the above figure appears quite miniscule in absolute terms if we compare it with the total global Asset under Management (AUM) size of $84.9 trillion in 2016. Likewise, if we compare the global daily trading volume of cryptocurrencies – estimated to be around $50 billion, it really pales in comparison to average trading volume in foreign exchange (FX) markets averaging $5.1 trillion[ii]. However, looking from the other side, analysis suggests that the cryptocurrency market is now hitting the same level of daily volume as the NYSE[iii]. Though, this comparison might appear a bit inaccurate, considering that the cryptocurrency market being more similar to the FX market than securities market.
Market debate and cacophony
The debate on cryptocurrency as an investment product option has been raging on for quite a long time now. Amidst the continued cacophony, it is difficult to determine as which side dominates the discourse – crypto-enthusiasts going the extra length on its (hyped) virtues and growth potential at one end and conservatives anticipating that crypto-investment would come to a bad ending sometime in the not too distant future. As recent as early May 2018, the billionaire investor Warren Buffet observed a bleak future for cryptocurrency as an investment idea, highlighting “bitcoin is an asset that produces nothing”. In a similar vein, Jamie Dimon, Chairman and CEO J.P. Morgan Chase criticized virtual currency investors last year:
“If you’re stupid enough to buy it, you’ll pay the price for it one day“.
Of course, he has subsequently reversed his above stance in recent months.
At present, cryptocurrency as a digital token is purchased or traded mostly with speculative motives. It is yet to gain wider acceptance for commercial usage to make payment against purchase of goods or services. Also, while price information is available across different trading platforms, a transparent basis of price formation and its reliability does not inspire much confidence. As an investment asset, it has so far exhibited extremely high risk and high return characteristics, with extreme volatility and speculative swings as a hallmark.
Behind the haze
In absence of a robust and cohesive regulatory supervision, cryptocurrency markets are grappling with the issues of repeated fraud, cyber-theft, market manipulation, lack of transparency and increased volatility since its inception. Thus, it raises the fundamental question about the reliability of cryptocurrency as a safe and stable long-term investment asset. It is in this context of extreme risks associated in dealing with virtual currencies that we have witnessed some of central banks (e.g. China and India) choosing to ban cryptocurrency in their jurisdictions in the recent past.
Against this background, two recent regulatory developments have become quite significant in the context of investment in cryptocurrencies:
- Firstly, CFTC issued a Staff Advisory with respect to virtual currency derivative product listings on 21st May 18[iv]. It highlighted CFTC’s priorities and expectations in its review of new virtual currency derivatives[v] to be listed on a DCM/SEF or to be cleared by a derivatives DCO. As a part of it, it highlighted focus areas that require closer attention for listing of a new virtual currency derivatives contract, Enhanced market surveillance, DCO risk management and large trader reporting being some of these emphasized areas.
- Secondly, MAS Singapore in a press release of 24th May 18[vi] has warned eight digital token exchanges in Singapore not to facilitate trading in digital tokens that are securities or futures contract without MAS authorization. It also warned an Initial Coin Offering (ICO) issuer to stop the offering of its digital tokens in Singapore, which was made without a MAS-registered prospectus per Securities and Futures Act requirements.
Both the regulatory actions are aimed to provide more clarity around the clouded cryptocurrency world. It also highlights the current regulatory stance of keeping pace with emerging market innovation in a slightly distanced manner, yet closely looking at associated risks which might affect users, traders and investment communities.
Growing investor interest
If ongoing trends of crypto markets provide any plausible indication, investors have been appearing inexplicably obsessed with virtual currencies. It is not as if they are completely ignoring the fundamental risk discretions, rather it could be a calculated risk to gain exposure in an unexplored investment product, anticipating an exotic return profile.
This particular sentiment of investor community possibly gets reflected in CME’s notification to CFTC as well. While launching bitcoin future contract in Dec 2017, CME highlighted about increased level of customers’ interest across market segments and geographies (covering buy-side clients, commercial participants, potential market makers and ETF providers). Exploiting this particular level of interest, few start-ups and specialized firms have now come-up, who provide services to institutional investors to acquire and manage crypto-assets being traded on different trading platforms.
Need for robust global regulation
It is important to highlight that regulators in different jurisdictions have been adopting more of a laissez faire approach so far and appear in no hurry to regulate cryptocurrencies, unless it breaches any existing law, violates their regulatory authority or affects investor protection. Behind such a regulatory stance, there could be other reasons as well. It might not be driven solely by an avowed mission of promoting innovation and may be an outcome of existing compulsions – e.g. recognizing the supervisory gap in terms of technological advancements or inadequate product expertise or absence of coordination amongst global regulators.
Even if we do not give much weightage to market transparency and price volatility issues for a moment, there are persisting concerns regarding potential abuse of cryptocurrency involving money-laundering or illegal financing. Given the global ambit of cryptocurrency, a comprehensive and well-coordinated global regulatory framework and its roadmap becomes a critical requisite for a healthy growth of the market. However, as per the recent FSB pronouncement[vii], it does not have any immediate plan to regulate cryptocurrencies – reckoning it a tiny sector (less than 1 percent of global GDP) with no significant risk posed to global financial stability at present.
Looking forward: Evolution of mature market ecosystem
So, the fundamental question arises – what do we see as the next phase evolution of the market? For cryptocurrency to truly emerge as a reliable and safe investment asset, functioning of a stable, transparent and credible market ecosystem becomes a crucial first step. Even if a comprehensive regulatory framework is not expected in near future, a fundamental shift in operating principles of unregulated platforms becomes a vital necessity to instill much required market confidence. Complementing it, the evolution of a resilient market infrastructure, enabling operating protocols, mature processes and data standards would go a long way – something similar achieved in securities markets in its growth journey.
A fundamental dimension of market ecosystem will also hinge on design of market information architecture – as how transparently and efficiently information is shared amongst investors, who analyzes and interprets it for identifying a viable investment opportunity. More importantly, such investment decision is executed with least deviation and without incurring significant transaction and holding costs.
An indicative (and non-exhaustive) list of critical requisites for a cryptocurrency market ecosystem and underlying information construct is provided below:
- A consistent global classification of cryptocurrency as an investment product – whether currency, property, capital asset or commodity
- Transparency and reliability of price data, benchmark references and other market dynamics vitals – market size, demand, volume, volatility, spread, liquidity etc.
- Reliable market data basis for market / price risk models
- Counterparty and credit risks involved as a part of investment/trading chain
- Treatment in terms of investment transparency, suitability/appropriateness, concentration requirements applicable for buy-side firms as per existing regulations
- Fool-proof safekeeping and custodial access arrangement
- Treatment of investment gains and taxation basis
- Performance analysis and reference benchmarks
Without much emphasis, a credible and mature market ecosystem will help investors to make a realistic assessment of investment decision fundamentals – e.g. inherent investment characteristics and its outlook, intrinsic value potential, nature of investment (purely speculative or fundamental investment), associated risk profiling and safeguards. Till the time such evolution of cryptocurrency market is conclusively realized, it will remain to struggle to come out of its checkered shadow.
[ii] Source: BIS Triennial Central Bank Survey of April 2016
[v] It could be recalled that on 1 Dec, 2017, the Chicago Mercantile Exchange Inc. (CME) and the CBOE Futures Exchange (CFE) self-certified new contracts for bitcoin futures products and the Cantor Exchange self-certified a new contract for bitcoin binary options – as per applicable CFTC self-certification norms.
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