One of our favorite Reagan quotes reveals government’s view of the economy: “If it moves, tax it. If it keeps moving, regulate it. And if it stops moving, subsidize it.” While we don’t doubt that we may see government subsidies for cryptocurrency operators in our lifetime—particularly if deemed “critical green energy infrastructure” as discussed below—that’s not on the near-term horizon.
At present, however, we are confronting the other two horsemen of the productivity apocalypse for cybercurrency: Congress is looking to tax the industry to support a nearly trillion-dollar infrastructure bill; and the SEC has clearly stated its intent to impose substantial regulation. Add the industry’s current woes on the “E” front of ESG and other headwinds, and it may be time to pay closer attention to the laggards when it comes to estimating future value and conducting due diligence.
The high-profile inclusion of enhanced cryptocurrency tax collection in the US Senate’s recent trillion-dollar infrastructure bill is perhaps most notable for signaling the arrival of Bitcoin and its ilk as an asset class. While already taxed like other property, a drumbeat of interest from policymakers in securing this revenue, as well as the industry’s increasing organization behind lobbying efforts to educate and influence Washington’s efforts, can only be seen as the maturing of an industry ironically built on decentralization and freedom from government involvement. Last week the notoriously volatile asset class again topped two trillion dollars in total value, while investment in crypto infrastructure—standalone operations like exchange companies Coinbase and FTX, and in-house efforts housed by the likes of payment companies from PayPal to Visa—could easily double that estimate. Once solely a lark of libertarians and true believers, crypto has increasingly shown an institutional side: institutions represent over 60 percent of trading volume; perhaps a dozen crypto-ETFs await SEC approval; traditional financial institutions are wading in, from Goldman Sachs trading Bitcoin futures to Fidelity providing a range of custodial services to BNY Mellon, State Street and the other banks creating their own cryptocurrency trading venue to compete with larger incumbents.
Growing Regulatory Scrutiny Amidst Growing Pains
With such size and momentum, it is no surprise that the crypto market is attracting increased regulatory attention. New Securities and Exchange Commission chief Gary Gensler riled markets in recent weeks by announcing a regulatory focus on the “Wild West” of cryptocurrencies, seeking at a minimum to weed out significant levels of “fraud, scams and abuse.” The SEC has already tackled Initial Coin Offerings (ICOs) as securities requiring registration, but Gensler—who taught a class at MIT on blockchain and money—shows signs of expanding the regulatory scope to include supervision of exchanges and other crypto activities. The industry has certainly earned this regulatory spotlight, with high-profile stumbles like this month’s $600 million heist on the Poly Network—notable not just for eclipsing the largest bank robbery in history, but for the perpetrator (dubbed “Mr. White Hat” for self-proclaimed “ethical hacking” motivated not by money but to reveal vulnerabilities) voluntarily returning the stash.
Earlier this year one of the world’s largest cryptocurrency exchanges, Binance, saw its platform freeze during a sharp drop in crypto prices, leading to investor outrage reminiscent of that faced by free trading app Robinhood; with no headquarters or regulatory oversight, however, even lawyers hired by groups of Binance victims have been reduced to sending e-mails to anonymous “help desk” addresses. Yet such growing pains spur innovation and investment, as traditional financial institutions feel pressure from clients to help them wade safely into the swamp: Over $1 billion in venture funds has been invested this year in cryptosecurity startups, which help secure digital wallets and transactions involving cryptocurrency—ten times 2020 amounts and more than was invested in all earlier years combined.
Managing Extreme Volatility
The Binance story highlights yet another headwind for crypto as an institutionally acceptable class: extreme volatility. While a growing chorus promotes Bitcoin as an inflation hedge during a time when sovereign governments are printing fiat currencies with unprecedented abandon, there are those who compellingly ask whether something can be considered a sound store of value when a Tweet from a single individual (even if it is Elon Musk) can send the asset into rapid decline. To be sure, some investors value the volatility, if nothing else. Luke Ellis, CEO of the world’s largest listed hedge fund manager Man Group in an interview with the Financial Times encapsulated the irony that a significant portion of crypto trading is done by players who doubt its ultimate utility: “If you look at cryptocurrencies as a whole, it is a pure trading instrument. There is no inherent worth in it whatsoever. It is a tulip bulb.” But crypto’s wild price swings will necessarily limit its institutional market. Perhaps unsurprisingly, the Basel Committee on Bank Supervision has proposed that bank exposure to cryptocurrencies be limited to equity capital rather than debt. And The Economist this month put forward a sobering piece —titled “What if Bitcoin went to zero”—in which it outlined how leverage in crypto trading, interconnectivity with the traditional financial system through US-dollar pegged stablecoins, and broader impact on investor sentiment could lead from a Bitcoin route to full-blown systemic risk.
Exasperation among crypto promoters over the lack of technical understanding exhibited by Senators as they imposed an overly broad, probably unworkable, and almost certainly innovation-stifling definition of “brokers” in the infrastructure bill may be assuaged as they engage Professor Gensler and his fellow, more informed regulatory colleagues. As we went to press this month, Treasury indicated that it would fix the broker definition in implementing legislation. (Drooling over what it estimates as a $28 billion windfall from tightening taxation of crypto, the Biden administration broadly defined a broker as any person who “for consideration” regularly provides “any service effectuating transfers of digital assets on behalf of another person”, which the crypto industry argues is way too broad and would simply drive the industry offshore.) On the other hand, as technical expertise and attention in government expand and combine, improved competence could also present a competitive challenge to private cryptocurrencies, as Central Bank Digital Currencies (CBDCs) emerge as a regulator-friendly alternative, particularly for many institutional investors yet to jump on the bandwagon. Pointing to the Boston Fed’s collaboration since last year with MIT, which is expected to product two policy papers next month, Fed Chairman Jay Powell in July told the House Financial Services Committee: “You wouldn’t need stablecoins; you wouldn’t need cryptocurrencies if you had a digital US currency. I think that’s one of the stronger arguments in its favor.” Government competence and competition could undermine first mover advantage enjoyed by the likes of Bitcoin, which to date has underpinned the strategy of investors like hedge fund manager Paul Tudor Jones to “own the fastest horse” in the crypto race.
Energy Use and ESG Mandates
Another challenge to the asset class comes from a very different direction: the issue of energy intensity of crypto-mining operations going against government decarbonization efforts and private Environmental Social Governance (ESG) mandates. The Musk Tweet-inspired Bitcoin tumble came as he rescinded the plan for Tesla to accept the environmentally unfriendly coin as payment for its popular electric vehicles. More critically, energy use was a primary concern in Beijing’s crackdown on crypto-mining earlier this year; deriving about 60 percent of its energy from dirty coal, China had accounted for roughly two-thirds of Bitcoin’s electricity consumption—which at its upper limit (500TWh annually) exceeded that consumed by all of the UK (300TWh). A moderately sized professional mining operation, with walls of computers pushing 150 degrees Fahrenheit, can easily require hundreds of megawatts of power—equivalent to hundreds of thousands of homes or a medium-sized metropolitan downtown area at peak demand.
Securing that kind of power supply in a friendly and stable regulatory environment has become increasingly challenging, while Tesla’s position is likely to resonate with other ESG-focused institutional investors. Innovators in the industry are working to address this criticism, whether as a branding issue (soon-to-be-public company TeraWulf touts its zero-carbon sustainable nuclear-hydro-solar powered mining platform) or in a more novel argument that, counterintuitively, crypto mining in fact can act as a store of value by using periodic excess renewable energy that would otherwise be dumped, in effect further subsidizing renewable production. For the short term, however, energy intensity could represent a significant drag on the asset class both in operations and reputation.
How Strong are the Legs of Decentralized Finance?
Despite these headwinds—massive cyber heists, fraud, tax dragnets, regulatory scrutiny, volatility, potential state-level competition, ESG concerns—consensus is starting to form that the industry and asset class has legs. In fact, the industry’s resilience in the face of major blows like US regulatory opposition or China’s crackdown has been pointed to as a sign of its maturity, flexibility, and durability. Describing what might be considered a bloated field, Gensler cited 77 separate tokens worth at least $1 billion each (total issued value) and 1,600 valued at more than $1 million, while a recent survey of 100 hedge fund CFOs found that they expect to hold an average 7.2 percent of their assets in crypto within five years, equating to $312 billion if replicated across the hedge fund industry.
PwC estimates in a 2021 report that more than fifth of traditional hedge funds are already investing in digital assets, on top of 150 to 200 active crypto-focused hedge funds. Some investment observers see plenty of opportunity coming on the short side, especially considering that, despite headwinds, venture capital (VC) continues to plow into crypto: as of July, the Financial Times quotes Pitchbook data showing that VCs had invested a record $7.3 billion in nearly 670 crypto startups year-to-date, already eclipsing the number of deals and total value invested last year. VCs exiting into frothy public markets, in particular the SPAC boom, will likely present myriad shorting opportunities.
The current state of crypto is routinely compared to early internet years and their inflection point of the circa-2000 dot-com collapse; when so much uncertainty about the potential of a new technology combines with regulatory structures being caught flat-footed and hot capital pouring in, there will be consolidation. So how to find the Pets.com or Global Crossing of the crypto world? We are still mulling The Economist’s thought experiment on the “collapse to zero” model—where a Bitcoin rout takes down the global financial system. In the meantime, intriguing advice for those in search of short opportunities focuses on finding those market players—currencies or broader crypto-infrastructure providers and decentralized finance (DeFi) endeavors—that lack an organizing principle or unique selling proposal. Specifically, according to Michael Sonnenshein, CEO at early adopter Grayscale Investments, “It’s important for investors to scrutinize use cases and whether the asset is viable and has the potential to gain real world traction by solving a real-world problem versus a solution in search of a problem that may not exist.”
Mark Andreessen, co-founder of storied VC firm Andreessen Horowitz, who wrote in April 2020 wondering if all our “stuff” (technology that solves real problems) was, has ironically seen some of his most successful investments recently in crypto—which Business Insider contentiously argues is “a technology that has no use case aside from speculation and crime.” While it’s nerve-wracking in this brave new world to go up against the meme-stock army and short dogecoin—the Shiba Inu-inspired “joke” payment system designed to poke fun at the wild speculation in cryptocurrencies—dogecoin and its ilk’s popularity appear to be based solely on tribalism, so are unlikely to survive the increased costs and scrutiny associated with the impending regulatory maturation of the class.
Take ether-settled, Ethereum-hosted, lawyer-free smart contracts as solving a real-world problem; if a coin or other crypto-company doesn’t present such a value proposition or have first-mover advantage and institutional support like Bitcoin, from a due diligence perspective it’s probably worth asking whether it will weather the storm.
Or the tide. Warren Buffett, who described Bitcoin as “rat poison squared” and coined the phrase “Only when the tide goes out do you see who’s been swimming naked,” vowed that Berkshire Hathaway would never have a position (long or short) in Bitcoin but joked that they might “short suitcases because the money that was taken [illegally] from one country to another” was now moving via Bitcoin. Conversely, he called blockchain ingenious and useful, and Berkshire in June invested $500 million in Brazilian digital bank Nubank, which offers its roughly 40 million customers exposure to Bitcoin and recently announced it plans to list on Nasdaq this year. We’re guessing Nubank does useful things too.