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Aon Retirement and Investment Blog

Demystifying cryptocurrencies: technology, investment merits and challenges

Introduction to cryptocurrencies
 
Cryptocurrencies are virtual currencies that are created, stored and governed electronically. Bitcoin was set up in early 2009 and was the first digital currency to use cryptography to keep transactions secure and users hidden. It runs on a decentralized network of computers rather than a centralized ledger under the control of a central bank or government. Blockchain is the distributed ledger technology that allows cryptocurrency systems to operate independent of intermediaries or bank networks so users can exchange value directly. There are over 1,500 cryptocurrencies in existence with a market capitalization of ~$400bn as of February 1, 2018. The largest cryptocurrencies are bitcoin and ethereum.

Dozens of cryptocurrency hedge funds have emerged that cater to wealthy individuals and family offices. Most of them employ a simple momentum trading strategy of buying cryptocurrencies and selling them after they appreciate. Some are, however, also using the newly launched futures to go short bitcoin.
We recommend clients not invest at this time because there are too many unquantifiable risks, but the topic is getting so much attention in the mainstream media that, in this blog, we want to provide a handy guide to cryptocurrencies, as well as some context around recent developments.
 
Cryptocurrencies are not just new currencies, but also a new technology – Blockchain
 
Blockchain is an innovative combination of 3 longstanding technologies: a peer-to-peer (P2P) network plus public key infrastructure (PKI) encryption technologies plus the use of a cryptographic hash (used for the consensus algorithm that solves problems in a Blockchain). Most banks steer clear of cryptocurrencies, worried about money laundering or terrorism finance because of the inherent anonymity of the assets. But the banking industry has been very active in pursuing initiatives around the underlying Blockchain technology, which has potential application in areas like payments, clearing and settlement among others. For example, the widespread adoption of Blockchain-based systems, if endorsed by regulators, could facilitate cross border payments between global banks in seconds, compared to days for traditional systems, and at lower cost.
 
The rise of initial coin offerings (ICOs) as a mechanism to raise funds
 
Cryptocurrencies are infringing on some traditional investment banking and venture capital activities. Some cryptocurrency startup companies that historically might have hired a bank to take them public or given up equity to venture capital firms in order to raise money for their operations are instead financing themselves far more efficiently from a broader range of people through initial coin offerings (ICOs). ICOs are similar to crowdfunding and initial public offerings (IPOs). Blockchain technology is used to issue two types of new cryptographically secure “tokens” or “coins”: (i) a utility token, which is similar to a crowd sale of a discount coupon for the purchase of an entity’s future goods or services; and (ii) a security token, which is somewhat similar to selling shares. Once issued, these coins are traded on cryptocurrency exchanges around the world. Such initial coin offerings (ICOs) raised nearly $4 billion in 2017 capitalizing on a gold-rush mentality around cryptocurrencies. Almost 50% of last year’s ICOs, however, have already failed, highlighting fraud risks and prompting increased regulatory scrutiny. The U.S. SEC has issued a warning against ICOs and China and South Korea have banned them.
 
Fraud and hacking remain worrying aspects of cryptocurrencies
 
Cryptocurrencies have historically been beset by frauds, with ICOs being just one example, and their anonymity complicates governments trying to track the people behind transactions. Proponents of digital currencies point to surveys that suggest the share of illegal transactions had dropped to 20% in 2016 and has continued to fall since as authorities around the world have started clamping down on dark web sites and demanding tax information from companies that support cryptocurrencies.
 
In addition to fraud, there is also the threat of cyberattacks due to the digital nature of cryptocurrencies. One way to invest is through a cryptocurrency exchange, an online trading platform, where you can buy, sell or exchange cryptocurrencies for other currencies. Cryptocurrency exchanges act like traditional exchanges, matching buyers and sellers for a transaction fee and require that participants register and go through a series of verification processes to authenticate their identity. They are, however, fairly easy for hackers to infiltrate and expose customers to potential theft and irrevocable losses. There have already been two large hacks so far this year, including $530mm stolen from Japan’s Coincheck and another $170mm from Italy’s BitGrail.
 
Cryptocurrencies have exhibited boom and bust tendencies that are showing no signs of diminishing
 
Cryptocurrencies are the most watched market since dot-com stocks of the 1990s. Bitcoin’s nearly 60-fold increase during the 2015-2017 period was extraordinary and outshone virtually every conventional investment. In 2017 alone, it rose more than 13-fold and an index of around 17 cryptocurrency hedge funds from data provider Hedge Fund Research rose almost 3,000% on various bets associated with digital currencies. Most market participants will, however, agree that cryptocurrencies cannot be reliably valued and moves are exaggerated because of limited liquidity, rampant speculation and market manipulation. 

The past 5 years have been punctuated by several massive sell-offs in cryptocurrencies of at least 30% and cryptocurrency skeptics often cite the extreme volatility relative to core markets as a reason to avoid investing. Bitcoin’s realized volatility over the past year, for example, has been about 10 times that of equities or commodities and about 15 times that of the average currency.

Major digital currencies dropped about 70% from their December 2017 record highs before recovering somewhat in February in a stark reminder of the degree to which they remain a highly illiquid and volatile investment. 

Some analysts have suggested that the recent sell-off may have something to do with the introduction of bitcoin futures late last year, as well as the increase in regulatory scrutiny.
 
The launch of Bitcoin Futures viewed as a big step toward legitimacy
 
In December 2017, two established/ major U.S. exchanges, the CME and CBOE Global Markets, launched bitcoin futures contracts on the back of strong interest globally. Nasdaq Inc. is still considering entering the digital currency futures competition. Derivatives help increase liquidity and improve markets for an asset category by allowing investors to bet on ups and downs. But the assumption that opening a path for bitcoin to institutional buyers would increase the appeal and accelerate the momentum trade in cryptocurrencies has not materialized.
The debut of bitcoin futures had also been expected to lead to the launch of ETFs based on the cryptocurrency. ETF issuers, however, have been withdrawing filings for bitcoin funds at the request of the U.S. Securities and Exchange Commission (SEC), which has cited concerns on lack of regulation and liquidity of the underlying products.
 
Regulators across the world are stepping in
 
Experts have warned that if cryptocurrency use continues to expand at a rapid pace, the industry will face increasing regulatory scrutiny. In fact, some believe cryptocurrencies have significant tail risk that could come in the form of a regulatory ban. Regulators are concerned about money laundering and investor protection as cryptocurrency payments are irreversible. To date, there has been little global coordination on cryptocurrency regulation, but many security regulators have started to set ground rules. In the U.S., we have a fractured regulatory approach to digital currencies across agencies, demonstrating the challenge of defining the asset class. While cryptocurrencies remain largely unregulated, the SEC and the CFTC have issued regulatory orders on the basis that cryptocurrencies fall into the categories of securities and commodities. European regulators have taken actions similar to their U.S. counterparts. In Asia, where there has been strong interest in cryptocurrencies, Japan has embraced digital currencies, creating regulations to legitimize trading. China, however, has recently banned ICOs and commercial exchanges.

Conclusion
 
Cryptocurrencies were initially viewed as havens for illicit activity, but are pushing further into the investment world. While there are few cryptocurrency funds managed by credible investors that have developed a more sustainable strategy outside of pure market timing, there will, unarguably, be fortunes made and lost. Whether there is a long-term opportunity to create an institutionalized digital asset manager or whether digital currencies will prove the biggest bubble of our lifetimes, it is likely that some of the underlying technologies will become very valuable.
 
Zornitza D. Taleva is a Senior Consultant in Aon Hewitt’s Global Investment Management group and is based in New York.

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