Gold has
historically been recognized as the premier hedge against market volatility. As
a store of value, the commodity boasts global recognition – an entire industry
has been formed to extract, provide services for, and invest in gold. The next
generation of gold’s evolution is here today and being powered by a blockchain
revolution just starting to climb the J-curve.
How and
Why Retail Investors Participate in Gold Today
Gold has
long been recognized as a premier hedging instrument against market volatility.
Comparing LBMA benchmark prices for gold and the gold ETF (ticker GLD) with daily
price returns of the S&P 500 over the last 20 years demonstrates the consistently
uncorrelated nature of gold’s performance:
This
performance has not required additional position-specific risk, as gold has
been able to somewhat match the overall volatility of the S&P 500:
Examining
the daily results, I observed how gold performed on days where the S&P 500
was in the red. Based on the last ~23 years of data, gold outperformed the
S&P 500 greater than 75% of the time.
Participation
in the value of this hedge, however, is not equal between institutional and
retail investors. Today’s gold investment options for high net worth (HNW) and
retail investors are starkly different, which contributes to unequal asset
performance over time. HNW investors enjoy the luxuries of being able to afford
custody fees for secure banks (such as those popular in Switzerland), discuss
investment options with brokers that will not charge exorbitant fees (as a
percentage of the total investment), and obtain liquidity without the use of
complex derivative instruments. These abilities enable more direct exposure to
gold’s actual performance over time.
Since
November 2004, GLD was introduced as an efficient option for retail investors.
While GLD enjoys benefits of being easy to access, hard to steal, live pricing,
and the ability to garner leverage, many factors reveal inefficiencies in this
ETF structure. Retail investors are not able to redeem GLD certificates for
actual gold (this option is only available for investors with greater than
~$1,000,000 worth of shares), suffer from counterparty risk related to banks
and sub-trustees of the physical supply, and experience performance drag as a
result of management fees. Technically, even GLD’s live pricing is based on the
trading of shares rather than that of actual gold.
Further,
these inefficiencies are illustrated in actual performance data (daily
returns). Observing trading performance since the introduction of the GLD ETF,
the S&P 500 has been negative 45% of the time. Of these days, the LBMA gold
index performed positive relative to the S&P on 73% of days while GLD was
positive only 50% of the time. Moreover, average performance during those
negative days were better for gold (almost 1% total) relative to GLD.
Looking at a
more recent trade, we observe the latest performance of GLD and Gold during the
most recent S&P 500 drawdown between 5/3/19 and 6/3/19. As a quick recap,
many attribute this downturn to trade tensions between the US and China. Over
that period, there were 7 days where gold and GLD were split between being positive
and negative. The performance for GLD was ~25% greater than that of Gold during
the same period. Although a positive for this specific period, the performance
differential demonstrates that the true value of gold is not accurately reflected,
especially in quick moving markets.
While
certainly an improvement over legacy retail liquidity options for Gold, GLD
will one day be a steppingstone to the more improved, tokenized version of the
commodity. Tokenized gold enables investors to ‘own’ the index in a seamless
manner.
Why
Tokenization is Better
The use of
blockchain to facilitate gold investments is significantly more efficient than
our current system. Most of the questions pertaining to tokenized gold refer to
the actual process of ‘tokenization’.
There are several
competing systems that are just now coming to market. For example, DaVinci
Token works with an LBMA accredited refinery in Switzerland. They have created
a proprietary system where nano-lasers are utilized to engrave ID numbers in QR
code format on each of the gold coins. New systems in the tokenization process
are being created, but the overall idea is that the physical commodity requires
a unique identifier to tie it to the digital version.
The benefits
of the tokenization process are plentiful. Digital gold solves for the security
element of physically owning the commodity and simultaneously the counterparty
risk associated with publicly traded ETFs. Other benefits include the
following:
Access to
premier gold offerings at a fraction of today’s cost of ownership;
The
ability to quickly leverage gold assets either to double down or generate
portfolio liquidity;
Redemption
of tokens for actual gold (most platforms allow you to redeem in 1g units of
gold and receive the physical commodity in a few weeks);
Minimization
of acquisition fees (in some cases it’s $0); and
Real
time, auditable pricing.
Leverage
2.0
Gold has
been the best store of value for as long as investors can remember; however,
the trading strategies and liquidity options with tokenized gold will
revolutionize the way we think about the commodity.
First, the
following are structural improvements to liquidity with the use of blockchain
technology:
Easier
access to loans – Historically, secured lending against gold has required a
robust diligence process. With tokenized gold lending, the market will allow (i)
a smaller dollar value loans due to the reduced marginal cost of lending and
(ii) unify a fragmented market.
Avoid High
Currency Conversion Fees – Today’s fees for currency conversions typically
exceed 5% for situations as simple as a vacation. Tokenized gold could be
exchanged at real market prices for any currency in a frictionless manner.
Currency stablecoins further reduce costs to the consumer.
Access
More Traders – With the global nature of the tokenized asset, GLD is unable to
compete given the difficulty in accessing foreign investors.
Conflict-Free
Gold – As blockchain gets tied to the actual production process, it becomes
easier to trace the history of each bar of gold and the ecological /
humanitarian impact of each mining operation.
Second, with
the improved liquidity, various investment strategies can be built in a customized
fashion.
Leveraged Lending Strategies – Investment funds can achieve better loan performance against an overcollateralized product without the red tape in setting up the appropriate infrastructure to lend against traditional gold. Gold is a liquid asset with no credit risk, adding blockchain-based liquidity creates an ideal secured lending platform for leveraged debt investors.
Investment portfolio adjustments – Get liquidity for more divisible interest in Gold. ETFs must be purchased at an exact share count and coins suffer from other inefficiencies that prevent portfolio optimization.
“Reverse the Hedge” – Gold’s cyclical movements resulting from supply/demand imbalances may also be a drag on portfolios in situations where there is downward pressure on prices. If investors feel an upcoming bear market (e.g., those resulting from an interest rate hike, newfound supply, etc.) for gold prices, leveraging their asset to invest in the market prevents a taxable event of selling one’s gold and arms investors with a valuable portfolio optimization tool.
Summary
The new
generation of gold investors have a lot to be excited about, we can see a
number of these platforms gaining significant interest over the next few
months. For those excited about Bitcoin, tokenized gold presents institutions
with a better form of something they already understand and a real use case.
Finally, tokenized gold offers another path for retail investors to minimize
gaps in their investment capabilities – i.e., blockchain can enable more and
better access to the most widely used hedging commodity in the world.
The early stage of the cryptocurrency lending market has dramatically changed in the short time since the birth of the industry. These changes were driven by a combination of digital asset volatility, increased competition, an influx of financial products, and correlation to traditional market events. Investors and lenders are still struggling to find equilibrium pricing on interest rates against the backdrop of high price volatility and reduced demand during the protracted cryptocurrency bear market. Below, we review traditional loan pricing fundamentals and extrapolate what lessons can be applied to this dynamic, emerging asset class.
Loan
Fundamentals Review1
Pricing
Loans are typically priced as
a percentage of par value (per $1,000 in most cases). Discounts reflect
percentages less than 100% and premiums reflect percentages greater than 100%.
Discounts to par indicate that the buyer of the security requires some level of
return when they are repaid their principal balance. For example, a buyer of a loan
may pay 99% of par ($990) to get $1,000 at some point in the future when they
are repaid by the borrower. This specific structure would reflect a return of
1% ($1,000 / $990 – 1) over that period. If the yield of 1% is generally
attractive for this type of loan, it would be considered the yield to maturity;
i.e., the expected rate of return. If the rate is too low, lenders will not
underwrite the loan. If the rate is too high, competition will quickly bring
prices down.
The yield to maturity (YTM) is
considered the ‘discount rate’ for loans. Generally speaking, the lower the YTM,
the lower the risk. The ‘risk free rate’ represents a theoretical return with
zero credit risk. In the US, US Treasury rates are typically used as a proxy2. The difference in the YTM for
other assets (assuming securities other than Treasuries have greater than 0
risk) above the risk-free rate is considered the credit spread (i.e., credit
spread = YTM – risk free rate).
Coupon
Rate
Often confused with the YTM,
the stated coupon rate is the interest income paid to the lender by the borrower.
The payment can be made in multiple forms:
Cash – Reflected as a periodic payment paid as
a percentage of the total principal value (i.e., the loan amount) to the
lender. For example, an 8% coupon rate on a loan of $1,000 would reflect an $80
payment.
Payment-in-Kind – The payment is instead
reflected as compounded interest and paid lump-sum on exit. In the example
above, the $80 would equal $1,080 total balance due to the investor. These
structures typically demand a premium to a cash payment structure given they
are utilized by issuers with imminent cash flow needs.
Interest Only – Only interest is paid to the
lender until the entire principal balance is paid at exit (referred to as a
bullet payment).
Principal + Interest – Each payment to the
lender includes a portion of interest and a portion of the lent capital. This
reduces the burden of paying a lump-sum payment at exit. This structure is
typical with real estate mortgages.
Variable versus Fixed – Interest rates can
fluctuate (floating-rate securities are typically used to hedge inflation risk)
or be paid in the form of a fixed amount. Historically, the interest rate on
these loans are expressed as a rate on top of a floating instrument (e.g.,
LIBOR, TIPs, etc.).
Hybrid – Each of these instruments above may be
combined for exotic instruments to fit various needs.
Origination
Fees
Fees paid to the lender (or
the originator of the deal, I will keep it simple for this post and assume they
are the same) for work performed to consummate the deal. The funds go to pay
the lender for time spent preparing documents, marketing the loan, covering
expenses for legal and accounting, etc. In complex deals, the origination fees
are greater.
Origination fees can be paid
in multiple forms. They can be paid up front, as a portion of the notional balance
(e.g., original issue discounts), or built into some exit fee (usually as a
multiple of the amount).
A portion of the interest is
paid to a servicer. A servicer performs administrative duties (such as recordkeeping,
recording the ledger, etc.) related to the loan. More complex instruments
generally require a greater fee. Larger banks may have deals where a lender
teams up with a servicer and structures as a revenue-share or a JV model.
Prepayment
Penalty
A penalty imposed by the
lender in case there an is voluntary early prepayment of a loan. The fees are
assessed on exit; for example, a 1% prepayment fee would mean the lender would
need to return 101% of the principal balance if paid before the stated
maturity. Exit fees can also be assessed, where a premium or discount is
reflected in the final payment. The purpose of these structures is to protect
the lender against early repayments, which negatively impacts their ability to
find a replacement borrower at the same (or greater) interest rate.
Credit
Ratings
A financial scoring system for
issuers that provide standardization for risk analysis. S&P’s rating
system, for example, goes from AAA down to C. Indices can be measures for loans
with the same credit rating to get an average yield. Some of these indices can
be observed on the St. Louis FRED system with daily reported yields and spreads3.
The ratings typically reflect the probability of issuer default, although more
recent models with the advent of P2P alternative lending may reflect a greater
breadth of data points (although it is questionable as to which data sets
contain statistically significant data with meaningful predictive power).
The intent of credit ratings
is to standardize risk and allow for comparability. Typically, both the issuer
and the actual loan receive a credit rating. No blockchain-based loan (nor
issuer) currently has a credit rating associated with it.
Primary
versus Secondary Markets
Primary markets involve the
issuance of new securities to investors. Secondary markets involve the purchase
and sale of securities after the borrower has sold its shares in primary
markets. Secondary markets may reflect updated prices as the YTM changes based
on a company’s credit rating over time, macroeconomic changes (such as a
liquidity crunch), or demand for a particular issue. Primary market dealers may
receive favorable pricing (up to a 50% discount in many cases) for providing
liquidity.
Loan-to-Value
Ratio
The Loan-to-Value ratio is expressed
as the ration of the loan’s principal amount to the value of the firm or asset.
For example, a company that takes out a loan of $500 and is worth $1,000 has an
LTV of 50.0%. The inverse of the LTV (1 / 50% = 2x) represents the asset
coverage ratio.
As the LTV increases, it
becomes riskier for the lender and they may compensate by increasing the
interest rate or adjusting the loan structure to acquire a greater rate of
return.
Loan
Risk
There are four primary risk
factors to consider as a lender:
Interest Rate Risk – Loan prices are inversely
related to market yields (the coupon rate certainly plays a part in determining
price, but the coupon rate is distinct from a YTM). The impact of a shift in
rate of return expectations are measured by factors such as duration and
convexity (which estimate the magnitude of the change given a change in interest
rate expectations). Also, when interest rates decline, lenders worry about the
impact of prepayments on their portfolio.
Inflation Risk – The risk that the interest you
earn as a lender is less valuable considering future inflation. This risk
factor helps us understand why a rate of return is expected even on ‘risk free
assets’ such as T-Bills.
Market Risk – Represents the systematic risk of
the loan market (e.g., a liquidity crunch).
Credit Risk – An asset specific measure,
standardized risk buckets are estimated by credit rating agencies. This factor is
more commonly referred to as default risk.
In order to deal with the risk
factors above, derivative contracts have become popular. These contracts are
either embedded within loan structures (e.g., calls/puts) or traded in the form
of OTC products (e.g., interest rate swaps or forward contracts). Borrowers
utilize these contracts to either create more predictable cash flows (e.g.,
swapping floating for fixed payments) or speculating on future rates (e.g.,
swapping fixed for floating payments).
Loan
Valuation Methods
Loan valuation techniques are primarily based on cash flow analysis. Given that the structure of the cash flows is predetermined based on the credit agreement (as opposed to estimated in an equity valuation), modeling the cash flows is a relatively straightforward exercise. The key input used to value these loans is the discount rate (i.e., the yield to maturity). The YTM can be extrapolated based on the factors explained above; however, the general build-up to a discount rate will look like (not intended to be drawn to scale) the image below. Like the capital asset pricing model used to calculate the cost of equity, the cost of debt is built using the risk-free rate as the base. On top of that, layers of risk are added based on various, mutually-exclusive risk factors. In the chart below, the YTM is comprised of the risk-free rate, a premium for expected inflation, and an asset-specific risk factor. The combination of the tenor and the asset-specific risk is the ‘credit spread’.
The rates of return for bonds
by credit rating are posted daily on the St. Louis Federal Reserve database3.
In more private transactions, information on comparable yields are typically
harder to acquire given investors benefit from the information asymmetry.
However, some companies – such as SPP Capital – post average rates for recent
transactions4. Either way, increasing yields (referred to as
‘widening’) point to lower credit quality and decreasing yields (referred to as
‘tightening’) point to improving credit quality.
The YTM deciphered for each asset represents an array of risk factors; however, the primary concern for any lender is default risk – i.e., 100% loss of capital.
Extrapolation
to Blockchain-Based Loans
The initial model for
blockchain-based loans has been focused on providing liquidity for popular
cryptocurrency assets such as Bitcoin, Ether, and Litecoin. This conversation
will focus on loan products targeted at these assets; however, I note the
expansive universe of securitized assets will soon hit the industry. In
determining an appropriate yield for blockchain-based loans, it is important
consider a few factors:
First, this is a completely
new industry. Granted that Bitcoin has been around for more than 10 years, the
initial retail ‘splash’ happened late 2017. A true understand of market risk
(from the standpoint of traditional financial theories) has not been developed.
Today’s popular blockchain-based loans are effectively margin loans, the same as those you would have access to in a typical brokerage account5. Interest rates are developed based on consideration of trading liquidity (which is exponentially deeper than cryptocurrency markets), algorithmic / high-frequency trading with sophisticated electronic networks, operating expense margins, and an appropriate margin to the cost of servicing the loan. Given that price volatilities today on crypto assets are 3-4x broad equity indices, the need for a lender to have high-quality OTC and exchange relationships with sophisticated trading functions are a priori.
Another consideration involves estimating supply & demand for various security structures, a process typically known as price discovery (i.e., the notorious invisible hand of the market). The market has evolved so quickly that APRs have declined from greater than 20% at the top of the market to below 10% within a year. This decline is the result of greater competition in the space, low interest rate pricing strategies, and further development of portfolio surveillance and monitoring systems. At some point in the future, capital pricing may begin to reflect equilibrium. Until then, pricing competition between firms may reflect hyper competitive behavior as the market continues to discover itself.
There is also a focus on ‘paying down’ points at origination. In real estate mortgage loan structures, the borrower usually has the option to pay an additional amount to reduce the interest rate on their loan. On average, paying the lender approximately 1.0% of the notional balance of the loan will reduce the interest rate by 0.25%. For crypto loans, there are different methods for a borrower to reduce their interest rate such as the traditional ‘paying down’ points method, membership / token purchase staking, or through increasing AUM on a company’s platform.
The lack of a securitization and
secondary trading market contributes to a slower growth profile of
blockchain-based loans. Traditional unsecured credit markets were previously
disrupted by a slew of new fintech P2P lending models that could still quickly sell
their loans given they had the same look and feel of traditional bank loans.
Currently, no market exists for lenders to quickly sell / securitize
blockchain-based loans, forcing them to be conservative with underwriting and in
developing their risk models. Despite being 100% secured and ~2x collateralized,
loans against these cryptos are sold at a premium given the nascent stage of
the industry.
The intent of many cryptocurrency
advocates is to reduce reliance on traditional central banking influenced
economic models. Given the lack of a central authority influencing the cost of
the largest cryptocurrencies (although one could argue that the exchanges,
operating costs of miners, and primary markets are currently influencing prices
for their benefit6), debates about the concept of a ‘risk free rate’
are now emerging. As the market evolves, it will be critical to observe
correlations in traditional interest rates with those in emerging
cryptocurrency assets.
Finally, the lack of custody and asset insurance solutions has been discussed in depth since inception of blockchain-based loans. Given the lack of these products, potentially billions of dollars are currently on the sidelines7. Moreover, effective custody solutions are just now beginning to emerge, but it will be years before institutional investors begin to see blockchain-based financial products as a common piece of their investment portfolio. Security audits can and should be mission critical items to review during due diligence.
Final
Words
Margin loans are quite risky.
If underlying assets fall, it could lead to an uncomfortable situation for the
borrower as they either need to come up with the money to add LTV cushion, sell
assets, or get liquidated – all at a magnified loss given the interest paid on
the loan. The future of blockchain-based loans will depend on a decline in
price volatility and maturation of institutional investment administration
products.
While no exact science exists today, the bright future for the cryptocurrency industry will compel the creation of new financial products to accelerate liquidity in this burgeoning market. We see an array of products built this year on the back of crypto technology, such as interest accounts, derivatives contracts, custody solutions, and the addition of many more types of digital assets on these lending platforms. Reaching equilibrium will require an optimal balance of supply & demand, and I believe we are on a long path to its discovery.
Finally, I leave you with a short comparison of blockchain-based loans and two similar loan structures: auto loans and stock portfolio margin loans.
The
rapid inflation in blockchain-based asset values has contributed to a new
generation of “crypto-millionaires.” As of the date of this article, there were
7,046 active addresses with greater than $1.0 million in BTC assets. Back in
August 2018, there were approximately 24,000 addresses with greater than $1.0
million in BTC assets. Estimates at the height of the market range from 10,000
to 200,000 addresses with greater than $1.0 million of BTC1.
Assuming BTC values grow over the next 2 decades, I expect for this figure to
exponentially grow.
A
key question for these millionaires is how to create liquidity using BTC (in a
world where common goods cannot be purchased without BTC) in a tax efficient
manner. Today, utilizing BTC for the purchase of goods and services would
require two levels of taxation: (i) income / capital gains tax on the appreciation
of BTC and (ii) sales tax. Another unforeseen tax is the estate tax, which is a
unique consideration given that many crypto-millionaires had a low cost basis
when entering their positions.
While many structures will likely exist in the future to facilitate tax expediency with blockchain-based assets, I propose a strategy using a traditional universal life insurance policy and loans acquired through a crypto service provider as a means for an investor to both protect against steep declines in blockchain-based assets and boost returns.
Life Insurance Structure
Before going through the math, I wanted to start with an overview of the structure. The graph below depicts the mechanism in 3 stages. The blue boxes represent a crypto service provider activities, the green boxes represent activities of the investor / grantor, and the pink boxes represent activities of a life insurance company.
The first step in the process is for the investor to post their crypto collateral to a crypto service provider. A crypto service provider then secures the assets in their cold storage wallet with multi-signature functionality and lends fiat currency against the crypto collateral. The fiat currency is then used to facilitate a single-premium universal life insurance policy and an 8-year annuity (this is the max allowable LTV based on the math below). The selected universal life insurance policy is structured to provide a return linked to the S&P 500 with a floor / cap of 0.0% / 8.0%.
The investment thesis is to provide a greater rate of return on $5.0 million of BTC while protecting against downside risk. Below, we detail the steps in the process and the sensitize the resulting economics to the investor.
Exhibit 1: The Structure
The Math
The first step in the process is to obtain a loan from a service provider. Currently, you can take out a fiat-based loan against 50.0% of the value of your BTC assets. For example, if you have $5.0 million in BTC, a crypto service provider would offer a loan up to $2.5 million. While the lowest rates offered are around 6-7%, we used 8% in our analysis. The loan proceeds are granted by an investor to an ILIT to avoid the proceeds being counted as part of the owner’s estate.
The
amount of the loan required to facilitate the strategy would be $2,347,852. This
amount is calculated as 14.5% LTV for the fiat loan (in order to finance the
premium payment) plus the amount required to finance an annuity that covers
interest payments on the total loan balance ($2.4 million) for the longest
period possible (in this case, 8 years). We estimated that the insurance premium
for a $5.0 million universal life insurance policy to be roughly $725,0002.
Assuming a time to liquidity of 20 years (i.e., death), the annual loan payment
would be roughly $240,000.
Exhibit 2: Loan Payment Calculation
Exhibit 3: Financing the Annuity3
Note
that the total debt ($2.4 million) was established at a 47.0% LTV.
Phased Approach
In
terms of the change in value of BTC, we assumed no growth. Later, I sensitized
the results on both the upside and downside. In order to understand the
strategy, I broke it down in the following phases:
Phase
I: Annuity Payments cover interest payments through the initial 8 years.
Increasing the number of years would take above the LTV target. These payments
would be made at the beginning of the year / period. The annuity payments have
another function in that they defer the risk for the underlying collateral base
– if BTC has 8 more years to gain liquidity (and one is a believer in the
growth story), the annuity offers a valuable strategy to defer the holding cost
of holding BTC.
Phase
II: Annuity payments have ended; therefore, future interest payments would be
funded either through liquidation of BTC (given LTV is more favorable as a
result of the PI structure of interest payments) or accessing the cash value
(discussed below).
Phase
III: Exit and distribute proceeds to trustees of the ILIT. For the purpose of
the below analysis, we assumed that the ILIT would immediately distribute the
proceeds on the date of death.
Cash Value
A
key component of life insurance policies is the cash value. The cash value
represents an internal account within a whole / universal life insurance policy
that could be accessed by the owner on a tax-free basis. For a whole life
policy, the cash value usually turns positive beginning year 4 or 5. For a
universal life insurance policy with a single premium, approximately 25.0%
would be kept by the insurance company for fees, and the remaining balance
would be deposited as an immediate cash value balance. That amount could be
accessed by the grantor for whatever reason, like paying interest due. Day 1,
the cash value would cover about 2.3 years of interest ($725k * 75.0% = $534.8k
/ annual interest). Assuming a long-run growth rate of 5.0% for the S&P 500
over the next 8 years on an annualized basis, the cash value account would be
worth $803.4k, covering 3.4 years of payments.
Exhibit 4: Cash Value Calculations
Remember,
any loans taken from the balance would be drawn 1 for 1 against the ultimate
life insurance payout. In addition, there is no need to take out any funds from this account for the strategy to
work, it just provides additional value.
Exit
We
assumed an exit at the end of 20 years to estimate the net distribution. At
exit, the total distribution would be $5.0 million. The remaining payments
after the annuity include the loan’s interest ($2.9 million) and tax liability
(for the purpose of this analysis, we assume that the cost basis was $25,000 –
resulting in a large tax liability of $995,000).
At
exit, the trustees would receive the net distributions plus the BTC. Assuming
the mechanics above and no growth in BTC, an additional $1.1 million would be
added to the value of the estate.
Exhibit 5: Exit Waterfall4
Sensitivities
I
sensitized the performance of the investment strategy based on growth rates of
BTC. Assuming a decline in the value of BTC, the portfolio outperforms given
the uncorrelated hedge built into the life insurance policy. Furthermore, the
tax liability would be reduced. The net benefit of the strategy works better as
we sensitized lower performance. In a worst-case scenario where BTC goes to $0,
the insurance policy is still fully paid for.
Assuming an increase in the value of BTC, I note that the portfolio return is greater due to the tax-free distribution from the life insurance policy covering a portion of the increased tax liability. The gains are diminishing if greater rates of return are achieved, without performance drag as a result of the policy.
Exhibit 6: Sensitivity Tables
Conclusion
The
wave of crypto-investing we all experienced the last couple of years will need
to be monetized in some fashion as investors consider their exit strategies or
look to diversify their portfolio. The structure described above can be
combined with other mechanisms to either increase the hedge or increase
exposure to the underlying crypto. We note that improvements in crypto
liquidity in futures markets may one day enable a low risk hedging option for
investors that want less asset volatility but still wish to participate on the
upside. Additional liquidity would also enable dynamic tactical hedging
strategies informed by burgeoning asset management services in the crypto
space.
Any
strategy focused on providing liquidity to crypto holders should consider
optionality for repayments. The approach above considers 4 sources of
liquidity: (i) growth in the BTC asset, (ii) cash value principal + growth,
(iii) annuity stream, and (iv) deferring a large tax liability5.
The annuity was “back-solved” so that the resulting annuity distribution equals the interest on total debt.
Interest after annuity represent the remaining interest payments on debt. We assume they would be paid lump-sum on exit but note they would be paid periodically over the life of the loan. No PIK options currently exist on crypto-based lending platforms.
No transaction fees were considered in the analysis (except the large haircut required for the annuity stream).
Disclaimer: I am not a
financial advisor, none of the information contained in this blog post should
be considered investment advice.
The top 5 monthly performers have changed quite bit over the last 3 years, we analyzed 30-day returns for the current top 200 cryptocurrencies (by market capitalization) and analyzed some of the top performers
A notieable change since the 2017/2018 bubble is the decrease in the average traded volume. Looking over the past three years, we observed that both the top 200 cryptocurrencies (blue) and the top 5 (orange) have experienced roughly a 50% drop in average daily volume since last year. The chart also demonstrates that the popping of the bubble began the process of cleaning out crappy / fraudulent protocol (note, I said started, still a long way to go). The top 5 crypto’s percent of total trading volume crept back up since last year, indicating money was moving out of riskier assets due to increased investor attention to detail, regulatory pressure, and other industry factors.
While it is too soon to call a bottom to the issue of volume, the average figures seem to indicate some trading stability is returning . It is also the first time that the average trading volume increased relative to the last quarter. While this could also be associated with trading behavior exhibited towards the end of the year, exchanges are fighting tooth and nail to avoid looming interest rate hike implications and competing to be the best offering.
The table below shows the top 5 performers on a monthly basis for the same period:
Based on the chart above, the top 10 performers were as presented below. The top performer was defined as any monthly ranking in the top 5 chart above.
Notably, some of the top performers include coins focused on instant & private transactions. The top 10 performers include only 1 crypto was not focused on payments or broad platforms – Jack Peterson and Joey Krug‘s Augur. As utility token companies begin to deploy the insane amount of capital raised for their projects, we may see the successful projects begin to creep up on these charts. Given the recent boom-and-bust raised the eyebrows of institutional players, we can expect decent market trials and venture-esque projects to provide further insight on future winners and losers.
The often volatile nature of the industry may be quelled by current attention on fomenting stability. The market’s competition on establishing a stablecoin provides additional evidence that capital is getting smarter and key players are finding ways to take advantage of other emerging technologies (e.g., AI/ML, edge computing, virtual/augmented reality, etc.). The above charts illustrate investors may be consistently reward certain industry segments and protocol. However, as always, it is important to keep tabs on all of your names and keep a diversified portfolio – even historically successful names like Bytecoin may potentially be worth $0 at any time.
Since the inception of Bitcoin and the concept of ‘digital assets’, institutional and retail investors kept their distance (and rightfully so) given the extreme volatility in prices, uncertainty around regulation, and questions around consumer adoption. Not only was the concept of Bitcoin foreign, but potential opportunities surrounding the digital currency and its underlying technology were also quite nascent.
As investors and entrepreneurs increased attention and resources to trading, mining, and building tangential services around these digital currencies, we have witnessed a bumpy road to stabilization and maturity. A study of market cycles demonstrates the relative boom and bust of any new industry. A particular article in Hackernoon shows a great example of this by overlaying BTC prices on stock market performance during the inflating and pop of the dotcom bubble.
In order to attract capital and accelerate a new growth cycle, trading statistics of cryptocurrencies need to be more in line with traditional asset classes. Evidence of that trend has already been reflected in trading price data. Analyzing the trading data of the top cryptocurrencies (based on market capitalization), a decline in 30-day rolling volatilities and significant compression in the volatility spread between BTC with the S&P 500 and Russell 3000 indices were observed.
While there is certainly a long way to go until the industry begins to “mature” (with respect to long term cycles), the sharp decrease in implied volatilities points to certain tailwinds.
First, there have been a plethora of services and applications built with blockchain tech and successful companies in the space are now emerging. Payment services companies such as BitPay demonstrate various applications focused on consumer and business adoption. Ripple’s partnerships provides further evidence that there are tangible results that will disrupt status quo tech. The Zerocoin project has improved its capabilities and made meaningful progress towards secure transactions.
Second, investors are starting to reap rewards of their early investments in blockchain and recycle capital within the industry. The success of Coinbaseillustrates blockchain companies can attract significant investor attention and capital. Prior management teams that have exited these companies have been able to raise money for their own projects; their niches are focused on plugging gaps with current technology offerings.
Finally, large multi-national corporations are beginning to introduce new and specialized product lines for industry participants. For example, Samsung released a new chip to improve BTC mining profits. These new products will reduce the overall marginal cost to enter related markets, just as cloud computing decreased the capability gap between small and large corporations.
While we cannot ascertain where the winners will be (equity investors, miners, coin investors, etc.), there seems to be a long runway for investors and entrepreneurs to figure it out. What we can see is that the railroad is making its way to the wild west, both the numbers and trends point to opportunities for those paying attention.
Without the advantage of being part of a reputable VC or Angel group, or actively working on early-stage company investments, public market information offers retail investors with the best knowledge to invest in micro and small cap companies. Due to the asymmetric information and profit potential associated with any new industry, there will always be winners, losers, and fraud. Penny stock trading hacks show that this fraud can be depicted in the form of newsletters, sexy new ‘ICO deals’, fake advisors, and fake thought leaders.
In order to understand this risk, investors typically analyze the trading history of publicly traded stocks and form ratios (e.g., beta, volatility, etc.) to compare. Analysts can then split risk into various categories based on size, geography, industry, and so forth. These ratios are often compared against benchmarks such as the S&P 500 and the Russell 2000 to gauge relative risk of each position. Also, in theory, high risk of a particular stock can be ‘diversified’ through the addition of uncorrelated stocks in the context of a portfolio.
Unfortunately, investors in cryptocurrency assets and companies lack a strong public market to assess these industry and operating risk factors that have been traditionally embedded in the trading prices of public stocks. Since the volatile end of 2017 to the beginning of 2018, investors rushed into the asset class to share in the promises of finding the Treasure of Lima. Comments like “Ethereum and Bitcoin seem to be safe given the attraction of institutional money” or “I’m going to take a shotgun approach and see what sticks” built a guise of both stable and rapid growth, both of which have not played out over the last year.
Rather than focus on the drivers of the market, the intent of this post is to analyze publicly traded companies to better understand risk. We analyzed 29 publicly traded blockchain-focused early-stage companies (Exhibit A) that were primarily pre-revenue in the blockchain industry; the companies trade across various international exchanges such as the TSXV, Nasdaq, and CNSX and on the pink sheets. We then calculated a market capitalization weighted index and observed the Crypto Currencies Index[1] to compare traditional ratios against these two benchmarks. It’s important to remember that these two indices represent different estimates of performance. The average market cap method measures the performance of the 29 selected companies. The CCI 30 index represents performance of cryptocurrency assets. While we would assume the indices to be highly correlated during sharp up and down movements, one area of focus was to see whether there was a decoupling effect between the two asset classes (like the relationship between gold and gold-mining companies) in performance after the recent drawdown of cryptocurrency asset values.
The first chart shows the risk-to-reward ratios (based on calculated weekly performance and volatility since the beginning of 2014) of the 29 companies and the indices. The indices also show greater risk-to-reward ratios, indicating potential benefits of diversification. A majority of the positions illustrate a weekly volatility range of 10 to 30 percent. This implies annual industry volatility of approximately 70% to 200%.
Chart 1 — Plot of Publicly Traded Companies
The second chart illustrates the growth of the market cap weighted index and CCI 30 index compared to the total IPO values (calculated as the market cap on the first trading week) over time. The area chart represents the gross invested capital of each position but ignores and fluctuations in the underlying stock. The indices (represented by the line charts) demonstrate the strong performance of cryptocurrency assets through the beginning of 2018, followed by a sharp fall.
The analysis reveals a few items. First, the trend of asset inflation likely contributed a almost $800 million of new IPO money flowing after the new year. Second, we calculated volatility ratios since the beginning of 2014 (or since inception of the other companies). Calculated off weekly performance, the implied volatility figures were significantly greater than those calculated for general market indices such as the S&P 500 (Exhibit B, at the time of this post the VIX index was trading around 19). In addition, we observed differences in risk associated with business strategy. For example, Hut 8 Mining Corp. represents a relatively recurring revenue type business model. On the other hand, Blockchain Technologies, Inc. is an early stage R&D company focused on applications to IoT. As the industry matures, we expect additional differences and sub-industries to emerge. However, for the most part, it seemed that the two asset classes were fairly correlated over the last 1–2 years.
Chart 2 — New Blockchain Companies
Finally, we wanted to note the obvious shortcomings with the analysis, which include (i) the short trading histories above the different companies, (ii) we ignore invested capital from large strategic companies such as IBM or Oracle, (iii) the private capital markets are substantially larger, and (iv) the initial focus for retail investors has been the currency rather than the underlying equity. Over time, we expect new innovations and industry maturity to allow valuation professionals and investors to increase reliance on traditional valuation tools.
Footnotes:
[1] CCI30, Source: https://cci30.com, Represents a barometer of cryptocurrency asset performance by analyzing the top 30 market cap cryptocurrency assets (index methodology is located on their website).
Today, I sat down with Forrest Marshall (Software Architect) and Mustafa Inamullah (Creative Director) of MIMIR Blockchain Solutions to discuss the current state of blockchain technology and their company. The intent of the interview was to uncover some of the key value drivers of the blockchain industry and separate fact from fiction after the recent popping of the cryptocurrency bubble.
For a quick summary of MIMIR Blockchain Solutions, please view the video located at the end of this blog post.
Intrinsic: Thanks again for sitting down with us today. Given recent market dynamics (you end last paragraph with same phrase), we wanted to begin today by discussing some of the lessons from the Dot Com bubble and how they apply to blockchain. Could you discuss some of the learned themes that may have influenced your business model?
MIMIR (Mustafa): Our focus in researching the technology bubble was to answer a simple question: what companies survived and why? No matter if you look at the Dot Com bubble of the late 90s, the Railroad bubble of the 1880s or the Tulip mania of the 1630s, the lesson is that the underlying technology or asset still exists. Innovations from the technology bubble still power economic growth, railroads continue to connect and enable businesses, and tulips can still be found at your local supermarket.
The big takeaway was that companies focusing on infrastructure to improve and sustain the internet survived. Think about Amazon, Adobe, IBM, and Oracle. With the benefit of hindsight, we can see that (1) companies focused on short-term gains were severely challenged and many even failed, (2) investors can punish you fast, and (3) infrastructure-focused companies prevailed.
Intrinsic: How does MIMIR apply some of these lessons to their own strategy?
MIMIR (Forrest): Since the founding of the company in 2017, we have always focused on how to provide long standing value. Initially, we set out to create a particular decentralized application (a “DAPP”). We soon realized there were serious holes in the ability to create and deploy a successful DAPP. Specifically, the ability for end-users to seamlessly and securely acquire data from the blockchain presented itself as an immediate obstacle to adoption. Therefore, our mission at MIMIR was to solve the obvious infrastructure problem to make blockchain more accessible to everyone, including users of off-chain, edge-connected devices. We have gone to lengths to educate the general public, establish credibility, and form invaluable partnerships wherever applicable.
Not many people really understand the unique strengths and weaknesses of the blockchain security model, or when and how to leverage it effectively. It is our goal to change this.
Intrinsic: Yes, but at the same time, there are numerous internet and database security companies out there and their services improve year after year. What should companies ask themselves if they are thinking about implementing a blockchain solution rather than today’s alternatives?
MIMIR (Mustafa): Before answering, we wanted to dispel a certain myth about blockchain technology. It isn’t a silver bullet. This technology won’t fully replace most information security systems, but it can greatly improve security and efficiency for certain mission-critical systems. There are many potential costs to consider including the limited throughput of most blockchain systems, and the limited availability of skilled blockchain developers. A quick litmus test for whether an information system really needs blockchain might be (1) is it handling mission critical information, (2) do the rules around modifying this information need to be strictly enforced, and (3) can you afford relatively low throughput for these modifications? If you didn’t answer yes to all three, there are probably better alternatives.
Intrinsic: As a valuation firm, one of the focal points of our work is to isolate key performance indicators of a business to determine future performance and risk. One of the difficulties we have seen is that people often conflate cryptocurrency with DAPPs, with blockchain technology, with computer stuff. In addition, the categorization of blockchain technologies is still quite elementary — unless you know the industry, it is hard to understand the competitive landscape. Can you please describe how value is generated in the industry and, more specifically, by MIMIR?
MIMIR (Forrest): One of the critical discrepancies we often note when discussing blockchain technology, and specifically its application in cryptocurrencies, is that tokens/coins themselves do not generate value. Just like a security, the underlying assets generate value. Ultimately, just as Apple stock is determined by the performance of Apple’s assets, a token or coin’s value is determined by their respective assets (if you discount some of the more behavioral based trading).
We consider ourselves a middle-ware company that adds a second layer of security to enable companies to develop DAPPs and implement them for your everyday end-user. Our mission is to build a DAPP interface to improve the security and scalability of interactions with blockchain services from resource-constrained environments. Today, there are approximately 30 million Ethereum accounts but only about 30,000 nodes serving those accounts (we note that the figures presented include multiple account ownership as well as smart contracts). This illustrates the huge discrepancy between the number of users directly interacting with the blockchain and those using third-party services.
Our system acts as a decentralized blockchain API and content-distribution network, connecting end-users with those who can serve the information they need. We will pay individuals to host blockchain data and supply it via specialized security protocols. The individuals that supply and secure the data buy into our platform via the B2i tokens (written as an Ethereum smart contract), which also acts as a contractual agreement between MIMIR and the individual. Individuals will only be able to ‘work’ up to an amount commensurate with the tokens they secured as collateral. If said individual attempts anything malicious, the collateral can be revoked and redistributed to honest parties.
Finally, in terms of categorization, you are correct in terms of the difficulty given the plethora of facts and fiction out there about the blockchain ecosystem. There are current projects aiming to figure out categorization. We recommend reviewing Tech Crunch’s classification framework as an example.
Intrinsic: Touching more on the topic of value drivers, can these technologies contribute to an enhanced bottom line? How can companies utilize blockchain technology to improve operational efficiency?
MIMIR (Forrest): We are positioned to capitalize on the rapid expansion expected in the DAPP industry. As the industry matures, we expect for specific applications to be developed that can enhance value. The key driver of value for this industry will be the ability for users to acquire the right information and secure it as well. Specifically, there will be large growth in IoT based devices, Decentralized Applications, and secure platforms needed for a digital identity. All of these could benefit greatly from blockchain technology, most importantly infrastructure.
Another example can be found in industries with complex supply chains. For example, let us assume an aeronautical products company like Airbus. Given the specialized requirements for each of the components that goes into building an airplane, they must be sourced from all over the world. The length of time it takes to build and ship components, risk in transporting the components, and order of units received will all play into how quickly a company can build their airplane. Also, this information goes into planning for the project, such as hiring the necessary number of workers and other financing decisions. This is a scenario where the accuracy and auditability of information is paramount, and the latency of a blockchain is inconsequential. Given the number of moving parts, the inherent fault-tolerance of blockchain data stores is a plus too. This has applicability to many global industries.
Intrinsic: Taking a step back, could you explain how and why blockchain technology is the future? There can so much buzz about new technologies that it becomes difficult to isolate true disruptive potential from ephemeral investment fads.
MIMIR (Mustafa): In a world facing greater digital identity security needs, we believe that the blockchain technology offers enormous upside. This not going to happen soon given the lack of infrastructure (as well as security of that infrastructure). That is why this has become our primary focus to help create this “Netscape moment” — opportunity that brings about massive adoption through better user experience. Our goal is to help facilitate this Cambrian explosion of new Decentralized Applications, by providing the necessary tools and infrastructure needed.
To say it another way, we can relate this next technological wave to the advent of the internet. Initially, the internet was not as useful for commerce because you could not trust the other party. The advent of HTTPS added an extra layer of security. You could now securely verify the identities of the entities you interact with online. If the entity was reputable, you could choose to trust the information it gave you. Blockchain technology is the next step in the process. Where HTTPS allowed you to verify the identity of an entity, blockchains allow you to verify the state of a system. If we imagine a digital chess board, HTTPS can tell you who you are playing with, and blockchain can tell you where the pieces are.
Using another example, in Healthcare there is a known gap in electronic medical records and their ability to communicate with software across other clinics. If a patient wants to track their own records, it is a nearly impossible task to first aggregate the information and then store it for future use. Furthermore, these records are a form of intellectual property, but the value may not be fully realized given the information is often disorganized and incomplete. Adding a blockchain service to verify and secure this information would save time and hassle for both patients and businesses.
We are certainly looking forward to the vast possibility of blockchain infrastructure to be used in facilitating secure growth across industries. Some industries we are particularly excited about include: advertising, fintech, compliance, auto, voting, P2P markets, and more. Collectively it’s the vast potential for the use of blockchain infrastructure that MIMIR is excited to be a part of.
Intrinsic: Mustafa and Forrest, thanks again for taking the time out of your schedule to talk with us. It was great to hear your insight into an early but rapidly growing field.
For readers, please feel free to reach out to Mustafa or Forrest with any questions about MIMIR Blockchain Solutions. We have left their information below along with theshort introduction video.
In this lesson, we will discuss using futures data to predict changes in the federal funds rate. Changes in the federal funds rate have a critical impact on the yield curve, value of bonds, and economic growth. While this discussion will not go into depth for those topics, it will help you understand the relationship between investor expectations and how you can safeguard your portfolio.
Gathering Information
The first step in predicting interest rate hikes is to gather information about current prices from the Federal Reserve and investor expectations from futures prices on the 30-day federal funds rate. In order to understand why futures are useful, please review the following:
Now, let’s start the process of gathering the data to make predictions! We are going to start with acquiring data from the Federal Reserve website. Specifically, we are looking for the current target rate set by the Fed. This is usually in the latest minutes released by the Fed. If we navigate to the FOMC calendar on the Fed’s website:
Find the last FOMC meeting and review the PDF, the header and relevant sections can be seen below:
Here, we can see that the current target federal funds rate is 1-1/14 (meaning 1.25%). The next step is to find the latest futures price on the 30-day federal funds rate futures. We first navigate to the CME group site for the 30-day Federal Funds Rate (the easiest way to do this is to just google that term).
This page shows the current quotes; however, we want a more stable figure to help us in our analysis. Click on the Settlements to see finalized settlement prices from the prior business day.
Here, we can see that the last settled price is 98.8425. According to Robertson and Thornton (Click here to access paper), the futures quite can be thought of as the average price for Fed funds in a particular contract month.
In this case, the implied yield on the federal funds rate can be calculated as 100 – 98.8425 = 1.1575%.
The last piece of the puzzle is to note the date of the next FOMC meeting and select the appropriate futures instrument. Above, we have selected the November futures price (although this should usually be determined afterwards). Looking at the FOMC calendar meeting, we observe that the next FOMC meeting is October 31, 2017. Therefore, we selected the futures instrument with the nearest maturity to the next FOMC meeting, and represents the most relevant instrument to gauge investor sentiment.
Putting it All Together
Using this information we gathered, we can apply Geraty’s formula to determine the probability of an increase in a federal reserve hike (click here to access the article). The other key factor is what the expected rate hike will be. Based on the information above, we see that the implied yield of 1.1575% exceeds the federal funds rate target of 1.25%; therefore, we can determine that investors are not expecting an increase in the federal funds rate. Instead, let’s examine a 25 basis point reduction.
The formula is presented below, in addition to the application of the inputs gathered above.
Based on the analysis, there is an 8.0% probability of a reduction in interest rates. From an investor’s perspective, this implies that the federal funds rate is unlikely to change at the next FOMC meeting!
Summary
Keeping in mind there are adjustments to be made to the formula (read the literature I have posted links to!), this is a simple way to gauge investor expectations. This strategy becomes even more powerful when combined with your own interest rate projections, topics we will cover at a later date!
