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Cryptocurrency: the good, the bad and the ugly

12 January 2018


Given the dramatic rise in the value of cryptocurrencies, it is no surprise there has been a spate of new cryptocurrency fund launches, or funds expanding to offer a crypto trading strategy. In this article we will make it less cryptic, by examining the upsides and downsides for those with an interest in financial services.

The (possibly) good

It is not the increase in value alone that active fund managers find attractive. It is also how volatile the rise has been, with ever-increasing peaks combined with sharp troughs.

Let’s take the most famous of the current cryptocurrencies, Bitcoin. At the beginning of August 2017, the market capitalisation was $45.9 billion. This had risen to $71.7bn by October 2017 and reached $170.9bn by the beginning of December 2017. By 17 December 2017, Bitcoin reached a high of $324.6bn, before dropping as low as $229.4bn and then climbing to $263.2bn later that same month.

December 2017 did indeed see some of the sharpest drops in value around Christmas, followed by rumours of South Korean regulator interference that could affect how exchanges such as Bithumb can operate in the country. But if we look further back, November 2017 opened at $108.1, went as high as $175.0, as low as $101.8 and closed November at $170.9. Perfect conditions for an active fund manager.

Yet it is not just these fluctuations that present opportunities for fund managers. One attractive attribute of cryptocurrency is that no prime broker is required: managers can go straight to the exchanges, therefore cutting down on costs.

There are also a large number of exchanges available, offering different exchange rates in various currencies, in turn giving rise to arbitrage opportunities. In addition, if an existing fund is trading in eight existing currencies, there are 28 currency pairs. Add Ethereum to this and you get 36 trading combinations; add Bitcoin on top of that and there are 45 potential trading pairs.

The more recent ability to trade in options and futures products also provides more opportunity to make a return and cash out too. Bitcoin futures would allow exposure to Bitcoin without actually having to hold any of the cryptocurrency. Some exchanges also offer margin trading services, allowing a trader to leverage up their positions.

But it is not all upsides. The entry into a cryptocurrency strategy or market also poses some significant problems.

The (possibly) bad

The absence of a traditional prime broker raises issues around safe custody and how to keep the wallets secure. The safest option would seem to be a physical device that is not connected to the internet, though this could be cumbersome and lead to missed trading opportunities. But would investors settle for less from a risk perspective?

The ‘large number of exchanges’ we mentioned vary in quality and reliability and have even been known to crash. It also makes larger trades harder to execute without affecting the market. That can mean that in reality, a particularly large holding could actually be illiquid. Again, security must be considered: hacks of exchanges have already been reported.

Derivative products will of course increase the level of risk. Perhaps the introduction of futures is to blame for the huge rise in value of Bitcoin during the first three weeks of December 2017, leading to the steep price correction in the last week of the same month. We have also seen what happens when this can go wrong, with the GDAX (Global Digital Asset Exchange) reimbursing a number of traders out of its own pocket.

The cynic in you may be thinking that when people push for a product that allows shorting of the market, there are also people aware of where this is ultimately heading.

Having covered cryptocurrency’s upsides and downsides, we must also acknowledge its dark side.

The (historically) ugly

Cryptocurrency has an infamous past: a deep association with illegal activity through sites on the dark web such as Silk Road. Its anonymous nature has appealed to those wishing not to be traced by a paper trail back to the sale or purchase of contraband.

Despite that, the technology behind cryptocurrency has the power to make an immense difference in hundreds, probably thousands of businesses. In theory it could allow the complete cutting out of middle men, provide a transaction trail verified by a number of different sources and lead to true peer-to-peer transactions.

The situation as it currently stands will lead to someone catching a tremendous cold from trading in cryptocurrency or linked derivatives. It will likely be a layperson, rather than a sophisticated investor, which will certainly lead to increased scrutiny from regulators such as the Financial Conduct Authority (not that they aren’t taking a keen interest already). HMRC will also be paying closer and closer attention, as the tax implications of cryptocurrency can still be somewhat complicated and unclear.

That begs the question: is cryptocurrency in fact something that can be regulated? Yes, you can regulate exchanges by enforcing rules in respect of knowing your clients and anti-money laundering. But if two people wish to deal in cryptocurrency without an exchange, it would seem impossible for it to be monitored and regulated.

By definition – that is, UK GAAP (Generally Accepted Accounting Practice) definitions – cryptocurrencies do not meet the definition of cash or cash equivalents, due to their susceptibility to violent value shifts and the fact they are not necessarily liquid.

In thinking about the cryptocurrency marketplace, we are inclined to draw comparisons to VHS versus Betamax, or Blu-ray versus HD DVD. It is not so much about superior technology as it is about better branding. The first cryptocurrency to legitimise itself completely could win out and become the new currency used by the masses.

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