Editor’s Note: In light of the FTX debacle, now nearly a month old but still unfolding daily, we thought it was worthwhile to re-run this piece on how to answer difficult questions on crypto investments from clients.
It’s been a rocky year for crypto. If one were to look back at the most recent peak of bitcoin prices, it could be thought to coincide with a kind of peak for crypto in general in November 2021.
Since then, despite a modest rebound, most of the digital assets space is trading at less than half of its former value. On top of that, there’s been a string of failures across stablecoins, decentralized finance and crypto exchanges, custodians and brokerages—the latter of which may result in irrecoverable losses for some investors.
But interest in cryptocurrencies, blockchain and digital assets continues to run high, said Alex Brown, investment management associate with Sarson Funds, a crypto asset manager and education source for financial advisors.
“Your typical retail crowd, which skews young, doesn’t naturally align with the RIA client base, which is mostly made up of retirees and soon-to-be retirees,” said Brown
“The crypto space struggles to match up with the RIA audience for that very reason, it’s programmed very much for the retail side of the industry.”
From volatility to custody solutions, investors are raising questions about crypto, said Brown.
Volatility and Correlation
Two popular theses for investing in crypto have been challenged by 2022’s volatility. Bitcoin fell more than 60% to begin the year, before moving more or less sideways.
As the volatility started, cryptocurrencies in general lost their diversification benefits and became more correlated to equities. Since equity markets also dropped to begin the year before settling at the beginning of the summer, crypto has also failed in the short-term as a hedge against inflation.
“We definitely highlight in our conversations that bitcoin, as a hedge against inflation, has not yet really been proven wrong, but the thesis has certainly been shaken in this cycle,” said Brown. “The idea of using bitcoin as a hedge against the federal government printing money is not as consistent or correlated as it was a year ago.”
Rather than an alternative, bitcoin itself has behaved more like a levered play on technology stocks, said Brown, and thus he looks at it as a growth investment.
The volatility occurs because bitcoin prices are most influenced by the behavior and sentiment of retail investors.
“Most of the participants in crypto markets are growth investors,” said Brown. “As the sector matures, we’ll get better metrics around which chains are producing income versus which ones are going to be a growth play. As value investors begin to have an outsized impact, we’ll see a decoupling.”
Even bitcoin, once touted as digital gold, is best discussed as an investment similar to Tesla, said Brown, whose high valuation is contingent on a growth narrative versus any fundamental value.
The bad news around crypto has piled up, not just the decline in prices, but Luna and Terra stablecoin and decentralized finance (DeFi) collapsed. Then, more recently, crypto hedge fund Three Arrows Capital failed, leading crypto lender Celsius to go bankrupt and crypto exchange Voyager Digital to go bankrupt.
“Advisors are asking about some of these specific events,” said Brown. “The more centralized side of crypto has seen some really ugly events over the past five or six months, and under the surface it has highlighted the need for decentralized finance solutions. We’ve noticed that a lot of the more vintage defi projects, the ones fully collateralizing any type of lending, have held up just fine. It’s the projects with opaque practices, like Celsius and Three Arrows, that have had issues. It’s harder to see where they have leverage and risk.”
Brown said that the story of cascading failures surrounding Three Arrows Capital is similar to collapses in traditional finance that have moved up the chain of leverage.
Advisors are poorly equipped to discuss some of these failures, said Brown.
“There isn’t a good understanding of the different etymologies and different causes of collapses among traditional finance people,” said Brown. “There’s a difference when a collapse happens in an off-chain protocol, like Celsius, versus an on-chain protocol. An on-chain protocol is transparent. Anything that happens on chain is fully visible to the chain’s community and it can be recognized as a risk.”
The Custody Problem
Wrapped up in the Three Arrows collapse was Voyager Digital, a crypto exchange that eventually declared bankruptcy. The collapse highlights the challenges of crypto custody.
Crypto die-hards will tell you that if you don’t hold the keys, you don’t hold the crypto—they advocate for off-line cold storage to ensure the maximum security for their assets. Many come-lately crypto enthusiasts keep their crypto in “hot wallets,” often hosted by their broker or exchange. These hot wallets, in most cases, are not protected by the same sort of insurance that defends your bank and traditional brokerage assets from liabilities.
“As an advisor, you have to make a big decision as to whether you want to take the web3.0 self-custody route, or opt for a more centralized and user-friendly option,” said Brown. “A lot of people in my position would tell you to do the former, but I don’t think we’re quite there yet.”
Advisors can’t really afford the risk of a hot wallet solution, said Brown, but don’t have options to provide self-custody solutions for their clients.
That has led to a lack of custody solutions for financial advisors at a time when crypto custody is top-of-mind for investors, said Brown, and that’s where companies like Sarson Funds are carving out a niche.
“It seems to me that RIAs are left with no solutions when it comes to self-custody or providing custody or understand the best trading practices on their own,” he said. “They would have to visit a private placement company like Sarson Funds or a private hedge fund to access some of the safer custody solutions. RIAs can opt for the centralized option and treat it in the same way they treat a lot of their decisions in traditional finance. Find where they can receive the best counterparty risk protection.”
Make sure firms are embracing best practices when it comes to custody and cybersecurity, said Brown.
In general, if helping clients choose a hot wallet solution or a custody solution, it is safe practice to steer towards major players, the biggest businesses with the best track records.
“Binance and Coinbase would be right up there,” said Brown. “Circle is not an exchange or a custody solution, but it is among the best projects in stablecoin, there’s a lot of backing there to address potential counterparty risk.”