The market for cryptocurrencies has exploded over the past few years, with Bitcoin and Etherium being two currencies that have dominated headlines over the past year. In fact, the cryptocurrencies have performed so exceptionally well over the past year that they have caught the attention of Wall Street hedge funds. Over fifty hedge funds have now launched funds focused on cryptocurrencies. The question remains, does the movement of hedge funds signal the rise of a new asset class or is it more like hopping onto a bandwagon, much like mortgage-backed securities of 2008?
What are cryptocurrencies?
At a high level, a cryptocurrency is a digital currency that leverages encryption techniques to verify and facilitate the transfer of funds independent of a central bank. Today, nearly all cryptocurrencies have no government affiliation and are operating in a grey area. All cryptocurrencies allow for anonymous transactions, making it difficult for governments to follow a digital money trail. Two of the most well-known and popular cryptocurrencies are Bitcoin and Etherium, but there are many smaller cryptocurrencies. Much like IPOs for stocks, individual coins are also released through a process called ICO – Initial Coin Offering.
Incredible performance of cryptocurrencies
As an investment class, cryptocurrency performance has trounced vanilla investments such as stocks, bonds, or ETF. In the past year, Bitcoin prices have grown over 700% and Etherium prices have grown by over 1,000%. Outside of these two large cryptocurrencies, new cryptocurrencies are being offered through a process called “Initial Coin Offering” – or ICO for short. There’s overlap between how ICO’s and stock IPO’s are handled - ICO’s provide an opportunity to purchase digital currency at a very initial offering process, which can mean significant upside if the currency does well in the future.
The Grey Area of Cryptocurrencies
However, all is not well in the world of cryptocurrencies. It’s a world of high risk and high reward. The fact that many cryptocurrencies operate in a grey zone means that there is an enormous risk of government regulation affecting the ability to trade or even own cryptocurrencies. In fact, a number of countries such as China and South Korea have already banned ICOs, or the creation of new cryptocurrencies in their borders. Some countries such as Bangladesh or Bolivia have banned outright cryptocurrencies in the country. There is huge uncertainty when it comes to how each country’s regulation will manage cryptocurrencies – some countries want to remove it from inside their borders whereas others are looking to create their own government-held cryptocurrency. Looking towards the future, the introduction of cryptocurrency focused hedge funds helps legitimize the space, but the variance in each country’s regulation has the potential to create a chaotic future where each country has different rules regarding digital currency and creating a bureaucratic nightmare.
ICOs have been the poster child of risk associated with the cryptocurrency market since many ICOs in the past that have flopped due to technical mishaps or were simply scams. While some investors have been able to reap huge gains when they invested early in blockchains such as Etherium, there are dozens of cryptocurrencies that were technically deficient or outright fraudulent. On the plus side, the entrance of wall-street money means that the white papers for ICOs will gradually become more and more sophisticated – hedge funds are already pouring through the technical details of each potential cryptocurrency to verify if the feasibility and upside of the digital currency. The increased scrutiny on ICOs will greatly increase the barrier to entry as it will become more and more difficult to launch an inferior product (or no product) when sophisticated investors are pouring through all details of the offering.
Wall Street Money in Cryptocurrencies
Many hedge funds are now trying their hand in the cryptocurrency market. The influx of wall street money can lead to significant change within the cryptocurrency space and ultimately making it a more safe and palatable market for individual investors as institutions begin to take on more of the risk.
One of the first potential changes in the space will be decreased volatility. Today, the cryptocurrency space is infamous for its daily volatility – price swings can be as much as 30% in either direction during a single trading day, which means the market has enormous potential for an investor who likes to trade on volatility. However, new Wall Street money will cause volatility to die down as institutional investors and day traders will look to cash in on volatility for short-term gains, which will ultimately cause the market’s price to self-regulate by taking into account put and call options held by traders.
A second change in the space is in the legitimacy of blockchain currencies. Since cryptocurrencies operate in a grey area today, many countries are unsure about how to handle the growing asset class. The entrance of wall-street money signals to the world that cryptocurrencies may be here to stay and that they are a legitimate form of wealth. The issue here lies in how different governments will handle cryptocurrencies or, what rules, requirements, and regulations they may create for investors. It may be no surprise in the future if cryptocurrencies merge together with the FX market to become just another currency.
Cryptocurrencies are here to stay
At the end of the day, the influx of wall-street money through hedge funds serves to legitimize cryptocurrencies – making clear that they are here to stay. It is important to remember that cryptocurrencies such at Bitcoin and Etherium have enjoyed tremendous growth in the past few years, but are entirely digital with no physical form. The risk of government regulation and technological advances are ever increasing as cryptocurrency becomes more mainstream. While the blockchain portion of cryptocurrencies is unhackable today, future technological advances may render their impenetrable status obsolete. As cryptocurrency’s future status is still not entirely clear and holds no real tangible value – the future of cryptocurrency is starting to look very similar to the mortgage-backed securities.