Crypto — Coming Into Its Own

By Jenny Shaver 

A look at indicators of industry maturity and assessing the right kind of investment risk.

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(This article is adapted from a keynote speech delivered at the April, 2019 Crypto Invest Summit.)

I often get asked, whether it’s by former colleagues, or people I meet at social events, or even my dad, “Why would people invest in crypto? It seems risky.”

Depending on your investment strategy, sure, it’s risky. But…it’s a different kind of risky than it was even two years ago.

So, what’s changed?

Crypto asset performance isn’t correlated to any other asset class. It doesn’t move with fiat inflation or commodities prices. It’s not tied to the performance of a company like a security. That inherently creates risk but also opportunity for significant gain. This is a risk that we as an industry weather and accept.

The perceived risk my dad is referencing has less to do with crypto asset volatility and more to do with the perception that the crypto industry reflects the lawless, undisciplined behavior and unbridled speculation akin to the caricature of the wild west.

This perception is inaccurate.

I was having a conversation with a colleague about this very topic and he said,

“Our industry isn’t in a state of chaos like The Wild West. Our industry is more analogous to The Space Race.”

John F. Kennedy said of The Space Race, “We choose to go to the moon in this decade and do the other things, not because they are easy, but because they are hard.”

Blockchain technology attempts to solve previously unsolvable problems. The complexity of the technology and the nascent nature of the regulatory framework, requires new and emerging expertise. It requires risk takers to set new precedents.

This pursuit has resulted in a pouring in of talent and capital which have given rise to increasing competition and meaningful industry advances. We are seeing this manifest via several indicators of industry maturity.

Broader Adoption

Despite the crypto winter, or bear market, or whatever we want to call 2018, we saw a nearly doubling of the amount of individuals who hold crypto assets. A survey published by Forbes suggests that crypto holders are skewing older and more affluent than previously thought.

UTXO analysis conducted by Delphi Digital suggests that most crypto holders who held a position longer than five years largely sold off their holdings, partly contributing to the downturn, but clearing the way for new investors seeking engagement with new types of products.

From an institutional perspective, traditional financial services and crypto financial services are converging. We are seeing validation of crypto assets in traditional companies incorporating crypto services or blockchain infrastructure.

Institutional adoption also extends to partnerships and service providers for crypto companies. Just in the past 12 months, I have seen an increased willingness of vendors and service providers to work with crypto companies. Companies who were saying “no” to providing services for us 12 months ago, are now actively trying to work with us.

Compliance

US-based crypto companies have made significant strides to create risk and compliance programs that are comparable to traditional financial institutions.

This includes a robust KYC/AML program, customer data protection standards, SOC compliance, compliance monitoring of blockchain addresses, and dedicated resources to oversee compliance programs.

As our industry attempts to navigate its purpose of removing barriers for transferring value, even regulatory barriers, compliance programs at this stage of our industry maturity, are a necessary step for broader adoption and mitigation of regulatory risk.

Insurance

Insurance has been a hot topic as of late because it’s a relatively new advancement in our industry. But it’s meaningful.

The fact that insurance providers are willing to underwrite affordable insurance policies for crypto-specific operations is a strong indicator that we as an industry are demonstrating the safety of holding crypto assets.

I urge investors to ask critical questions about the specifics of insurance programs — the coverage amount, incidents covered, and the claims and payout process and timeline.

The good news is that as our industry continues to prove itself, the competition amongst insurance underwriters will increase, which, in turn, will drive down costs.

Market Data Integrity

Our industry is dealing with our own data integrity issues just like any other high volume, high velocity industry.

Recognizing these gaps and the dependence on reliable market data to drive participation, there has been a surge of data research companies dedicated to improving the quality of market data.

The recent incident of BitWise calling out CoinMarketCap for overstating trading volumes, is a great example of our industry’s maturity in this area.

This is significant not just because companies like BitWise are expending resources to conduct due diligence on our industry’s leading data providers, but also because of CoinMarketCap’s acceptance of accountability to address the issue and improve their product.

It demonstrates that we are holding ourselves to a higher standard, and that investors will have increasingly accurate sources of information to make informed decisions.

Response to Scalability Challenges

JPMorgan announced earlier this year that it is investing in its Quorum blockchain infrastructure to facilitate payments in a more efficient manner using its dollar-backed JPM Coin.

It’s currently being piloted with a few institutional clients but is promising to revolutionize their payment processing.

To realize this potential will require blockchains to dependably support concurrent transactions at a scale that is not yet possible, or at least not yet largely practiced and tested.

Our industry is investing significant resources to solve this problem, and promising solutions are surfacing.

A second layer protocol solution, Lightning Network, is perhaps the most exciting advancement in the race for scalability.

For crypto to deliver on its potential of revolutionizing the transfer of value on a global scale, it must rise to meet the challenges of scale.

We’re working on it.

More Sophisticated Investment Products

What I see as the most exciting indicator of market maturity is the increasing diversification of product offerings.

Interest-bearing accounts are seeing promising early performance, futures and options are now available on select exchanges, as is trading on margin, and ETFs are on the near-term horizon.

What I have seen is an industry response to the unique nature of crypto assets and the needs of crypto holders. In crypto lending, for example, simply offering a crypto-backed, USD loan, does not address all market uses cases.

If 2018 has taught us anything it’s that we need products that drive market engagement in both bear and bull markets.

Our industry now offers several ways for investors to participate — directly through investing in crypto assets, less directly by offering fiat capital pipelines for interest-based products, or indirectly through investing in the growth of crypto companies and projects.

These options are allowing for a wider breadth of investor participation with varying risk appetites.

I return to the question, “Is crypto investing risky?”

When we empower a company like Charles Schwab to manage our wealth portfolio, we know there is some risk in the investment strategy but we don’t worry about them losing or mismanaging our money.

There are enough responsible companies in the crypto industry that can provide the same amount of assurance about the handling of your crypto assets. I encourage investors to seek out reputable companies and ask tough questions about their operations due diligence. Watch how companies respond to industry incidents like a hack or key compromise event. Our industry is still young and we’re still learning our vulnerabilities. The good companies will have a disaster recovery procedure that cure customer losses.

We have seen what happens when more resources are deployed to our industry. The result is more talent, innovation, and increasing sophistication that results in better products and better opportunities for investors.

Everyone wins.

The views and opinions expressed in this article are those of the author and do not necessarily reflect the official policy or position of SALT Lending.

Evaluating Interest-Bearing Crypto Accounts

By Zev Shimko, Jenny Shaver and Blake Cohen

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The latest offering in crypto custody is an interest-bearing crypto account. Although marketed similar to cash deposit savings accounts offered by traditional banks, the structure of this type of interest-bearing crypto product is more closely analogous to securities lending and should be viewed as such when assessing the risks associated with placing crypto in an interest-bearing account.

There are certainly benefits to interest-bearing crypto accounts — namely the ability to earn a return on a custodied asset beyond its possible appreciation value. However, those interest benefits aren’t without their own risks. Here are some important considerations when assessing if an interest-bearing crypto account might be suitable for your risk appetite*:

When opting for an interest-bearing product, your crypto assets may be commingled (where funds belonging to one party are mixed with those of a second party), and rehypothecated (practice whereby a broker or lending agent uses assets in their possession, but owned by their customer, to invest with or lend to a third party). In this structure, your funds may be taken by your custodian (acting as a lending agent), pooled with other assets owned by other customers of your custodian, and lent to a third-party. As a result, and in return for interest payments, you may forfeit several rights associated with your crypto assets. For example, you may be unable to quickly withdraw your crypto in whole or in part and you may lose, due to the commingling of your assets with assets owned by other customers, the ability to independently verify the security of your assets on-chain. Instead you may be supplied with a percentage statement or value statement regarding your interest in the crypto collateral you deposited into your account.

With a traditional bank savings account, your cash deposits may be lent to other financial institutions and vetted borrowers who have a multitude of options for generating wealth with the borrowed funds. In many cases, these traditional bank accounts are also insured and operate within strict regulatory guidelines and limitations on the collateral percentage, number of parties, among other restrictions for and to which the deposited assets can be lent, distributed, and relevered. These regulatory guidelines and restrictions prevent traditional financial intermediaries of this type from participating in some high-risk lending behaviors when it comes to their customer assets, but do not, generally, prohibit the rehypothecation of deposited assets under certain conditions. These intermediaries then cover their costs, not by the fees charged on the interest-bearing customer accounts, but through the income generated by lending and investing those assets during the rehypothecation process. While this process seems straight forward and analogous to what might happen with the crypto you deposit in an interest-bearing account, some additional crypto market specific comparison will help to highlight the difference in rehypothecated use between cash denominated and crypto denominated accounts.

While there are certainly financial institutions which take short and long positions on various currencies, the typical use case for rehypothecation in cash accounts is the lending or investment of the cash deposited directly to a third-party and not for direct speculative purposes in that asset. However, for many institutional crypto holders, the primary use case for generating returns with crypto assets is often to take a speculative position on the asset itself. An institution with a bearish view on the market, for example, may look to short sale opportunities — borrowing crypto and immediately selling it in hopes of a future purchase at a lower price to close the position. The institution will only net a profit if the value of the crypto falls below their initial sale price, which means you and the counterparty borrower are betting on opposing outcomes. As a HODLer of crypto assets, it’s important to understand the motives of each party involved aside from what traditional rehypothecation in cash accounts might suggest. This comparison highlights the operational difference in the rehypothecated use of cash deposits and crypto deposits in interest-bearing accounts and should motivate anyone seeking to deposit their crypto into such an account to carefully inspect the intended and permitted uses of the assets they plan to deposit.

Any custodian or intermediary entrusted with your crypto may be required to act in a responsible capacity either by their position as a custodian or fiduciary or by some applicable regulatory regime. However, there are still strategic and operational choices which may put your assets at risk. For companies offering interest-bearing crypto accounts, how might they be regulated? Traditionally chartered banks, for example, are regulated by the FDIC and must carry insurance and maintain fractional reserves to address withdrawal, and other requests without becoming overextended. Lending intermediaries are also often required to maintain capital reserves to cover risk exposure of defaults in capitalized accounts and through bonds or other insurance policies.

Given that crypto regulation is scant, the savvy crypto account holder may want to make a detailed investigation of how and through what methods companies offering interest-bearing crypto accounts have structured their risk mitigation. For example: Does the company carry insurance for your assets? What is the claims process in the event of an incident? In a relatively nascent industry, transparency of risk mitigation protocols should be table stakes for any interest-bearing products. In addition to the primary lender or custodian involved, downstream market participants face similar responsibilities as any loss throughout the ecosystem may lead to direct counterparty effects.

As an extension of assessing operating risk, a savvy account holder should also understand how counterparty risk is being mitigated and which or what counterparties may be involved. When it comes to borrowers of your crypto assets, who are they and how have they been vetted for their own operational risk? Should a third-party default on their obligation, what are the implications for your account? For loan agreements, it’s important to know how they are being structured to mitigate default risk. For example, in securities lending, borrowers are often required to post collateral. In this case, it’s important to understand what the lender is doing with the collateral and how the collateral account is being managed. Is the collateral itself being rehypothecated to earn additional returns? If so, what are those direct or indirect investments and how risky might they be? Transparency and accountability are key and so is a keen eye for the fine print.

Since all-time highs, the price of Bitcoin has dropped roughly 80%, with the largest recent weekly drop of 22% and one-day drop of 12%, both in November 2018. Heightened volatility is no stranger in the cryptocurrency world as the market can turn meaningfully in a period of days, or even hours. It is important to take note of an extended lock-up period (or simply a delay in withdrawal) associated with any interest-bearing deposit account as any delay in or restriction on your ability to liquidate or transact your assets may subject you to additional market risk. Alongside normal course market volatility, an increase in borrowing crypto for the purpose of a taking a short position, especially if undertaken by a large subset of holders in a particular asset, may potentially exacerbate any downward pressure on price, heightening lock-up risk through increased intensity in negative peak volatility.

Before depositing crypto into an interest-bearing account, take a look at the fine print. Returns initially quoted may carry restrictions on the period of time they are available, may require additional deposits or transfers, and may have additional caveats regarding market conditions and other impediments. It is important to understand the process and any notice requirements or promises made by your lender or custodian for any changes to the quoted interest rate. Depending on the size of the custodian or lender, interest bearing accounts which carry guaranteed interest rates may require significant cash outlays by the custodian or lender as a cushion for the quoted returns. Understanding the custodian’s cash and balance sheet position may also be important depending on the amount of crypto being deposited.

There is a place for interest-bearing accounts in the crypto ecosystem and as the market matures so will the terms and safeguards associated with these accounts. In the meantime, you must seek transparency for how your funds may be distributed and how risks are being mitigated. It’s important that you request adequate information, and that you handle your crypto assets with a full understanding of the risks and tradeoffs. Happy HODLing.

  • None of the information contained in this post should be taken as investment advice or any suggestion for or against the suitability of any interest-bearing, custody, or other crypto currency product for any investment, diversification, or market strategy. Salt does not offer investment advice. Please speak to your advisor, tax accountant, and/or legal counsel regarding the suitability, risks, and legality of any crypto market position or strategy. Salt is not a bank and is not FDIC insured. Please see www.saltlending.com for additional information, references, and disclosures.