Investment managers may benefit from studying digital assets. This begins by understanding the difference between Crypto-currencies vs Crypto-assets, the role of the supply-side in setting the risk profiles for these assets, and how all these things combined introduces the concept of non-sovereign assets.
At their core, investment managers perform the important function of matching savings with investment opportunities. They either employ strategies to invest client cash into market tracking products (passive, index/ETFs) or into products which try to outperform (active, alpha-generating).
For most managers, the past 10 years since the crisis have presented a conundrum. Increasing central bank liquidity (Quantitative Easing), coupled with an increasing shift into passive strategies that do not consider fundamentals in their valuation, has led to a regime change in the global financial market structure. To generate alpha, most have had to take on more risk to generate similar historical returns.
Against this backdrop, the emergence of blockchain-based digital assets presents an interesting opportunity for managers. Based on the statistics alone (caveat: which are backwards looking), some Yale University researchers have calculated potential risk-diversifying benefits to holding digital assets. However, this alone would not be sufficient to catalyze a real shift in asset allocations. For investment managers to seriously begin looking at this asset class, there also needs to be some fundamental “plain English” factors which plausibly explain why this asset class has value and will persist for the long-run.
This article attempts to introduce some of the unique features of digital assets for managers, and outline what the potential opportunities are going forward. This builds on many of the concepts introduced in an earlier paper: Macro narratives for blockchain-based digital economies.
The article is split into three sections:
- Section 1: Distinguishing between (Crypto) Currencies vs Assets
- Section 2: Innovations on the supply-side
- Section 3: Entering the era of non-sovereign assets
Distinguishing between (Crypto) Currencies and Assets
Much of the confusion in the digital asset space (e.g. Bitcoin ,Ethereum, Stablecoins, ICOs, Securities Tokens, Non-fungibles) centers around a misunderstanding of what currencies vs assets are. This difference is critical for managers to properly identify the short and longer-term opportunities and the investment risk factors.
What is a currency vs an asset?
Currencies are a generalized point system which keeps track of value within an economy. Currencies have a practical use as it helps to facilitate transactions of goods and services between individuals over time and can be used as a tool for re-distributing wealth across a population (through inflation). Currencies only have prices (e.g. how many RMB will I pay for a USD), but no intrinsic value. There is no DCF model that will tell you how much a currency is worth.
Assets are a non-generalized type of value which are priced in terms of a currency. Real estate, stocks, bonds, intellectual property, and any other type of “asset” are things that are priced in terms of currency (e.g. it cost X US dollars for this good or service). Assets have a price (e.g. how much would one would pay for it today) and value (e.g. cashflows associated with the asset). Simply put, assets can be valued using DCF, but in terms of a given currency.
Pricing currencies vs assets
Currencies derive their price from a combination of supply and demand factors.
The demand for a currency is driven by the demand from buyers (within and outside of an economy) for assets denominated in a certain currency. More technically, this can be referred to as the balance of payments (e.g. in the US, the demand for US goods/services, and financial assets by non-US buyers). Note that the US dollar is unique in that there are some very important assets globally that are priced in USD (like oil).
On the supply-side, the price of a currency is impacted by the quantity of money. Money consists of both the base amount of a currency (E.g. money issued by an issuing authority like a central bank), as well as the broader money that exists as credit (e.g. how much banks loan and broker-dealers re/hypothecate). That is why FX traders will often consider factors like central bank actions, interest rates, and country debt ratios to price foreign exchange at a given point in time.
Assets on the other hand are more intuitive to understand. Assets are priced in a certain a currency, with its ultimate value determined by what cashflows the asset generates. The linkage to currency comes when considering what discount rate to apply. The discount rate is inherently tied to the currency’s supply (e.g. inflation and interest rates).
Why is this important for digital assets?
Investment managers evaluating digital assets must understand whether they’re evaluating a Crpyto-currency or a Crypto-asset. Referring back to an earlier post, Macro narratives for blockchain-based digital economies, the case is made for why different blockchains represent their own digital economy. Rather than being drawn around physical borders (e.g. US dollars, with US assets, governed by US borders), digital economies use digital currencies, with digital assets issued on top of them, governed by a borderless consensus of the protocol.
The fair “price” for a digital currency (like Bitcoin) has to do with understanding supply and demand — often monitored through the supply equations like PV=MQ. The fair “price” (present value) for an asset considers the currency’s inflation and interest rate characteristics when determining how to discount a cashflow (e.g. determining what “r” is in the equation: PV = CF/(1+r)^n). Perhaps the most intuitive crypto example is looking at the Ethereum network, whereby Ether is the currency, and Ethereum based assets (e.g. ERC 20 and ERC 721) are assets. Assets issued on top of the Ethereum platform are quoted in “ETH”.
Innovations on the supply-side
The real innovation (or difference) in a digital asset ecosystem vs a traditional asset ecosystem comes down to the supply-side dynamics of the currency. We’ll see why in a moment.
How does it work today?
To explain why this is, it may make sense to use the US dollar example.
US currency and US asset prices are directly impacted by the existing US monetary supply and future expectations regarding the US monetary supply.
Understanding how the money supply changes is not always obvious. Armies of bank analysts and fund managers are employed to guess / parse every syllable of what the Fed (Central bankers) say, and then look at how certain firms respond. This is reasonable as the creation of money (“base + credit”) happens through many different intermediaries. There’s the central bank (which prints money, sets reserve ratios, performs open market operations), banks (which lends deposits to create credit on a fractional reserve basis) to broker-dealers (which lends securities in exchange for cash).
If there are inflation concerns for the US dollar, it’s price will fall relative to other currencies. Likewise, as inflation concerns are baked into US interest rates, asset prices will fall as interest rates rise.
This should highlight the point that currency is one of the most fundamental elements in any type of global financial asset allocation. Any changes to the currency, will have a ripple effect through the entire system of assets issued on top of it.
How does it work with digital assets?
Crypto-currencies and crypto-assets issued upon them are fundamentally different because many do not follow conventional monetary policy (e.g. they use a different formula on the supply-side).
Many blockchain-based economies use a fixed, or an algorithmically fixed monetary supply equation. This is why you’ll hear that the Bitcoin network is using a progressively decreasing issuance model that is ultimately capped at “21 million BTCs”. Perhaps the most important implication of this is that there is a different type of interest rate risk in this monetary ecosystem. No army of bank analysts guessing at what the “Bitcoin Fed” will do. The supply is generally algorithmically fixed — removing one of the key risk variables from the equation.
On the asset side, the idea of a different monetary policy will affect prices, but ultimately will be a second order effect. For example, running a business where you operate a Lightning Node (earning fees in bitcoin) can be thought of as an asset priced in terms of Bitcoin. The NPV of such an asset is determined by the fees expected (Cashflow) discounted by the interest rate (which can be determined based on the supply algorithm).
Other blockchain protocol implementations experiment with different supply schedules. Some inflate at a fixed rate perpetually (e.g. Ethereum as it is today), or are pegged (e.g. Stablecoins today). At the end of the day, as long as these economic systems produce value for society (a topic for a separate article), then the assets issued on top of them will as well — and can have plausible investment theses.
Enter the era of non-sovereign assets
Taken together, the profile of these new digital economies, currencies and assets issued within them, creates a new type of non-sovereign asset class.
The construct of how assets are constructed today is based on a nation state model. Fiat-based currency prices and assets priced in them, are inevitably linked to central banks and how they influence the supply.
Investment managers considering digital assets should view this new asset class as another type of “country” in their tactical asset allocation models. The dynamics in which the country operates (a blockchain’s consensus rules) and the assets it issues will be subject to a slightly different set of constraints. The way that money is created will occur through a different set of intermediaries with a different set of regulations.
It’s important to note that it is unlikely that digital assets will replace nation-state economies and their system of currencies and financial assets. Quite the contrary. If anything, these new digital economies will create complements to the existing system.
Few can argue that the existing construct of the financial system is not without its risks. Many have hinted that the last crisis only served to shift the risk from the corporate sector balance sheet onto sovereign state balance sheets. Investment managers thinking about digital assets may be prudent to consider the digital asset class as an opportunity to invest in non-sovereign assets.
If they believe this to be valuable, then the natural follow-up question will revolve around determining which digital assets versus digital currencies to invest into. As alluded to in an earlier post, people generally invest in currency when economies are deflationary, and assets when economies are inflationary.
The allocation logic of different digital asset ecosystems could be addressed in a follow-up post. In conclusion, investment managers seeking diversification from sovereign risk, could begin studying digital assets.