Are Digital Assets a Fiduciary Responsibility?

 

Wealth managers strive to serve their clients’ best interests by managing risk and directing capital towards’ goals based upon time horizon, risk tolerance, current financial position, and the financial market’s movements. Since their inception in 2008, digital assets like Bitcoin and 

Ethereum has been considered too exotic – nascent, volatile, and small – to fit within a portfolio. 

Despite this perception, Bitcoin has offered the best risk-adjusted returns over the past 1, 5, and 10 years and institutions have started to gain exposure to this asset class. When the new supply of Bitcoin is dwindling, and the demand for digital assets is expanding due to monetary expansion and the field’s maturation, a manager must understand, consider, and allocate to the digital asset space. This is the intelligent fiduciary way. 

We recommend a 3-5% allocation of assets for High Net Worth Individuals, corporate treasuries, institutions, family offices, and the like. A true fiduciary must understand the space and take a closer look at what digital assets can do for a portfolio. Instead of asking whether the client should participate, strive to figure out how to participate on behalf of their clients intelligently. 

 

Risks of Digital Assets 

 

Digital assets are a $500Bn asset class with very high volatility. In physics, we speak of the quantity of movement, or momentum: it is defined as mass times velocity (p=m*v). Digital assets have a unique m*v characteristic in the financial landscape as an ultra-high momentum asset class.  Digital assets are the proverbial bull/bear in a china shop: their size is comparable to Facebook ($700Bn), but the volatility is more like a small-cap or IPOs.   

This momentum feature (high vol, high cap) may scare away potential investors; it should not, quite the opposite, this high momentum will attract intelligent traders. Like a good fiduciary, let’s first look at the risks. 

With thousands of cryptocurrencies in existence and reports of money laundering, small market caps, lack of regulation, poor liquidity, high volatility, market manipulation, hacked funds, and dark web activity associated with digital assets, where can an investor gain healthy exposure to digital assets? Begin with the established leaders (the “blue chips”), Bitcoin, and Ethereum. In fact, at Two Prime, we solely focus on these two.  

These two assets represent over 70% of the total digital asset market cap, have a global distribution, and benefit from real institutional participation. While digital assets’ roots may have had something to do with the dark web in the early days, today, they are becoming institutional grade. Digital assets have gone through various cycles.  

The last rally was driven by legitimate retail. We saw worldwide retail enthusiasm and participation in the last bull run of 2017; it shined by the absence of institutional participation.  However, this current cycle is all about HNWI, institutions, and corporates: the financial nature of Digital Assets is shining through.  

We argue that due to the size and scope of these two assets and the granularity of their funding, BTC and ETH have exceeded the ability of individual actors to manipulate the market.  Several institutional-grade products already exist on the market from players like Grayscale and 3iQ as well as TwoPrime. 

With billions in daily trading volume, liquidity also no longer presents a barrier to entry; we will argue that BTC is an optimal reserve currency for HNWI and corporations alike. The role that gold played in treasury management will soon be fulfilled at scale by scarce digital assets. High volatility can be turned around to the investor’s advantage. Derivative markets have emerged in this new cycle.  

Start-ups like Deribit and incumbents like the CME show robust futures and options markets. With wise management, volatility and tail-risk can be tamed and, in fact, put to work intelligently for the smart investor.

BTC vs. Gold: Are digital assets super Gold?  

 

BTC functions as an inflation-hedged store of value. Just like Gold, BTC has no intrinsic value. This lack of real economic value is, in fact, strength in times of economic uncertainty. Digital assets counter-intuitively have extrinsic value because they lack intrinsic value.  

They act as a refuge value when markets and the real world wobble because of their lack of connection to the real economy. The way to value the asset is like gold, purely based on a stock to flow analysis. Let’s look at supply and demand then. 

Supply: Let’s look at the supply side of BTC. Like Gold, BTC has a finite supply of 21M units. Like Gold, it is mined. Unlike Gold, the supply is programmatically halved every 4 years or so.  This feature is in stark contrast to Gold: no other industry sees its output halved for a fixed cost. This singular event is called the halving in the industry and has presaged massive gains in the price.  

This supply-side shock alone would be enough to turn the light off on any real economic activity (think about any business halving its output for a fixed cost: it only works if you double the price of the asset) but is actually the most interesting feature of BTC on the supply side. BTC is a techno internet super gold on the supply side.  

Demand: Just like gold, BTC is traded around the world. Just like gold, the demand is worldwide, and there are bridges to all FIAT. Demand is expanding from retail to institutions. In contrast to Gold, BTC is easier to transfer and hold: it exists virtually as an open-source software ledger. 

No one entity owns this blockchain, and no one can hack it. Retail investment into Gold exists, but we predict that demand for BTC will soon outpace the demand for the various forms of Gold. There is a generational argument on the retail side and an epochal argument on the corporate side: smart corporate treasuries embrace digital assets en masse as better than cash holding. 

These characteristics mean that BTC, just like Gold, is positioned as an inflation hedge against economic uncertainty and government monetary debasement. Even more so than gold, it will feature prominently in corporate treasury allocations.  

Above and beyond the traditional dynamics of gold, we notice a supercharged supply and demand financial characteristics of BTC vs. Gold. As a reminder Gold, today sits at $10Tn total market cap, while BTC sits at $500Bn.  

This points to a 20x expansion to even Gold Parity (GP): GP means $500,000 per BTC. This will be the beginning: BTC has the potential to inflate beyond this GP price.   

 

Institutional Entrants

 

Alongside this, we have seen institutional participants, including corporate treasuries, enter rapidly, accumulating positions of hundreds of millions of dollars—established firms like BlackRock, Stanley Druckenmiller, SkyBridge Capital, MassMutual, and Guggenheim Partners. Wealth managers no longer need to worry that a move into digital assets will appear foolhardy.  

We foresee a day where the opposite will be true: not having intelligent exposure will be a guarantee of sub-performance.  JP Morgan reports that many family offices and millennial investors see Bitcoin as a preferred store of value to Gold. 

This rising narrative fuels increasing interest for professional investors, and inflows to digital asset products suggest that capital is starting to move from one asset class to another. The combination of institutional entrants and retail speculation makes the possibility for rapid growth quite possible. 

Models of scarcity like stock to flow suggest new highs are imminent, as seen above.  With such a global and internet-centric asset, fiduciaries will soon need to ensure they do not enter too late. 

Benefits of Digital Assets

 

What can digital assets uniquely offer a portfolio, though? Top digital assets have historically produced uncorrelated yields to equity markets and offered outsized returns. CitiGroup has predicted a rise above $300,000 per Bitcoin within the next few years. With a finite supply, Bitcoin can also hedge against inflation risk for investors and corporate treasuries. 

Lastly, digital assets’ decentralized nature can also prevent seizure for those living in high-risk political environments. The ability to gain significant beta exposure and add hedged risk parameters through interest-earning accounts and options trading makes digital assets, unlike any other asset’s behavior. 

With a relatively small market cap, purchasing Bitcoin today would be like buying an ounce of Gold for ~ USD 60. In retrospect, many fiduciaries and investors will look back on this time and ask why they did not buy more. 

S&P 500 Correlation to Bitcoin

Managing Volatility 

 

Volatility still does remain significant, with 2 and 3 Sigma movements occurring with relative frequency.  The high momentum (mass x velocity) is perhaps the most interesting feature of BTC. However, with derivative markets showing volumes of greater than $500MM daily, vol can be managed with intelligence just like equity market products, for hedging or yield depending on the environment. 

Derivative markets have seen rapid growth, with an 1800% increase in options volume in 2020. Also, these derivative markets’ relative nascency presents an additional layer of opportunity for savvy traders possessing the requisite experience and technical familiarity with these assets. 

The digital asset landscape has started to shift significantly over the past few years. Whether a fiduciary wants to accept it, a digital asset strategy and portfolio exposure will be unavoidable. 

Fortunately for those that move quickly, the digital asset market has matured enough for wise managers to make this permanent asset class a winning proposition for intelligent investors and their clients. 

This article is for informational purposes only and does not constitute an offer to sell or the solicitation of an offer to buy any security in any jurisdiction where such an offer or solicitation would be illegal. This does not constitute a recommendation or take into account the particular investment objectives, financial situations, or needs of investors. There is not enough information contained in this document to make an investment decision.