David Lebovitz: Welcome to the Center for Investment Excellence, a production of JPMorgan Asset Management. The Center for Investment Excellence is an audio podcast that provides educational insights across asset classes and investment themes. Today's episode is on digital assets and cryptocurrencies, and has been recorded for institutional and professional investors. I'm David Lebovitz, Global Market Strategist and host of the Center for Investment Excellence. With me today is Paul Zummo, Chief Investment Officer for JPMorgan Alternative Asset Management. Welcome to the Center for Investment Excellence.
Paul Zummo: Thanks for having me.
David Lebovitz: My pleasure. So, today, Paul, we're going to be discussing a topic that has caught the attention of investors and the business community, really not just in the United States, but more broadly around the world, and that topic is digital assets and cryptocurrency.
So, in terms of the road maps for today, I want to begin by touching on a couple of high-level topics, just talking through, what is the blockchain? What are cryptocurrencies, and how do we think about allocating to these assets within the context of diversified portfolios?
And then following that, Paul, I want to bring you into the conversation, and learn a little bit more about what you're doing in the space, and how you’re taking advantage of some of the volatility that we're seeing in the current environment, in an effort to add alpha.
So, with that is the road map for today, I think it's important to recognize that the rise and subsequent fall over the past couple of months of Bitcoin, has certainly caught a lot of investors’ attention. And, you know, one of the questions that I get more than anything else is, is this a bubble?
And when people ask me the question of, is this a bubble? To me, bubbles, when they pop, they never reinflate. And one of the things we've seen from Bitcoin specifically is this element of resilience over time, a big run-up in 2017. Things came back down to earth, bounced around a little bit. Another big run-up in late 2020, early 2021, obviously followed by a 50% decline in the price of these assets.
But the fact that they are resilient, the fact that the bubbles didn’t pop and the value didn't go to zero, really suggests to me that these are going to be around for the foreseeable future. And so, on one hand, investors need to understand exactly what's going on in this space, but at the same time, investors need to also understand the different strategies that they can implement to take advantage of some of the volatility that has obviously caught so many investors’ attention here over the past couple of years.
And you know, what's also interesting is, when I talk to clients about Bitcoin and crypto, people love to say, well, the value is in blockchain, right? But then you begin to press them on it, and they don't really have a good answer as to exactly why that is the case.
And so, understanding the blockchain, I think, is an important place to start any conversation around digital assets and cryptocurrencies. And, you know, effectively, a blockchain is just the database. And the database fundamentally is a collection of information that's stored electronically.
The big difference between the blockchain and the traditional database, is that a traditional database structures its data into rows and columns. Think about a table or a sheet in Microsoft Excel. Blockchain on the other hand, perhaps hence the name, structures its data into blocks.
And so, very simply, all blockchains are databases, but not all databases are blockchains. And obviously in the current environment, you really see blockchain being used to store cryptocurrency transactions, but there are a number of real world applications that we believe exist as well.
And there could be huge improvements in terms of trade finance, very secure way of storing medical records, a way of tracking voting records over time. The real-world use cases for the blockchain, I believe, are pretty significant. And again, that's where the value really lies, is moving away from some of these crypto assets, and thinking about the real-world economic applications of this way of storing data.
And so, how does the blockchain work? Well, the way that it works in the current environment is that new transactions entered into the ecosystem of computers that store the blockchain, that transaction is sent to these computers, which work to solve an equation to determine the validity of the transaction. And this is where the blockchain is decentralized.
This is where you hear a lot about proof-of-work. And I think we'll touch on some of the sustainability issues with proof-of-work later on during our conversation. Once the transaction is deemed legitimate by the network, so it's received 51% approval from the computers in the ecosystem, those legitimate transactions are clustered into blocks. Those blocks are then chained together, and the transaction is therefore complete. And so, that's how the blockchain works.
The other thing I see people tripping themselves up on is, well, what's the difference between cryptocurrency and traditional currency? And I personally don't really like the term cryptocurrency. I think of them more as being crypto assets, because to me, one of the biggest differences between, say, the US dollar and Bitcoin is, you can only use Bitcoin to transact where it's accepted, and that's a limited number of places. You can use the US dollar effectively everywhere in the United States.
And so, from an economist’s perspective, if a currency is a medium of exchange or a store of value, I'm not sure that a lot of these cryptocurrencies, crypto assets, necessarily check all the boxes here at the current juncture. But there are a number of differences between traditional fiat currency and these crypto assets that are obviously front of mind for so many folks.
In terms of who manages this, these crypto assets are managed by the computers that are running. It's open source code. You think about a traditional currency. Well, that's being managed by the government that issues it. How does it hold value? I think that this is a really interesting area to discuss. A crypto asset, its value is going to be purely based on supply and demand.
I mean, it's worth whatever somebody will give me for it at any given point in time. You think about the way something like the US dollar holds value, and it's really based on confidence in the issuer, right, the full faith and credit of the US government, if you will.
How is it secured? Well, the network of computers obviously verifying every transaction, secures crypto. Third parties like banks secure traditional currency. And then perhaps the most obvious one, are there physical bills or coins? The answer to that is no in the crypto space. And although they are not used the way that they once were, I do still have a couple of dollars in my pocket for when I find myself someplace where they won’t take my credit card.
So, we’ve talked a little bit about blockchain. We’ve talked a little bit about how crypto differs from fiat currency. Bitcoin as an example for kind of crypto more broadly, and I know we're going to get into the nitty-gritty of the differences between all these various tokens, but, you know, Bitcoin is just one example of a crypto asset.
And I actually try to segment Bitcoin from pretty much everything else in the digital asset and the crypto universe, but everybody talks about Bitcoin. So, what exactly is it? And the Bitcoin ecosystem, if we start there, is really just the group of computers that are running Bitcoins code and storing transaction history, storing its blockchain.
And when it comes to keeping balances of Bitcoin, they're kept using keys. And the way that I think about it is, you know, Paul, if you and I want to engage in a transaction, I’m buying something from you and I'm paying you with Bitcoin, I need to know your public key. That's kind of like your bank account number. And then you have a private key, which is kind of like an ATM pin, that allows you to access those funds once they've been transferred
Bitcoin, and I think a lot of people know this, is released into circulation through mining. Every time a new block is added to the blockchain, miners are rewarded with six and a quarter bitcoin, and that number will half for every 210,000 blocks that are created. The most recent halving was on May 11th of last year. Again, currently getting six and a quarter Bitcoin per block. But that will continue to decline as more blocks are added to the blockchain.
And then finally, people always ask me, well, how do I get my money out? And it's not as simple as walking to the forex window at JFK and saying, here's my Bitcoin. Now, give me some US dollars. You need to use something called stablecoins in order to make that transition.
And so, the first thing you need to do is take your Bitcoin, again, just as an example, transition that into stablecoins, which are going to be digital tokens that are backed one-to-one by things like US dollars, and then you can convert that stablecoin into the end currency that you desire.
And so, there are a lot of nuances here that I'm not sure a lot of people are aware of. And the final point that I want to make before turning it over to you, Paul, is really about how all this ties into portfolio construction. The blockchain is interesting. I do think that there's value there.
Bitcoin is the dinner table conversation. It's important that we understand the way that it works and the way that it differs from traditional currency, but how does it fit into a portfolio? Well, if we think about traditional portfolio construction, and we assume that mean-variance optimization is the approach that most investors take, you know, the optimal allocation is going to be based on estimates of future returns, future volatility, and the way that the asset interacts with the other parts of the portfolio.
And, you know, the reality about these crypto assets, is that it's very difficult to come up with an estimate of expected return, given that price action is purely based on supply and demand. Volatility has been through the roof, and that creates opportunity, Paul, for guys like yourself.
But forecasting what the volatility of Bitcoin is going to look like over the next 10 years, I would argue, is a bit of a fool's errand at the current juncture. And then furthermore, when you look at correlation, the correlations with equities, with gold, with high quality fixed income, they're extremely unstable over time.
And so, you know, I don't think that there's a right number when it comes to adding crypto to a portfolio, but I think that there are a lot of interesting investment strategies that are being created around the crypto universe. And that's really where I want to take our conversation from here.
And so, Paul, bringing you in to talk a little bit about what you're seeing, you know, let's just start with the 20,000-foot question. So, there's tremendous amount of fanfare around what's going on in the digital assets space broadly. What makes you so excited about the opportunity that's been created amongst the universe of digital assets?
Paul Zummo: Yes, great question. So at a high level, I'd say to a large extent, I'm excited for many of the same reasons that several others, or many other people are so apprehensive toward the space. So, what do I mean? I mean, if you take a step back and I think we would all agree what the market represents at this stage is, it's a nascent market.
Clearly, there's high levels of volatility. It's challenging to understand. You know, it’s speculative and there’s a number of issues, some of which have been solved, some are still outstanding, regarding custody and potentially fraud. And I think because of those issues, the path of least resistance for many investors, is to dismiss it.
And I want to - and I appreciate that stance. That said, on the other hand, I can't help but see the parallels between many of those observations and similar observations that were made toward the hedge fund industry when I started in business in 1995.
And back then, and I think what will prove to be true this time around as well, it's true those risks are real, but through structuring and property diligence and thinking about sizing, proper sizing in portfolios, you can put to bed, or at least mitigate a lot of those risks.
And for the hedge fund industry, it turned out in 1995, that was one of the best periods for the hedge fund industry. So, if you took the path of least resistance, you were on the sidelines, it was a mistake. But kind of coming back to digital assets, again, many of the characterizations are true, nascent market, volatility, challenging to understand.
And again, to most people, that screams of risk and loss at the end of the conversation. I acknowledge those risks, but what screams to me is inefficiency, opportunities, and potentially asymmetric returns. So you have to look at, what is the return out there? How much alpha is out there and does that compensate you for the risk? And again, can you mitigate those risks? So, I think the approach is important and sizing is important.
David Lebovitz: I think that those are great points. And you said the magic words that everybody loves to hear, particularly in the environment that we've been in over the past 15 months, and that's alpha. And so, when it comes to alpha generation, what types of investment strategies are you seeing in the crypto market today? And what are your thoughts about the ability of those strategies to generate alpha here going forward?
Paul Zummo: Sure, it's an excellent question, because I think when a lot of people think of the space, they have too heavy of a focus on associating digital assets with a kind of simple long-only investment in Bitcoin. And, you know, Bitcoin is the first use of blockchain. Ultimately, it may prove to be a valuable store of value, but I think there are far more interesting ways to gain access to the space.
So, let me take a step back and kind of describe how I see it. First, there’s an active versus passive choice. Do you want to have passive exposure to Bitcoin, Ethereum, Litecoin, other major tokens? And if so, how do you gain access? Today, there's no ETFs that are authorized in the US. There are some in Canada.
So, for many US investors, one option is investing through investment trusts. That being said, pricing is a bit elevated there, or through private bank kind of dedicated vehicles. And I think that's a reasonable way to take a long-term view on digital assets with specific tokens. But again, I lean heavily toward more actively managed side for sure.
Again, why so? At a high level, the less inefficient a market is, the more opportunity there is to add value through investment due diligence and structure. So, that should be material alpha. So, I'd break the approach into three different areas. The first is venture. And within venture, I'd really distinguish kind of two different approaches.
The first is traditional revenue-based model. So, Coinbase being, I think, the most prominent, just listed recently, other exchanges out there like Elise, Kraken, and Gemini, also funded with VC markets. Other things like Bitmain, which is focused on Bitcoin mining, (DoubleLab), others, really, really profitable, early stage.
And the second part is just early-stage projects that ultimate result in coin launches. The second category, I would note, is liquid arbitrage. And let me describe some of the arbitrage that are out there in the marketplace today, and some that was used in the past. So, the first thing I would just highlight quickly is something called triangular arbitrage, which is really setting up trading relationships across tokens on different exchanges, trying to capture small pricing dislocations across those exchanges.
The second thing I want to highlight is orbing some of the investment trusts that I just mentioned. So, like Grayscale Trust was one that was being orbed. It was trading at a premium. And you could kind of orb that premium or capture that premium by borrowing shares of say Bitcoin, placing that through the trust, waiting out the resting period, and then ultimately liquidating that back and capturing a premium.
And then lastly is basis trading. I think we're familiar with basis trading in other markets. So, long cash versus futures because futures tends to trade at a premium, but the return potential in the crypto markets is really like two, three, four or five times that of what we see in say the fixed income market. So, again, all different ways to express relationships, but not necessarily directional relationships, but kind of more relative value relationships.
And then the third category I'd mention is just liquid token trading. So, trading tokens and coins, so to speak, in liquid and kind of semi-liquid fashion, say the top 30 or so coins. You can do so long-only. You could put hedges against it in a long-biased way. Also use derivatives as well.
David Lebovitz: This is what's so interesting to me is that, you know, there's this obsession with Bitcoin. And as you put it, Paul, most people think that that simply entails taking a long-only approach to an asset class where price changes are purely a function of supply and demand.
I mean, there are ways of capitalizing on this volatility, taking advantage of the universes being created. And that's where I think the interest from the institutional investors that I speak with, is really stemming from. You know, they don't necessarily have a view on the underlying assets themselves in a lot of cases, but they understand there's an opportunity to apply investment strategies in a way that generates alpha, which certainly doesn't seem to be available across many other public markets.
Paul Zummo: That’s right.
David Lebovitz: And so, given the growth in the interest here and the growth in the number of strategies that you're seeing in that space, how have you seen the investment universe grow over time? And what are some of the issues that you see if we continue to see this very robust pace of growth going forward?
Paul Zummo: Yes. As you can imagine, it's been really robust. So, you know, I don’t have perfect data on this, but in the last year, you've seen assets double. Probably the number of funds have doubled as well. I think many people would be surprised to learn that there are about 800, if not more, crypto-focused funds in operation today.
What I think people would not be surprised to learn, is that most are not institutional quality at this point, nor investable necessarily. So, if you asked the question, how many are above 100 million in assets? It's probably 10% of that, kind of call it 80-ish. That being said, it's still a reasonable universe to work with. We've certainly identified a number of high quality, what we would describe as institutional quality firms across venture and liquid hedge funds side.
In terms of scalability, we often ask, how scalable is it? I think it really depends on the strategy. So, Tesla and MicroStrategy, I mean, they invested $2 dollars, I think it was, each in Bitcoin kind of passive long-only. So, there's ability to put money to work, if you want to kind of follow what I was outlining before, which is more alpha-driven approach across venture and liquid assets, I think, you know, you're looking at, say, $500 million that you could comfortably put into the space today. And of course, that's going to increase as volume increases and the breadth of liquidity across different coins increases as well.
David Lebovitz: I think that it's interesting to hear you kind of lay out the way that the universe looks today, and specifically the fact that there are really only a handful of strategies that are actually investable when it comes to the bite sizes that a lot of our clients need to take.
And so, another issue that is very front-of-mind here in the United States, obviously in Europe as well, is the issue of the carbon footprint. And a lot of the folks that I speak with who are anti-crypto, they'll say, well, you know, in 2019, there was more electricity consumed by Bitcoin than there was in the entire country of the Netherlands. And so, how do you think about that issue of the carbon footprint and ESG, particularly given all the momentum around sustainability across the investment community more broadly?
Paul Zummo: Yes, it's certainly an important issue, and I think that it's definitely one that's highlighted in the press, and thrown out there by the nay sayers. But I would suggest it's overstated for a couple of reasons. As you kind of outlined earlier, the ESG issue really comes from Bitcoin mining and transaction processing, because of proof-of-work, right?
So, solving of mathematical problems, sharing the rights to update the blockchain. And while it's widely understood that that is kind of an energy hog, what's less known is that about 40% of the Bitcoin mining is actually generated from renewables, which is more than the power grid itself.
And also, there's a case to be made that a material percentage is utilizing excess energy from the grid, which otherwise would be wasted. So, those are important facts I think are lost. That being said, is that where I want to fight the argument? Probably not, because I think it will continue to be in the forefront of people's mind, and sometimes logic doesn't always prevail.
So, to me, what is more convincing is just going into proof-of-work versus proof-of-stake. So, the reality is that a large number of major coins use proof-of-stake rather than proof-of-work. So, Ethereum is moving toward that. CopaDot and others are there are today.
And proof-of-stake is just to say alternative validation mechanisms. So, it's much more straightforward. It requires one 1/100th the amount of energy consumption that proof-of-work does. And again, I think more and more will go toward that. And this issue, while important today, will likely not be an issue three years out because of the movement toward proof-of-stake.
David Lebovitz: That's a very reasonable assumption. I would agree for what it's worth. And the more people that I talk to who are firmly ingrained in the crypto space, whether they're working for a company that provides the infrastructure, or looking at the assets themselves as investments, that proof-of-stake issue keeps coming up, and that definitely seems to represent the broader direction of travel.
And so, maybe just one last question before we bring things to a close here. And I think we're going to have to have you back, because there's a lot more that we can discuss about this universe of investable assets. It feels a little bit like the Wild West. The volatility is extreme. It's unregulated effectively. You’re seeing the regulators begin to sniff around to an extent.
What are your thoughts on regulation? Would it be good? Would it be bad? And really more so than that, what's needed? As somebody who's looking at this space every single day, how do you think regulation can help, and how do you think it can hurt?
Paul Zummo: Great question. Do you want regulation? I think we do. Of course, it depends on what type of regulation. And it should be noted that when there is some sort of regulation, actually crypto markets tend to rally. So, as a whole, I’d say, crypto markets want regulation.
I think one thing that's certainly clear is not only because of ESG, but because of this issue as well, digital assets have a public relations problem in a sense. And I think that regulation would actually help in that regard. So, let's take the issue of fraud and most recently ransomware, where digital assets are used as payments.
I think if you polled people and said, how much of an issue it is or what percentage is fraud and ransomware and related of the total? I think people would say 20, 30, 40%. The reality is, I mean, there's a very comprehensive analysis on this topic. It turns out it's 3%, which, look, anything above zero is not great, but like 3% is very manageable and similar to what we see in the non-crypto side.
So, I think regulation can do a large role in getting that number lower, certainly making sure it doesn't grow. So, just KYC focus, regulation, and client onboarding, would definitely go a long way in cutting down some of that illicit activity, and would be welcomed by all.
David Lebovitz: Yes. Well, it seems to me like that's likely the direction of travel, and clearly this is a space that is in constant flux. So, more than anything, thank you very much for joining us today. I really enjoyed the conversation. I hope you did as well. And again, I think we're going to have to bring you back because there's a whole lot of other stuff that we can unpack about digital assets here over the course of the months and quarters to come. So, Paul, as always, thanks again for joining me.
Paul Zummo: Thank you. I appreciate the conversation and look forward to joining again.
David Lebovitz: Thank you for joining us today on JPMorgan's Center for Investment Excellence. If you found our insights useful, you can find more episodes anywhere you listen to podcasts and on our website. Thank you. Recorded on July 14th, 2021.
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