The final comment in our 2021 “Questions about Cryptocurrency? Here are 21 Answers” piece was “ultimately, the stakeholders in the ecosystem would determine the next decade.” Cryptocurrency continues to be a rapidly developing space within investment management and diversification and there was plenty of advancement in 2021. After looking at the major developments over the course of last year, we offer our thoughts going forward.
The U.S. Securities and Exchange Commission (SEC) approved a Bitcoin exchange-traded fund (ETF). These ETFs had previously been approved in other markets (such as Canada), and after many applications, the SEC finally gave its approval. However, the current Bitcoin (and other cryptocurrency) ETFs are based on futures contracts, not a true spot Bitcoin ETF. While the ETFs based on futures provide investors a regulated, inexpensive, and liquid way to invest in cryptocurrencies, there is not a 1:1 correlation in price movement with the underlying cryptocurrency. The chart below shows the price movement of the first approved ETF (ticker BITO) compared to spot Bitcoin price. You can see the high correlation, but due to fees and the cost of futures contracts, there is under-performance. Market participants are optimistic the SEC will approve a spot Bitcoin ETF in the latter half of 2022, but it appears that the SEC still lacks confidence that the Bitcoin market is free of fraud and manipulation.
Acronyms: NFT and DAO
NFT stands for non-fungible token. NFTs are cryptographic assets primarily on the Ethereum blockchain. The Ethereum blockchain is intended for people to tokenize various things like art, collectibles, and even digital real estate. Numerous athletes, celebrities, and artists have entered this space and minted their own NFTs. Of course, one of the primary reasons they participate is the hope for additional income generation. It also allows them to create new galleries of art and set their own prices. The largest marketplace to buy and sell NFTs is OpenSea. If you want to look for yourself: https://opensea.io.
DAO stands for decentralized autonomous organization. This is a rib from the spine of some of cryptocurrency’s key tenets: to be decentralized, no controlling government, no bureaucracy. The rules are encoded, transparently, as a computer program controlled by the members of the DAO. They generally are founded by a smart contract that defines the rules and can only be changed by the members. While there is not one controlling member, not all smart contracts allow every member an equal say. The most (in)famous example from 2021 was when the Constitution DAO attempted to purchase one of the few remaining original copies of the U.S. Constitution. While the DAO lost the bid, it drew plenty of attention. DAOs are being used today for investment, charity, borrowing, and NFTs. If you are part of a DAO that wins a piece of art (either real or NFT), you would likely get a NFT to represent your ownership. (Yes, it is not only you noticing the circular nature of the transaction.)
While regulation continues to be a global challenge, and there are not agreed upon standards, we will focus on the U.S. During January 2022, President Biden stated new rules for Bitcoin and cryptocurrencies were coming, potentially as soon as March. This will likely take the form of increased policing of trading platforms/exchanges to be sure they are following the Know Your Customer Rule and potentially increase taxes. It is also likely crypto trades will be subject to the tax-loss harvesting “wash-sale” rule—if you sell at a loss, you cannot buy back the same stock or security within 30 days if you want to claim the loss. Currently, crypto is not subject to this rule but this provision is in the Build Back Better Act. Finally, it is expected Biden will weigh in on a digital dollar and tie together reports and research papers by the Federal Reserve and U.S. Treasury on the merits and drawbacks of a central bank digital currency.
Along with other annual tax planning reminders, it is still true that investors are responsible for tracking all their crypto transactions and reporting them to their CPA and/or on their tax filings.
As of February 2021, according to Glassnodes Insight, just 2% of Bitcoin holders own 72% of its value, which is extremely concentrated. Bitcoin is currently 38% off its high price from November 2021. (See chart below.) This is also seen across many other cryptocurrencies. Similar to how we observe interactions between the markets and economic conditions, there also appears to be a correlation with the equity markets; when equity markets are down, Bitcoin trends down.
It is unknown how much leverage is in the crypto ecosystem. We do know certain exchanges allow crypto investors to purchase on margin. This is similar to buying a stock on margin, i.e., borrowing from your existing portfolio to buy more stock. If and when the price of the security being margined drops, the investor needs to remedy the margin call by either adding additional funds or selling the existing investment, which might be the Bitcoin itself. (If no action is taken, the exchange will sell the asset to cover its margin liability.) However, we don’t know if any large financial institution has provided credit to exchanges directly and/or very large clients that are then buying on margin at many places. One of the concerns is a cascading effect if either a large exchange fails or one of the billionaires in crypto starts to face margin calls.
Thoughts for 2022
There is no question this is an investment space not just for those looking to strike it rich quick, reminiscent of meme stock market events driven by retail investors; it’s also for the intellectually curious. It draws people from all parts of life and all over the globe. Governments and very large companies (JPMorgan Chase, for example) have taken notice and understand this is part of our economy. While there are exciting use cases, there is still plenty of fraud and lack of security, i.e., hacking of platforms and wallets, in the system. Can the entrepreneurial, decentralized spirit of the main players coexist with a digital dollar created by the U.S. government? We are only in the beginning chapters of this book, and it still has the feel of a choose your own adventure. Stay tuned.
In the meantime, if you still have questions or concerns about crypto or other investment strategies, please contact one of our financial advisors. You can also sign up for our Insights Blog and newsletter to get our thoughts on current wealth management news and trends delivered directly to your inbox.
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