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That’s Our Two Satoshis: Cleaning Out the Bad Actors  in Crypto

Jeff Dorman, CFA
Apr 29, 2019
What happened this week in the Crypto markets?
Congrats Equity Market!  You’re #2!
After only seven “down” months, during which time the government shut down, economic indicators have faded, and Treasury yields have increased, somehow the S&P 500 Index climbed back to close at new record highs last week. Almost all of the equity market gains this year have been driven by multiple expansion rather than improving fundamentals.  “Don’t fight the Fed” is now glued to every Bloomberg Terminal across Wall Street.
Very curious to see how this ultimately plays out.
Screen Shot 2019-04-29 at 7.20.49 AMMeanwhile, crypto is still the best performing asset class YTD, even after taking it on the chin last week with 5-10% losses across the board. Bitcoin (BTC) once again outperformed the rest of the pack and is now sitting at an impressive 40% gain YTD.
 
Exchange Risk, Exchange Risk, Exchange Risk
Last week’s crypto losses were once again driven by Exchange Risk.  Bitfinex, a crypto-exchange that is mostly irrelevant in the US but still remains in the top 50 by crypto trading volume, has forever been tied to its loosely-regulated stable token (Tether) which is used as a trading pair for crypto since it is often difficult to move fiat into/out of exchanges.  These loose regulations caught up to Bitfinex and Tether once again last week. Anthony Pompliano at Morgan Creek Digital does a great job recapping the event, but bottom line, it’s another example of bad actors doing bad things.

As we’ve discussed over the past few months, the dips in crypto are still prominent, but they are becoming more shallow, as investors are eager to buy every dip.  Last week was no different. What once may have caused a 10-20% drop across the board, has now triggered only mild selling, and virtually no panic. That said, the dips do keep occurring, and many of them are caused by similar events to last week.  Over and over again, we sell-off on the same news.

The headlines are everywhere when this happens.  Fraud, deception, greed, regulatory arbitrage, and mistrust are easy stories to write about it.  What gets less press is that the crypto market has matured to a point where these shenanigans are completely avoidable by anyone in the U.S. looking to play by the rules.  Between regulated exchanges, OTC desks, institutional custody offerings, and common sense, most investors face absolutely no risk of these headline-grabbing events.  While many equity and debt investors were caught flat-footed in 2008-2011 when it came to counterparty risk, the crypto world has been focused on eliminating these risks since inception, and it’s quite easy to avoid now.  Most funds, including our own funds at Arca, have zero exposure to any of the tokens (like Tether) or exchanges (like Bitfinex, QuadrigaX, etc.) that give the industry a black-eye.

The regulators need to keep chomping down on these bad actors and we welcome all of these moves that cause short-term market dislocations and negative press.  Because long-term, cleaning up these bad actors is the greatest thing to happen to crypto.

Looking forward, we expect the crypto markets to behave a lot like debt and equities in terms of their resilience to bad news.   Broker-dealers, banks and exchanges in the US, all of whom are heavily regulated, get fined all the time for breaking the rules and employing bad actors.  In fact, Merrill Lynch literally did the exact same thing as Bitfinex less than a decade ago.  These events are often completely overlooked by investors and almost never have a negative effect on the overall market.  Crypto investors will soon be able to dilute this news as well.
image4-5
A Quick Note on Correlation
Bitcoin is still the most important asset in all of crypto, currently representing 57% of the entire market.  When it performs well, the best risk/reward is arguably to own Bitcoin over any other digital asset. This doesn't necessarily mean BTC's returns will be higher than those of other digital assets, but rather, the probability weighted return is the highest for Bitcoin given BTC is so far ahead of any other digital asset in terms of adoption and use cases.  If you look back to early April, when BTC rose 25% in a single day, every other digital asset rose as well... but since that day, BTC has remained well bid while many other digital assets have slowly begun to decline due to a rotation out of "altcoins" into BTC.
 
We focus a lot on the correlation between crypto and other major asset classes (near zero) and crypto’s correlation to each other (close to 1.0).  But April has been a great reminder that correlation itself has little to do with overall returns. When two assets move up or down together, the dispersion of the moves over time can still be quite high (i.e. Asset A always gains more than B on up days, but Asset A loses less on down days than Asset B).  Case in point, month-to-date, 14 of the top 50 digital assets are up more than 10%, while 19 of the Top 50 are down more than 10%, even though everything traded down on the Bitfinex/Tether news last Thursday.

Long-term, this is healthy and positive for all digital assets as the correlation to BTC has decreased significantly.  This leads to relative value opportunities between different tokens, and makes "security selection" (or token selection) more important because the entire space no longer moves in lock-step.  
 
Don’t let narratives sway you.  While crypto very well may outperform every other asset class in 2019 and beyond, this likely will not be an environment where every digital asset performs well.  We’re heading towards a decoupling, where there are clear “haves” vs “have-nots”.
 
Notable Movers and Shakers
It wasn’t exactly a straight line, but Bitcoin ended the week exactly where it began - $5300. The storyline isn’t so dull for the rest of the market, with some projects showing substantial growth (50%), and others showing significant bleeding (-20%). A few tokens stood out:

What We’re Reading this Week

Blockchain 50: Billion Dollar Babies
Forbes released a new report last week highlighting over 100 big companies (minimum revenues or valuation $1b+) that are exploring blockchain technology. The article focuses on larger businesses as their impact is far greater than smaller “ICO-funded upstarts”. Interestingly, the report revealed that over 50% of these firms are building applications of some form on the Ethereum network.

Tulip Mania or the New Internet?
Crypto is often either written off as a one-time fad or touted as the most important innovation since the internet. The reality is that it is somewhere in between: despite all of the positive headlines, crypto still only has fringe use cases and little-to-no mainstream adoption. While this narrative is skewed towards the anti-crypto camp, the author does make valid points about the hurdles that still exist.

Circle Research’s Q1 2019 Retrospective
Circle Research released their quarterly crypto report last week that includes high level findings about the crypto markets, an update on crypto financings, network usage and much more. The report is incredibly data rich and informative with respect to new developments such as Initial Exchange Offerings (IEOs), decentralized finance, and staking and lending solutions.

NASDAQ Offers BTC and LTC Paper Trading
According to leaked images on social media last week, TD Ameritrade is offering its user simulated exposure to BTC and LTC through an unreleased NASDAQ product. Despite the leaked images and corroborations from outside sources, TD Ameritrade denies that they are offering cryptocurrency trading outside the Bitcoin Futures market. It’s interesting to observe traditional financial groups wade into digital assets despite the broader financial sector pretending to ignore crypto as an asset class.

Consumers Can Now Pay with Bitcoin via the Lightning Network on Amazon
Moon, a crypto payment processor, released a browser extension last week that allows consumers to pay for items on websites like Amazon using Bitcoin via the Lightning Network. The extension does not require any work by the merchants, nor does it mean that merchants are directly accepting Bitcoin and other cryptocurrencies as forms of payments. Tools and technologies like Moon are what will drive adoption for Bitcoin as a mainstream form of payment.

Global Cryptoasset Regulatory Landscape Study
The University of Cambridge released a comprehensive report last week that studies cryptoasset regulations across the globe. The study provided  interesting insight including the problems with unclear cryptoasset terminology, the regulatory focus on ICO and exchange activity, and the willingness of countries with less rigid financial regulation to provide comprehensive cryptoasset frameworks.

Samsung
Samsung is wading further into crypto: first, news broke that the company is working on a private blockchain based on Ethereum, with the promise of one day releasing its own token. Inside sources claim that the project is still in the “internal experimental” phase. Second, Samsung invested $2.9m in crypto hardware wallet provider Ledger. The recent news out of Samsung comes as no surprise as the electronics giant eyes crypto, beginning with the release of its Galaxy S10 that boasts a crypto wallet, private key storage and crypto dapps through Enjin.

Sneakers on the Blockchain?
Last week, patent filings revealed that Nike has filed a trademark for “Crytpokicks” with the intention of launching its own cryptocurrency and related services. Speculation is swirling about what the apparel giant is planning to do with blockchain technology - track merchandise authenticity, user rewards programs - but Nike’s involvement surely spells something big.
 
And That’s Our Two Satoshis!
 
Thanks for reading everyone!   Questions or comments, just let us know.
 
The Arca Portfolio Management Team
Jeff Dorman, CFA - Chief Investment Officer
Katie Talati - Head of Research
Hassan Bassiri, CFA - PM / Analyst
Sasha Fleyshman -  Trader 

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©2018 by Arca Funds Past performance is not indicative of future results. Investors should carefully consider the investment objectives, risks, charges and expenses of Arca "(The "Funds"). This ad other important information about the Funds are in the respective Fund's offering documents which can be obtained by entering Arca Private Investor Portal. All of the offering documents should be read carefully before investing. Disclaimer: This commentary is provided as general information only and is in no way intended as investment advice, investment research, a research report or a recommendation. Any decision to invest or take any other action with respect to the securities discussed in this commentary may involve risks not discussed herein and such decisions should not be based solely on the information contained in this document.