Investing in Bitcoin, or any cryptocurrency, is not for the faint of heart. Originally launched in 2009, Bitcoin has climbed and crashed several times over the years. But none of this compares to the rollercoaster ride that started in 2017. It culminated recently with an incredible four-month rally that saw Bitcoin rise from a little over $10,000 in October 2020 to briefly surpassing $41,000 for the first time in January 2021. Other cryptocurrencies, such as Ethereum, have benefitted from the Bitcoin boom and seen prices rise as well.

This is nothing short of remarkable for an asset class that is not backed by fiat currency and not regulated by a central authority.

Unlike previous spikes, which were predominantly driven by retail investors, this one can be attributed to institutional investors. According to Bitwise Asset Management, a provider of cryptocurrency index funds, inflows in Q4 2020 surpassed the “cumulative total inflows from 2018 and 2019 combined,” due to demand largely from hedge funds and institutional investors.

Mass Mutual and J.P. Morgan are among the many well-known institutional investors jumping into the market, and that’s in spite of rising prices and the inherent risk of digital assets. The launch of new funds and products are providing a range of specialized investment options that are also helping to attract investors.

Global investment manager BlackRock, for example, recently filed with the U.S. Securities and Exchange Commission (SEC) for two of its funds to invest in Bitcoin futures. And, alternative investment firm, SkyBridge Capital, announced in January the launch of a new institutional-grade Bitcoin-focused fund.

Balancing challenges, risks and rewards

Heightened interest among hedge funds, private equity firms and family offices, is an encouraging sign that the cryptocurrency market is beginning to mature and even going mainstream.

In addition to the potential of outsized returns, the attraction of cryptocurrencies is that they have a low correlation to stocks and bonds, so they offer diversification and a hedge against inflation. Nonetheless, this asset class is extremely volatile and not without numerous operational, regulatory and security challenges.

Liquidity remains a significant issue for investors. There are over 8,000 cryptocurrencies and hundreds of exchanges, each with its own wallet, interfaces and requirements. This fragmentation and incompatibility between currencies, wallets and exchanges, makes for an inefficient market that contributes to volatility. Even Coinbase, one of the world’s largest cryptocurrency exchanges, only supports trading in Bitcoin, Ethereum, Litecoin, and a handful of other digital currencies – a telling sign of the lack of liquidity.

Determining fair market value for an asset that trades 24 x7 is another issue. Unlike traditional exchanges, there is no end-of-day close upon which to strike a fund’s NAV, so investors must find a reliable pricing source that compiles data from numerous exchanges and weights valuations to determine realized gains and losses. Aggregating this information for accounting and reporting can be difficult.

Custody is another challenge. This comes back to fragmentation as well as the lack of a consistent regulatory framework. Many countries are taking steps to formalize best practices for custody and governance, which is critical for this asset class to achieve the trust and legitimacy it needs for wider acceptance. At the same time, new institutional-grade cryptocurrency custodial solutions are cropping up to fill the gap. In fact, the Office of the Comptroller of the Currency (OCC) recently gave the green light for U.S. banks to offer cryptocurrency custody services.

As cryptocurrency products evolve and begin to resemble more traditional regulated investment products, the industry is likely to see greater regulatory oversight and know your customer (KYC) requirements. Rather than hamstring growth, a heavier regulatory hand may very well be what is needed for mainstream acceptance.

What’s next?

One of the hottest new areas is decentralized finance, or “DeFi,” which uses cryptocurrency and blockchain technology to structure complex financial products that mirror traditional investment options. In the last year alone, the total value invested in DeFi projects jumped from US $830 million to more than $25 billion, according to DeFiPulse.

Adam Knuckey, who, along with partner Corey Caplan run Dolomite, a decentralized exchange, believes that DeFi may very well be the future of the market. “The products and opportunities are limitless,” said Knuckey. “Plus, DeFi enables any asset manager around the world to easily invest.”

One example of a DeFi product is margin trading, which has a fluctuating return. Margin trading relies on a pool of DeFi lenders who provide their assets for margin traders who then pay interest on borrowed assets to cover their margin positions. All this is done through smart contracts on the Ethereum blockchain, the primary infrastructure for DeFi projects. On-chain transactions provide the transparency and tracking needed to build confidence in products underpinned by cryptocurrency in order to attract pension funds, endowments and other historically risk-averse investors.

Getting the technology infrastructure right

A host of new specialized asset management tools are becoming available on the investing side to replace cumbersome spreadsheets. They provide a more straightforward way for investors to consolidate wallets, monitor traders’ positions, manage target allocations, handle execution, value assets and meet risk management requirements.

These systems must be able to feed an asset manager’s back-office accounting platforms to provide a unified view of investment activity. More importantly, the accounting system must have the flexibility to support cryptocurrency assets for analysis and reporting.

FundCount provides back-office accounting and investment analysis software that is flexible enough to handle digital assets. Users can establish “custom currencies,” such as cryptocurrencies, slice and dice data, analyze results, and quickly generate reports to meet client and management requests as well as support tax and audit requirements.

Contact us to learn more.