Crypto headlined a banner 2017 year with explosive returns. Such was the rise, that prospective investors fear the assets will go no further. However, crypto’s growth performance relative to risk creates a favourably skewed risk-return profile. Their portfolio broadening, uncorrelated characteristics accompany this asymmetry, making crypto a worthy asset class.

INTRODUCTION

Human ingenuity and innovation can be hard to predict. The process defies explicit projection. Price predictions carry little technical basis, but trends can be observed to outline generalized assessments. It is our contention that crypto’s development will leave behind a dramatically different landscape than the market we see today.

Throughout the Dotcom era, detractors ridiculed the technology’s lofty ambitions, but now the internet gorges itself on every industry in existence. Crypto is on a similar path, and the market will champion a motley pack of visionary tech. However, one cannot chart each point of such a trajectory. To profit from capricious destiny, an investor must cast a net of probabilities formed of austere analysis.

A pragmatic approach gauges the upper bounds of possibility. Therefore we analyze crypto’s growth capability relative to its current market capitalization, an evaluation contextualized by traditional assets as a comparative benchmark. A truly objective appraisal will measure these factors against the risk of complete capital loss. Any worthwhile investment strategy should minimize the fallout of such a crash.

Currently, pitfalls outside the technology itself loom over the crypto asset class, issues like regulatory threat and speculative turbulence. As global legislation becomes clear, as development polishes crypto’s flaws, the market will settle down. One must look towards this mature-market scenario, 5 to 10 years off.

The following analysis dispassionately considers the possibility of investment returns based on growth potential.

INVESTMENT OBJECTIVE

In determining market growth, it is important to consider whether or not traditional investment strategies justify an allocation in cryptocurrency at all.

Many believe investment managers excel through foresight, but in reality their selective methodologies merely consider risk relative to return potential. Their objective, then, becomes curating uncorrelated assets with positively skewed performance profiles. In investment management parlance, this means creating optimal efficient frontiers. High risk does not eliminate an asset from consideration as long as its return potential justifies its risk potential. In fact, the best efficient frontiers diversify with a variety of assets at different risk thresholds.

To gauge crypto’s viability in the asset allocation process, the following metrics need to be considered:

Correlation to other asset classes

Quantum of risks

Probability of risks

Return potential

If the correlations and risks relative to returns are attractive, then the asset will more than likely be included in the efficient frontier portfolio. The risk return tradeoff can be described using the probability distribution of expected returns. If the return distribution is asymmetrical, it offers a favorable profile. Cryptos have exhibited highly asymmetrical return profiles since inception, but this does not necessarily mean that this phenomenon will persist.

It is therefore important to examine the future growth potential of cryptos to determine the possibility of the “upside tail”. The risks are easier to quantify, as the worst case is considered near or full capital loss. The probability of these risks materializing however is also an important consideration.

RETURN POTENTIAL

Market Size Comparison

The total global wealth approximates at $280 trillion, excluding the derivatives market which cannot be included in a comparative analysis*. Crypto’s comprise just 0.15% of that base, but this alone does not illustrate growth potential. Cryptocurrency requires further analysis to determine which assets they will compete with for growth.

*Derivatives size are approx. $800 — $1,200 Trillion. However this measures nominal exposure, and not the real exposure after all positions are netted off.

Understanding the different crypto assets

Crypto assets span a range of classifications. Several individual profiles exist within the market. The asset class divides into 3 broad categories:

Currencies act as a store of value or a medium of exchange, similar to fiat currencies or gold. Currencies are represented by digital coins. Some prominent names within this category include Bitcoin, Litecoin, Monero, and Dash.

Protocols equip developers with the tools to create blockchain applications. An undergirding coin often fuels these cryptos, authenticating and allowing use of a blockchain. Protocols might be compared to operating systems such as Windows or Linux which enable computer applications. Some notable protocols are Ethereum, IOTA, Cardano, and NEO.

Applications refer to tokenized security contracts. They can also be noted as securities. These are represented by tokens and not coins. Applications use the blockchain to serve a function and fulfill an objective more like a company, and the crypto represents tokenized shares of the company. Ripple, Stellar, SALT, Augur, TRON, Golem are examples of applications.

Cryptos often blend between these categories, becoming hybrids in the taxonomy. These wide classifications make up the general consensus concerning identification.

Crypto Currencies

At further market maturation, crypto currencies will compete with traditional modes of exchange and stores of value. Therefore the current capitalization of these conventional assets illuminates a glimmer of currency growth potential. In the graph below “M2 Money Supply” refers to cash and short term money deposits, the proxy for a medium of exchange. The graph cites gold as a comparable store of value.

The stark disparity between the asset classes does not indicate how much of the general market capitalization crypto will absorb. However, the contrast does reveal a grand capacity for growth. If crypto currencies constituted even 2–3% of the traditional market, crypto’s total capitalization could spring forward 1,500%.

Further, Bitcoin accounts for nearly 90% of the crypto currency market cap. As Bitcoin’s dominance slips, challenged by new contenders, the growth capacity for the general currency market increases.

What is critical for an investor, is the knowledge that the growth capability outstrips the risk to capital, that asymmetry of returns is possible. This seems to be the case for crypto currencies.

Traditional valuation methodologies seem to vindicate crypto currencies further, hinting at exponential gains. Metcalfe’s Law details how telecommunication networks accrue disproportionately greater value as it adds more members. Historical examples best illustrate this theory: Fax Machines — useless as an individual unit, but extremely effective once adopted by a growing network. It is worth nothing however, that currently crypto’s main use is in investor speculation. Metcalfe’s Law would assert that crypto currency’s utility and thereby its value will grow by multiples as adoption gains momentum.

Protocols

These cryptos serve as entrance fee, validation, and fuel for decentralized applications on a blockchain. Unlike crypto currencies, approximating growth capacity is difficult because they are not comparable to any traditional asset. Protocol cryptos however enable the creation of decentralized applications, a hallmark of the crypto innovation. Additionally protocols are integral to application tokens. As additional applications form under respective protocols, both crypto classifications should grow in tandem.

Ethereum currently occupies the lionshare of the protocol market. However, Ethereum has recently fallen out of favour, with scaling issues and rival protocols slicing at its valuation. As the dominant protocol slips, the growth capacity for the general market increases.

Applications

Applications refer to initiatives that use blockchain technology to fulfill a clear objective. In order for the tokens to be purchased, the application will need to generate demand for the token. This is not unlike a company creating demand for its shares.

Therefore the share market serves as a reasonable benchmark for applications. Applications cannot be compared to the general share market, but need to be juxtaposed to the shares that the technology will compete against.

The Dot Com market had similar beginnings in the early 1990’s to Cryptos, and the total value of tech stocks today are $11 trillion, dominated by the FANGS with a value of $3.1trillion. Investor’s should not expect crypto to follow the Dot Com bubble’s point for point trajectory, but it is reasonable to assume the eerily similar markets will be, at least, comparable. Currently the crypto market is 20x less than the valuation of Dot Com assets at the time of the crash.

As application tokens represent a share in future income streams, they are suitable for fundamental analysis established by comparative assets. A price earnings multiple can be applied to the profitability of the application tokens.

The token market is currently in a hype phase, with many tokens trading at multiples without any real income or revenue. This was not dissimilar to the Dotcom era, when companies were also valued unrealistically. These unrealistic valuations are nonsensical for individual tokens, but when viewed as a collective industry, they do have merit. The market currently values the total applications at $170bill, which should equate to $6bill in earnings calculated at the NASDAQ price earnings multiple of 26.

Applications constitute .15% of the approximately $4 trillion in total world earnings. Apple’s earnings alone are almost 7x the total Application market’s implied earnings.

RISKS

Objective analysis demands holistic dissection, a robust examination of risks as well as rewards. In serendipitous calamity, certain hazards could trigger market-wide failure. Though many traditional assets run risk of collapse, these crypto specific threats warrant consideration:

Regulation

Liquidity event

Central Bank Intervention

Security attacks: 51% consensus Attack / Quantum computers

Collaborated effort by central banks

Regulation

A skeptical government’s legislative assault could prove disastrous for crypto. However regulative entities thus far persist with measured caution. Worldwide consensus seems to support technology that facilitates capital creation and liquidity, so long as the underlying operators do not deceive layman investors.

The SEC likely wields the greatest market influence of the global regulatory bodies. Their rhetoric tows a line of support and caution. An explicit articulation of their stance came in a December 2017 announcement from the SEC commissioner:

We at the SEC are committed to promoting capital formation. The technology on which cryptocurrencies and ICOs are based may prove to be disruptive, transformative and efficiency enhancing. I am confident that developments in fintech will help facilitate capital formation and provide promising investment opportunities for institutional and Main Street investors alike.

I encourage Main Street investors to be open to these opportunities, but to ask good questions, demand clear answers and apply good common sense when doing so.

The statement itself largely deals with ICOs (Initial Coin Offerings), but the commissioner’s positive appraisal of the technology itself bodes well for investors.

Liquidity Event

Any ETF, stock or tradeable asset can exhibit what traders call a “liquidity squeeze”. In a crypto liquidity event, the ability to sell Crypto and buy Fiat will be limited, and the prices will be driven down to extreme limits. A rush for the exit occurs under different scenarios, but it is often precipitated by a single negative event. This was evident in the Mt. Gox hack, where many Bitcoin holders fled to safety and tried to sell at the same time.

The liquidity risk is real, and it may take some time for the markets to correct to more reasonable levels. The introduction of options and futures in the crypto market however brings an element of stability, as investors have choices other than just selling.

Central Bank Intervention

It has been postulated that a large market player, or a central bank may manipulate the normal supply and demand dynamics of the larger cryptos in order to suppress the price.

There have been cases of price manipulation already, and this is a threat to the crypto market. However, these risk become smaller as the market grows and there are more participants. These risk are also evident in stock and other asset markets.

Security Attacks

A 51% attack is a method of assuming control of a blockchain’s infrastructure. Infiltration can be accomplished if an entity controls more than 50% of a network’s computing power. The attackers could then prevent confirmation of new transactions, halt payments between users, or reverse transactions. 51% attacks would likely be staged in order to double-spend coins. Most blockchains, like Bitcoin’s, feature a checkpoint where transactions are hard-coded into the software. These transactions would be inalienable even in the event of a 51% attack.

The larger the blockchain, the more computational power a 51% attack requires. Most blockchains would require too much power to compromise, making it infeasible and too expensive to justify.

In concept, quantum computers pose another threat to cryptocurrency. Such technology would boast computing power superior to all laptops, desktops, and supercomputers combined. To dilute the quantum threat to the most basic terms, quantum computers would overpower modern day encryption with brute force, processing data several billions times faster than currently possible. The machines could simply “guess” at combinations until finding the correct key.

Many cryptos are already building quantum resistant defense, and quantum technology is still in the early stages of development.

Conclusion

Crypto chops against the tumult of an asset class in embryo. Volatility, regulation and security cloud a future rife with potential. However, proven practice demonstrates crypto’s viability, especially as a means of diversification. With asymmetric return capabilities and attractive uncorrelated characteristics, the asset class enriches portfolios.

Market maturity will accompany a shift towards institutional grade mechanism. For instance, buying through an index fund casts a wide net, eliminating the guesswork involved in crypto selection. Additionally, these funds can offer familiarity to market influencers like family offices and high networth individuals comforted by investment management.

Such entry points can leverage crypto to offer tokenized incentive for investor participation. For example the SwissOne Capital Smart Crypto Index Fund caters towards institutional investors, and offers tokenized equity in the fund through a token generation event. Mechanisms like the SwissOne Index outperform Bitcoin and the general market, while providing offline security protocols and regulatory compliance. These structures benefit from seasoned investment managers that build allocation strategies and aid risk management.

Allocation methodology becomes the pivotal strategy in mitigating the substantial risk. A 1% distribution to crypto could energize performance with minimal risk to the overall portfolio. In the right entry environment, crypto warrants legitimate consideration.