A year on since The Hedge Fund Journal first interviewed Nickel Digital Asset Management in early 2020, the manager’s prediction for an increasingly institutionalised cryptocurrency market is materialising as various regulatory developments in the US and elsewhere lend additional legitimacy and credibility to the asset class. Growing adoption by institutional investors and some corporate treasurers, as well as use in e-commerce and decentralized finance, could all add to demand for Bitcoin, which has finite supply – in contrast to fiat currencies where the potentially inflationary macroeconomic climate continues to be supportive of inflation hedges.
“Monetary and fiscal policy that the current environment has forced on policymakers is likely to eventually lead to inflation, so the backdrop for assets that can store value is very bullish,” says Nickel founding partner and portfolio manager, Alek Kloda. Investor expectations of inflation have roughly doubled over the past year, with “inflation breakevens” as discounted by US index-linked government debt hitting an eight year high as of February 2021. This is not surprising when the consensus expectation for monetary policy remains “lower for longer”. The Federal Reserve is prioritising employment within its dual mandate, and Federal Reserve Chairman, Jerome Powell, recently opined that “true” US unemployment was closer to 10% than the official 6% figure. The Fed may tolerate inflation somewhat overshooting its target. Effective Democratic control of the US Senate (VP Kamala Harris has a casting vote) has also raised expectations of even more generous fiscal stimulus measures, both for Covid relief and infrastructure spending. Meanwhile in Europe even politicians in Germany – which was traditionally fiscally conservative – want to relax debt ceilings.
It is a common misconception to think that crypto investors are worried about regulation. We all want clear, concise, practical regulation.
Alek Kloda, founding partner and portfolio manager, Nickel Digital
As well as printing fiat currency, central banks are starting to roll out their own digital currencies – CBDCs. The Bank for International Settlements estimates that 10% of central banks will issue a CBDC within three years and 20% within six years. Given that some countries face the risk of a double dip recession, it is natural that central banks are expanding the scope of digital currencies. “Of course, commercial bank reserves held at the central bank are already digital currency in a sense. The new development is extending digital currencies to individuals, as a potentially more efficient way to control interest rates in the economy,” says Kloda. “CBDCs could also increase the power of negative interest rates since consumers could no longer avoid negative rates by holding physical cash. A societal tax on money-not-spent would then apply beyond bank deposits, increasing the effectiveness of the interest rate channel on economic activity,” he adds. CBDCs could also help governments to repay Covid-related debt: “If the government can automatically deduct taxes, it also makes tax avoidance or evasion more difficult,” says Nickel founding partner and CIO, Michael Hall. “This also invades privacy if the government can track and trace spending,” he adds. The extraordinary powers used by governments during the Covid-19 crisis, which sometimes borrow from martial law, could perhaps continue and reach into other areas of personal liberty.
All of this arguably increases the attraction of assets that may offer a stable store of value. Though CBDCs could provide some competition for the spending function of certain cryptocurrencies, they may not have much credibility as a store of value since faster inflation is now an explicit objective of monetary policy. CBDCs are centralised whereas Bitcoin is permission-less and semi-regulated, which could provide additional comfort. “Fiat on-ramps are regulated but the internet itself is difficult to regulate – firewalls can be avoided through VPNs. It would be technologically difficult to ban it in the way that the US Government prohibited private holdings of gold in 1935. In any case even if some governments do ban it, they cannot be coordinated to do so in unison,” says Hall.
Two constructive regulatory developments in the US would seem to make the chances of a ban rather remote, however.
“The Office of the Comptroller of the Currency (OCC) has in September 2020 allowed commercial banks to custody digital assets,” says Nickel founding partner and CEO, Anatoly Crachilov. Conceptually, this is not entirely a new departure since banks already custody and escrow encryption keys, but it confirms the constructive direction in which the US regulatory framework is travelling.
The Bank for International Settlements estimates that 10% of central banks will issue a CBDC within three years and 20% within six years
“A growing range of third-party custody solutions are making it easier for companies to directly hold Bitcoin, without carrying the risk of potential mishandling of the private key and loss of the underlying asset,” says Crachilov. Fidelity Digital blazed a trail, and has now been joined by NYSE, Northern Trust in partnership with Standard Chartered, and BNY Mellon. These are the world’s largest custodians, and they are also sitting behind some white label custody providers.
Of course, Nickel’s arbitrage strategy trading across multiple exchanges requires a more sophisticated custody solution, including a walled garden with off-exchange settlement, provided by Copper. Nickel’s Digital Gold strategy uses Fidelity Digital as their cold-storage custodian.
“In January 2021, the OCC allowed federally chartered banks to participate in independent node verification networks (INVN) and use stablecoins to conduct payment activities in a manner very similar to SWIFT and Fed Wire,” says Crachilov. Banks might end up processing a range of existing and future stablecoins, as well as CBDCs, a future wave of central bank issued digital currencies. “This is a massive step forward, allowing the legacy banking system to integrate with innovative crypto payment rails. Bitcoin currently may not be ideally suited for small direct payments when high throughput is required, but other protocols that can offer real time settlement with thousands of transactions per second would be very attractive,” he adds.
For now, Bitcoin can increasingly be used for indirect payments. “PayPal’s breakthrough announcement in October 2020, allowing an efficient access to the Bitcoin market and, ultimately, acceptance of payments in Bitcoin should not be underestimated. In retrospect, it may come to be called the “PayPal Moment”, that reignited mass adoption of cryptocurrencies. Statistics suggest that as much as 70% of newly minted coins are acquired by PayPal to satisfy growing demand from their clients. If 6.25 Bitcoins are created per 10-minute block, that comes to just 900 newly minted coins per day – a number easily absorbed by PayPal and Square alone, driven by the demand of their underlying clients. PayPal has a massive user base of over 300 million, which is likely to be pivotal for the unfolding mass adoption,” says Crachilov.
Of course, paying for a pizza with Bitcoin (the famous 2010 case) was an iconic moment as well, but that merchant who accepted payment in Bitcoin purely as an experiment, has proven to be right by booking the most profitable pizza sale ever in the history of humanity. “Now PayPal is bringing a crypto payment solution, allowing its clients to pay with crypto across some 23 million worldwide merchants. Importantly, all these merchants need not adjust their systems to accept it, as PayPal, acting as the intermediary, is seamlessly converting crypto-to-fiat at the point of sale, thus allowing all merchants to maintain their accounting in the traditional manner, while accepting these new types of payments. “This is a win-win for the whole value chain,” says Crachilov. “Finally, Tesla’s recent announcement of accepting Bitcoin as a new form of payment for its cars, further reinforces integration of crypto into the real economy,” he adds.
Meanwhile, Visa has tied up with one stablecoin provider – Circle – and Mastercard (which has been helping central banks to test CBDC pilots and is building its own portfolio of blockchain patents) also plans to start accepting certain stablecoins, which meet certain compliance criteria, laws and regulations.
This market resembles a “1996 moment”, i.e. the early days of the Internet, the full potential of which will become evident only years later.
Alek Kloda, founding partner and portfolio manager, Nickel Digital
Payments group Square invested about 1% of its financial assets into Bitcoin in October 2020. At least two other companies have publicly announced that they diversified their corporate reserves into Bitcoin; MicroStrategy initially allocated USD425 million in August 2020 and boosted the allocation to over USD2.2 billion by February 2021, while Tesla bought USD1.5 billion in January 2021. If other companies allocated even a small percentage of their treasury holdings into Bitcoin, this could have a massive impact on the market. At its recent price of USD54,000, Bitcoin surpassed market capitalisation of USD1 trillion, though this is still a fraction of other traditional asset classes.
Nickel is using Cayman as their fund domicile, but the May 2020 PwC crypto hedge fund report identified funds domiciled in US, BVI, Gibraltar, Liechtenstein, Luxembourg, Netherlands, Singapore, Isle of Man and Australia. This also shows growing acceptance and makes it easier for a wider variety of investors to allocate – whatever their preferences are for fund domiciles.
The growing diversity of fund domiciles indicates that more and more financial regulators are comfortable with the asset class – and investors are also embracing regulation: “It is a common misconception to think that crypto investors are worried about regulation. We all want clear, concise, practical regulation for a fantastic technology to improve lives and assets,” says Kloda. “New SEC Chairman, Gary Gensler, is pro-crypto and he has the mathematical mindset to appreciate the beauty of the concept. There is no hint of prohibition, but instead the approach is likely to be embrace and regulate. Structurally, crypto is here to stay,” says Crachilov. “The potential to replace 50 state regulations for crypto-exchanges with federal rules would also be positive,” adds Hall.
SEC investor protection actions in the US have focused on initial currency offerings, scams and allegations that Ripple was an unregistered security, but these need not pose any threat to Bitcoin. For instance, “Ripple had a discretionary, centralised issuance controlled by a few individuals, whereas Bitcoin’s protocol removes any discretion over its monetary policy,” says Crachilov.
The US regulator has yet to approve a Bitcoin ETF. Bitcoin ETPs or ETFs now exist listed in Switzerland and Germany with the latest approval in Canada in February 2021 proving very popular. “It is only a matter of time before a US listed ETF will be approved and this would be a welcomed move. Indeed, the absence of an ETF creates unwanted market distortions in price discovery, which led the shares of Grayscale Trust to trade at a significant (as much as 25-40%) premium to their fair market value. This would never have happened to a proper transparent ETF in the normal course of business. Indeed, such a vehicle would trade close to market price as arbitrageurs would keep price deviations to a minimum through a standard share redemption and creation mechanism,” says Crachilov. “This however is not possible in a closed-ended trust structure, as it is structured as a non-redeemable vehicle. The anticipated approval of a US-traded ETF has led the previously rich premium to flip into a discount, as the non-redeemable nature of trust will drive investors to more efficient ETF vehicles,” says Crachilov. These ETF products are not leveraged. Retail investors may be restricted from ETPs and potentially leveraged crypto derivatives in some countries such as the UK, but they can still hold Bitcoin directly. “Banning leverage is logical given the volatility. You do not need leverage for an asset you expect to rise by 10 times or more. And whenever an asset does well, scammers start to prey on small investors,” says Hall.
“Ultimately, even an ETF does not bridge the gap between traditional finance and crypto, as no trades can take place over the weekends,” says Crachilov. Nickel’s Digital Gold strategy allows investors to rebalance their positions on any day of the week, including weekends and bank holidays.
Statistics suggest that as much as 70% of newly minted coins are acquired by Paypal to satisfy growing demand from their clients
Bitcoin remains much more volatile than equities, partly because investors in some exchanges can get leverage up to 100 times. But this is a relative concept – Bitcoin is less volatile than some equity names, and its average holding period is now longer. Daily trading volume of around USD70-90 billion on Bitcoin is less than 10% of its market capitalisation, whereas some of the most speculative “meme name” US equities have in 2021 seen daily trading of 200-300% of their market cap.
Crachilov does not doubt that there will be price reversals but expects the current cycle might see declining volatility: “The market could overshoot, then correct and consolidate. But the next slowdown whenever it comes is unlikely to be as deep as the 85% seen in the last 2018 crypto winter, as the current market structure is increasingly geared towards longer-term institutional allocators who are driven by allocation rather than speculation. These are unlevered holders of physical Bitcoin and would be looking to add to their holding in a correction. For instance, the January 2021 correction immediately prompted buying demand, propelling Bitcoin to a new ATH just a few weeks later”.
All of this makes it much easier for institutional investors to diversify into crypto. “Technically, obstacles to institutional adoption, such as concerns about custody have now been removed. There is now a sea change in how institutions see it, hence we set up Digital Gold to offer cost efficient and daily access,” says Crachilov. If some macro hedge fund managers including Paul Tudor Jones and Stanley Druckenmiller were early adopters in 2020, key “mainstream” institutions such as reportedly some endowments, Fairfax and Mass Mutual insurance companies, and Guggenheim mutual fund are now invested while BlackRock has sought approval to include Bitcoin in some mutual funds.
DeFi (Decentralised Finance) is probably growing even faster than Bitcoin in 2020 and early 2021, and often uses the Ethereum protocol. “DeFi replaces functions such as lending/borrowing, trading, insurance and synthetic asset origination by incentive-compatible, decentralised equivalents. The rules are simple, virtually always available in open-source code, and no single entity determines whether to process a transaction,” says Kloda. “These protocols have extreme potential for network effects, as they provide cheaper, safer and more efficient alternatives to the current financial institutions,” he adds.
Nickel’s latest fund launch, Digital Leaders Altcoin Fund, offers an intelligent approach to investing in Layer 1 and 2 protocols. “Advances in decentralized finance (DeFi) applications threaten significant disruption to business models in traditional finance. The highly competitive Defi space is encouraging unprecedented innovation between competing business models and protocols,” says Kloda.
“This market resembles a “1996 moment”, i.e. the early days of the Internet, the full potential of which will become evident only years later. It will be a volatile ride, but those investors who are able to take a constructive long-term view are in a good position to capture the value creation within these emerging trends. We see our role in helping investors navigate this space and take advantage in this structural expansion, as a complement to Bitcoin exposure,” says Crachilov.
DeFi and cryptocurrencies could be particularly useful in promoting financial inclusion – a UN Sustainable Development Goal – in some countries that lack a robust and trusted banking system and financial market infrastructure for saving and investing. “Our long-term vision is a fully decentralised and automated financial system that, by design, does not allow transaction censorship and does not discriminate between the large users and the smaller ones – anyone staking their assets into a decentralised exchange for the purpose of liquidity provision benefits from the same return on capital, something that in traditional markets is limited to a handful of market-makers,” says Kloda.
An important ESG criticism of Bitcoin is the amount of electricity it uses, which may in some cases be generated from fossil fuels. “We take this seriously. ESG is very important and as electricity is the largest variable cost of Bitcoin miners, they are incentivised to seek out the cheapest power sources, which are locked-in renewable power, such as hydropower in Canada or China, or geothermal power in Iceland. In Texas, flared methane gas that would otherwise be wasted is also being used for Bitcoin mining,” says Hall.
The cost of mining Bitcoin (now estimated at over USD10,000 per coin) is expected to rise until ultimately stabilising around the cost of a coin. “Due to the recent rally, more hashing power is needed to mine a new block (and obtain the transaction fees and the newly-minted BTC). Bitcoin’s codebase increases the difficulty of the cryptographic task in line with the growth of the hashing power, in order to keep the blocks in a roughly 10-minutes interval. This is ‘by design’ and a virtue, as the security of BTC network relies on how difficult it is to mine chains of these blocks. The rise in the price of BTC is the market inherently putting a value on the security of this mechanism, which in turn makes it more secure – another network effect in our space,” says Kloda. Additionally, there are different opinions about how much electricity the existing conventional financial system uses: “ATMs, armoured trucks driving cash around and so on all consume energy,” points out Hall.
Nickel’s assets under management have more than tripled in the last six months to USD180 million. Its arbitrage strategy has been consistently positive for the past 21 months since launch, runs at a very high Sharpe of over 4 and is becoming more scalable as the market grows and proliferates: “As Bitcoin is now worth more in dollar terms and trading volumes are on the rise, capacity of the arbitrage strategy in fiat terms is higher. This is further supported by increasing depth of the derivative market, sophistication of exchanges and new product listings, which show no sign of slowdown,” says Hall.
Crachilov sees “a structural demand for both directional and market-neutral crypto arbitrage strategies from institutional investors, including sophisticated asset managers, endowments, insurance companies and global wealth managers”.
Readers should watch this space for new strategy launches.