Answering a common client question: What is 13D’s point of view on cryptocurrencies?

To our mind, abuse and manipulation is the most pressing short-and medium-term challenge for crypto values.

The following article was originally published in “What I Learned This Week” on August 9, 2018. To learn more about 13D’s investment research, please visit our website.
In recent months, we have largely stayed on the sidelines of one of investing’s most-polarizing debates: cryptocurrencies. We weighed in late last year (see WILTW September 7, 2017), concluding the speculative euphoria that drove the meteoric ascendance of cryptocurrencies would subside as rising regulatory scrutiny fomented investor uncertainty. As we’ve watched many of the market’s marquee tokens decline more than 60% since December, our position has remained constant. However, with developments mounting in the marketplace — from Intercontinental Exchange (ICE) announcing a federally-regulated market for bitcoin to the SEC’s looming decision on a bitcoin ETF — clients have asked for our current short-, medium-, and long-term outlook on cryptocurrencies.
To be clear, we fall neither on the disbeliever nor evangelist side of the debate. Bitcoin is not a “scam”, as JPMorgan’s Jamie Dimon infamously claimed, nor is it destined, or even likely, to replace fiat currencies. We see a technology in its infancy, one capable of playing a valuable role in the global economic framework — as an untethered store of value and a frictionless means of peer-to-peer and cross-border value transfer. However, we also see a technology and marketplace riddled with shortcomings that could prove crippling, from unanswered scalability questions, unrelenting volatility and endemic fraud, to global government concerns that may be irreconcilable.
A significant cryptocurrency rebound is possible this year, with institutional support the most-important potential catalyst. However, we remain cautious — unnerving revelations about crypto-marketplace shortcomings will likely continue to sap retail investor enthusiasm and keep institutional money on the sidelines.
Late last month, Murad Mahmudov — an angel investor and crypto thought-leader — posted the following chart on Twitter, which shows the potential monetary progression of bitcoin:

Mahmudov is a self-proclaimed “bitcoin maximalist”, meaning he believes bitcoin could and should render country-by-country fiat currencies obsolete and become the globe’s first dominant universal currency. While we don’t share that belief, the chart is nonetheless a valuable roadmap to the challenges cryptocurrencies must overcome to serve significant, trustworthy functions within the global economy, whether as a store of value or a widespread medium of exchange.
As he indicates, “greater perceived safety” is the next step from where we are today, and that is no small hurdle. In recent months, revelation after revelation has illustrated how abuse and manipulation are dominating crypto marketplaces. A study released in February by a team of economists out of Sydney and Stockholm concluded that 44% of bitcoin transactions are for illegal activities — roughly $72 billion per year worth or “close to the scale of the US and European markets for illegal drugs.”
Moreover, crypto hacks and scams have dramatically increased in size and frequency — according to a HowMuch report from late May, there have been 13 crypto hacks of more than $10 million, and 12 of them have come just since June 2016. Roughly $731 million worth of cryptocurrencies were stolen from crypto exchanges in the first half of 2018.
Meanwhile, “pump and dump” schemes appear endemic. This week, The Wall Street Journal released a report on the problem, concluding:
“Dozens of trading groups are manipulating the price of cryptocurrencies on some of the largest online exchanges, generating at least $825 million in trading activity over the past six months — and hundreds of millions in losses for those caught on the wrong side…Between January and the end of July, the Journal identified 175 “pump and dump” schemes involving 121 different digital coins, which show a sudden rise in price and an equally sudden fall minutes later.”
The Journal was analyzing the activities of “pump groups” — chatrooms where amateur coin traders (as many as 74,000) gather to coordinate activity. Yet, as a Forbes profile of Beijing-based Fintech Blockchain Group (FBG) — one of the biggest crypto hedge funds in Asia, doing roughly $10 billion in trades per month — “belowboard” tactics are not just used by amateurs.
FBG has built its crypto fortune — famously turning $20 million into $200 million in 2017 — by exploiting the market’s unregulated vulnerabilities. First, they profited off the inefficiency of nonstandard crypto exchanges, arbitraging price discrepancies — i.e. buying bitcoin on one exchange for one price and immediately selling it on another exchange where its price is higher.
Then, last year, they rode the Initial Coin Offering (ICO) wave, buying tokens in start-up companies offering “little more than research papers and lofty promises” and turning those investments into 500%-plus returns. Their tactics included paying bloggers to write positive ICO reviews and leveraging insider relationships with crypto exchanges to get particular ICOs listed. As Forbes concludes: “Not all of FBG tactics seem completely aboveboard.”
How can a market predicated on trust survive when you can’t even trust the market makers?
Huge long-term questions remain about whether cryptocurrencies and their underlying technology — blockchain — can be effectively scaled. Electricity demand is one concern — the total electricity use of bitcoin mining now equals that of midsize economies like Switzerland, according to the Bank of International Settlements. Transaction processing speeds are also a major concern — last year, the number of transactions the bitcoin network could process per second fell as low as 3.3, which compares to the 3,526 processed by Visa per second. Innovative solutions are no doubt required.
However, to our mind, abuse and manipulation is the most pressing short-and medium-term challenge for crypto values. As Bloomberg reported last week, bitcoin’s utility value — i.e. how much it’s used in commerce — has plummeted:

It makes sense: increased network usage spiked the net cost of a bitcoin transaction at the same time bitcoin owners became more hesitant to spend their rapidly-appreciating asset. The problem is, if bitcoin declines in value as an actual currency the more it grows in importance as a store of value, then it has only one path to appreciation. And that path relies on trust.
As we discussed in WILTW December 7, 2017, bitcoin’s store of value advantage over gold lies in the fact that central bank “manipulation of the gold price has been going on for a long time and most egregiously since May 2011.” Through decentralization, cryptocurrencies are supposed build superior trust by being less vulnerable to manipulation. However, if rampant manipulation and value stealing by both illicit actors and market makers continues unimpeded, store of value trust won’t build.
This is why, “greater custodial solutions, institutionalization, financialization, and regulatory clarity” — as Mahmudov’s chart puts it — has become the decisive step for cryptocurrencies. On Tuesday, all but two of the top 100 cryptocurrencies fell in value — bitcoin as much as 7% — after the SEC announced it had pushed a decision on VanEck’s bitcoin ETF to the end of September. An ETF will likely hasten institutionalization, pushing transactions off crypto exchanges and to traditional markets, opening the door to short opportunities, and providing some of the regulatory clarity institutional investors demand.
ICE’s new “federally regulated market for bitcoin”, dubbed Bakkt, could achieve the same goal. As Fortune reported last week: “The founding imperative for Bakkt will be to make Bitcoin a sound and secure offering for key constituents that now mostly shun it — the world’s big financial institutions.”
It is an antithetical idea: to grow, the great decentralizing invention of the 21st century requires the embrace of banking’s most-centralized powers. However, the more evidence emerges that compromises trust in unregulated crypto marketplaces, the more essential institutional support becomes. Hype has to turn to actual institutional action — whether SEC decisions or the entrance of significant institutional money into the marketplace. We will remain bearish on crypto values until then.