Is it worthwhile to take the risk of investing in cryptocurrency?

 

Is it worthwhile to take the risk of investing in cryptocurrency?

A discussion with hedge fund manager Amit Rajpal about the case for investing heavily in digital assets — and why Bitcoin is more long-term than investors believe.

 

This is the first in a series of conversations with Bloomberg Opinion columnists about how to address the world's most serious policy issues.

 

Trivedi, Anjani: You've been a long-time traditional bank investor who's tracked the evolution of global financial services organisations and the financial system. As the hedge firm Marshall Wace's chief executive officer for Asia, you're now focusing on cryptocurrencies, blockchain, and fintech. When did the switch take place, and what prompted it?

Marshall Wace Asia Ltd's chief executive officer, Amit Rajpal: I got to the conclusion about a year ago that we're transitioning from a process of redefining financial services by altering the architecture that underpins our financial system to one of truly reinventing financial services by changing the architecture that underpins our financial system.

There have been a lot of fantastic fintech companies, but they've mostly operated on the outskirts of the traditional system. Fintechs are now becoming mainstream, in my opinion. Unless the mainstream adapts, it will be compelled to downsize and function solely within the confines where traditional enterprises can compete under the current technology architecture.

AT: When you suggest that traditional banks will be increasingly restricted, can you offer an example of where this is happening in the financial system?

AR: The financial system accounts for between 5% and 10% of GDP in the majority of affluent countries. That is the revenue source from which it creates intermediate savings flows, which is the financial system's primary function. Payments are undergoing the most transformation, with a total addressable market of $2 trillion, according to McKinsey. Much of today's payment infrastructure was built years ago to support business-to-consumer payments, trade finance, and supply chain activities. Many of these payments use a standard template, have a lot of manual overlays, and are often costly. We can get a fundamental shift where we move from manual to automated and from significant economic rents to a much more effective manner of intermediating savings with the evolution of blockchain technology at scale and the correct compliance solutions underlying it.

 

The majority of central banks are already aware of this. They're only trying to figure out the best way to make this new technology mainstream without having bad implications.

AT: Do you think this is a turning point in the way investors view the financial system? During the financial crisis, the industry's regulation triggered a huge upheaval. Is this a similar situation?

AR: We're still in the early stages. From the perspective of an investor, there are several limitations. To begin with, there is a great deal of noise and confusion. Cryptocurrency is a system. It's a raucous and tumultuous environment. The emergence of non-fungible tokens, or NFTs, as well as blockchain's ability to redefine processes and flows, are all factors to consider. Because there are so many moving components, it's difficult to predict how things will turn out, which has diminished investor interest.

It's never a straight line process with anything new. It's always turbulent, which is what makes this a good investment opportunity for us. The general investor population is unaware that financial services are transitioning from the fixed-line era to the smartphone era. Investors' perceptions of the change are clearly out of step with the opportunity.

AT: Isn't there a distinction between how individual investors and institutional investors view these assets as an investment opportunity?

AR: There is a fundamental difference in the opportunity set. I divide it into three categories: Consumer-facing business models, such as Coinbase Global Inc. or Monex Group Inc. in Japan, which provide access to digital assets. Then there's the infrastructure that goes into making the ecosystem popular, such as payment apps, scaling, and compliance and regulation solutions.

 

The evolution of DeFi, or decentralised finance, is the third. The potential set for these protocols will grow as more assets are digitised.

 

These are items that aren't immediately available in stores. These are either private market listings or public market early-stage listings.

AT: What are the dangers for small-scale investors?

AR: A large number of trading venues are unregulated. Obviously, we've seen huge hacks in which exchanges were cleaned out and investors who backed those exchanges lost their money.

 

Trading futures on cryptocurrency also involves a lot of leverage. It's a combustible combination to trade a highly volatile asset type on margin. Volatility, on the other hand, is nothing new. People that participate in this activity are well aware of the dangers they are taking. The regulatory framework is strengthening with time, and more exchanges are becoming compliant. In a manner that they weren't three to five years ago, trading venues are also becoming more mainstream.

 

AT: Is the financial system at risk in a larger sense?

AR: I'm still of the opinion that it's a minor issue. The value of crypto assets has just surpassed $1 trillion. To put it in perspective, several large U.S. technology businesses have a market valuation that is double, if not triple, that of Apple. The value of crypto assets is less than 50 basis points when compared to the value of all financial assets outstanding in capital markets. While crypto receives a lot of attention because of its volatility and the fact that it's new and attempting to disrupt traditional asset classes, the truth is that it's still too small to pose any systemic risk.

 

AT: You identified the lack of regulation as a risk. Regulating and innovating rarely go hand in hand. Is that the case in this instance?

AR: I'd concentrate on how the United States is approaching it. Six regulators are currently devoted only to the adoption or mainstreaming of blockchain technology into the financial system. The Office of the Comptroller of the Currency (OCC) is first, followed by the Federal Reserve, the New York Department of Financial Services, the Securities and Exchange Commission (SEC), and the Financial Crimes Enforcement Network (FCEN) (FinCEN). They're all handling it in different ways in order to stimulate innovation while limiting negative actors.

 

Just this year, the OCC has accomplished a great deal. This year, they've given out three digital bank licences. These are banks, however they only trade with digital assets rather than fiat cash. This is a significant event. The United States also allowed public blockchain to be integrated into the traditional payment system, which had previously been prohibited. This opens the door to new ideas.

Other regulators are concentrating their efforts on restricting rogue actors. The travel rule, which applies to transactions above a certain threshold, will now apply to all digital asset transactions, according to FinCEN. They have stated that know-your-client and anti-money laundering procedures must be followed in order to achieve equivalency with the mainstream system. This is the correct strategy.

Having the correct regulations in place could prove to be a competitive advantage in this industry.

So far, the United States has taken the correct approach.

Other countries, especially China, must be more open to stimulate innovation while minimising bad-use situations so that the system can grow more efficient.

AT: Marshall Wace, your hedge firm, has built up a crossover strategy focusing on digital-asset investments. What do you think the most promising opportunities are?

AR: The goal of this strategy is to catch the redefining of financial services. The application of blockchain in reinventing financial services, as well as payments within the financial infrastructure layer, are two of our top goals.

We're putting a lot of effort on India. I see the potential for a massive financial digital leap. This is because India begins from a relatively manual position: digital payments account for only a small part of overall payments. It also starts from a low point of inclusion, so new technology adoption can make a significant difference.

Scale will grow at a breakneck pace. We believe that being ahead of the curve, rather than waiting for the IPO, is a significant benefit. And the investing community is still catching up in terms of understanding the changes that are coming.

 

AT: Can you give some examples of how blockchain is transforming financial services in the real world?

 

AR: Linklogis Inc., a publicly traded firm in Hong Kong, is one example. It employed blockchain to verify supply chains all the way down to the sixth or seventh level, starting with huge anchor clients. This information is constantly updated. It's also tokenized by means of digital payment obligations.

Others are more generic in nature. There are many states in India, for example, that maintain shoddy manual records on real estate and property ownership. There is always a battle for the championship. Many companies are turning to blockchain to update records in real time and avoid the litigation issues that come with title, which is a common characteristic of real estate ownership in emerging nations. For decades, these have been major annoyances with no resolution other than people going to court or settling out of court.

AT: Developing and scaling up underlying blockchains consumes a lot of energy. Do you see this changing when the space shifts from proof-of-work, where everyone can answer difficult equations, to proof-of-stake, where you have to have a stake in the game?

 

AR: Bitcoin's original blockchain was built on a proof-of-work model. And Bitcoin aspires to stay true to its word. I believe the balance will continue to shift in favour of proof-of-stake, which is far more energy-efficient, over time.

 

Proof-of-work is bad for the environment because it makes you a victim of your own success. If the value of the crypto asset – let's call it Bitcoin – continues to rise, more people will be motivated to solve the problem. As a result, the equation becomes more difficult, necessitating more processing power, which has an environmental impact.

 

The fact that Bitcoin mining can go to the source of electricity, as opposed to gold mining, which requires going to the source of gold, is a mitigating factor. Bitcoin mining still uses less energy than gold mining. Fourty percent of Bitcoin mining is already done with renewable energy sources. And if China is excluded from the equation, the figure rises dramatically.

If governments decide to impose a carbon price on Bitcoin mining, this trend might be accelerated. That is a very possible scenario. Bitcoin mining can become significantly renewable with the correct set of incentives and checks and balances. This is a problem that can be solved. And it's just Bitcoin. People should be aware that the remainder of the blockchain is beneficial to the ecosystem. It uses so little energy in comparison to what it replaces that as more objects shift to proof-of-stake, our net energy usage will decrease. Bitcoin mining will lower its carbon impact with the correct amount of concentration and attention, making it more sustainable and, ultimately, more investable.

AT: How long do you think it will take for other investors, the laggards, to catch up and start looking at this asset class in a more positive light?

AR: It'll most likely happen in the next three to five years. The financial system, for example, performs a variety of important and useful societal functions that we all require on a daily basis. Payment applications, for example, are essentially a message system in which you must continually calling each other, filling out paper and documentation, and going to your bank branch to move money someplace. You seem to go through a lot of paper. Anything that requires the use of paper is considered manual. It necessitates a physical presence.

The carbon footprint of the banking sector is roughly seven to eight times that of Bitcoin mining.

 

The entire debate will be flipped if we replace banal operations currently performed by the banking system with a proof-of-stake mechanism, which consumes far less energy than traditional tasks. In contrast to popular belief, blockchain will become a net contributor to reducing our environmental or carbon footprint. This is a set of wheels in motion. They take time to complete.

 

Anjani Trivedi is a Bloomberg Opinion columnist who focuses on Asian manufacturing firms. She was once employed at the Wall Street Journal.