Bitcoin, Ether and Ripple are just a few marquee names in a growing list of cryptocurrencies that investors are beginning to explore. Although these cryptocurrencies were created as a mechanism for private, peer-to-peer transactions in a way that bypasses institutional intermediaries, a growing number of investors are treating cryptocurrencies as dynamic fiat money alternatives--effectivelya new asset class--that generate, so far, attractive returns. Bitcoin and Ether, for example, have posted year-to-date returns of over 800% and 2,500%, respectively.
It may be a far cry from the privacy-first goals that drove Bitcoin and other blockchain-based currencies to the forefront of international attention, but it's a promising development for those buying in. As governments in Japan, Russian and the United States are warming up to cryptocurrencies, new investing opportunities are emerging that could foster more widespread adoption.
Kai Chen, whose company, OlympusLabs, is one of a few blockchain firms developing tools for enterprise and crypto-based derivatives that help "make a market" in various cryptocurrencies, sees great potential in this asset class.
"The cryptocurrency market is still in its infancy: the market cap is $200 billion," Chen said. "The world's stock market is worth $74 trillion, and the world's derivative market is worth $544 trillion. Once investors feel comfortable with the wide range of financial products such as derivatives, ETFs, and collateral loans, widespread adoption will happen."
Why the Asset Class Designation Matters
Treating cryptocurrencies as an asset class marks a huge step forward to making Bitcoin and its brethren more mainstream. Through today, the SEC has offered minimal guidance on whetherinitial coin offerings (ICOs) would be regulated as securities that would require SEC registration, and raised concerns about whether secondary token sale marketplaces would be considered marketplaces under U.S. securities laws. To top this off, the IRSdoesn't consider cryptocurrencies to be currencies, but rather items of property subject to capital gains taxes and strict tax form record-keeping requirements. It's possible that in the near future, if not already, that the SEC and IRS will differ as to the treatment of ICOs in their respective regulatory schemes.
Regulatory uncertainty, however, hasn't scared off investors. Until now, the only way that investors could buy into cryptocurrencies is by purchasing or exchanging fiat money directly for cryptocurrency units on one of a few online exchanges, and selling off at the right fiat currency valuation. Thanks to the CME and the Commodity Futures Trading Commission (CFTC), investors and market makers can participate in Bitcoinoptions and futures, expanding the trading potential of the underlying asset. Naturally, Bitcoin's price shot up to a then-recordhigh of $6,600.84 in response to news of the CME's approval of Bitcoin futures.
In theory and largely in practice, an operating futures market can increase liquidity and in turn, reduce uncertainty around a tradable instrument. In simpler terms, more dollars will chase currencies with an available futures market.
By treating cryptocurrencies as assets, exchanges and governments are only opening the floodgates for more investment activity. Since an asset-based designation can indirectly open up an asset class to more regulation, the road is now paved for cryptocurrency trading to demonstrate less of its colorful "wild west" environment, much like other asset classes with mature derivatives markets that have come before it. This, in turn, could lead to more widespread growth and functional adoption.
Cryptocurrency in Asset Allocation Models
The posture from the CME that treats cryptocurrencies as an asset-based class has, in turn, spurred a flurry of ICOs that treat cryptocurrencies as asset classes. Olympus Labs's Chen says that by designing its smart contracts that are focused and optimized specifically for financial technology, his company plans to eliminate the need for developers to spend time programming their smart contracts. One approach is to enable financial institutions and institutional investors to create their own cryptocurrency derivative funds quickly, with smart contracts that reduce the time to bring products to market.
Transaction frequency is a concurrent issue. "Right now, most fintech blockchain applications are built on Ethereum or Waves," said Chen. "These blockchains have been sufficient up to this point, but will not be able to keep up with the number of transactions happening as the market for cryptocurrency and cryptocurrency-based products expands." Olympus's publicblockchain, Vajra, is one of several competing products that aim to handle high transaction volume.
While cryptocurrency markets remain volatile, no other asset class has been generating such dramatic returns on investment in recent history. While the legal landscape for cryptocurrencies remains in its infancy, the CME's serious foray into developing a derivatives market appears to be a promising next step in seeing this asset class become fully functional.
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I hold stock in investment holding company, Leucadia, and remain a partner in an emerging technology fund. I hold no positions in cryptocurrencies or in any companies that invest in them.