Arbitrage may be one way to invest in volatile cryptocurrency

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The frenzy of headlines and social media posts about cryptocurrencies as more people dive into the world of digital currency has had some investors joining in due to FOMO. But the recent crypto crash that erased billions of dollars in value illustrates the reason many investors with an emphasis on wealth preservation have little Fear of Missing Out and are reluctant to wade in too deeply.

The most recent plunge occurred last week and resulted in an overall market capitalization loss of more than $205 billion for the total cryptocurrency market in just 24 hours, according to CoinMarketCap,  with Bloomberg estimating a loss of $1 trillion in value since last year.

Cryptocurrencies are digital currencies designed to facilitate decentralized, peer2peer, monetary transactions (no need for central banks or even financial institutions).

But their volatility, questions about their intrinsic value or ability to hold value over time, as well as the potential for regulatory pushback, has left many potential investors with concerns about this asset’s longevity and its usefulness as part of a portfolio.

“The general feeling is that of the tens of thousands of cryptocurrencies out there are probably, at most, a dozen that ought to be of interest and go beyond speculation or gambling,” says Henry Kim, an associate professor at the Schulich School of Business, York University in Toronto, and director of the school’s Blockchain.lab.

“Because a lot of cryptos move around in price you could definitely make a lot of money, but you could also lose a lot of money … 99 per cent is gambling,” he adds.

For him, there are three ways to look at cryptocurrency right now: First, it’s for gamblers and speculators; second, it should be looked at like digital gold, which mainly applies to Bitcoin; third, one of these cryptocurrencies might be worth something someday.

Digital gold

For investors who are mainly concerned with wealth preservation, such as the very high-net-worth, who are looking to dabble in the world of cryptocurrency, the potential for especially Bitcoin to act like digital gold as a hedge against inflation when other asset values fall may be interesting.

“If you’re comfortable owning gold then … I’d say you can take some of that money and spread it around into Bitcoin,” says Kim. “It really helps me to think of it as a commodity, [but] a commodity that most people in the world won’t know if it’s useful. … But if it does become useful, you’re going to make a lot of money.” However, he adds, “More likely than not, it’s not going to become useful.”

Neil Nisker, chief investment officer at Our Family Office, says he stays far away from cryptocurrency, both for himself and his clients, for very good reason: “We are in the stay-rich business, not the get-rich business.”

Nisker’s clients are all ultra-high-net-worth individuals and he is clear that he has been through many ups and downs in the markets throughout his almost 50 years in the financial industry, so he is not going to jump on the next big thing.

Gambling

“I’ve been around the block so many times and I’ve seen things like this in the past … and my experience tells me there is money to be made here, but there is also money to be lost,” says Nisker. “And my investment philosophy is similar to my gambling philosophy: I hate to lose more than I like to win.”

Nisker says there may be a place for cryptocurrency at some point and he does view it as an asset class, but it is not one he can see a stable future for right now as it is not based on fundamentals and “there are just so many ifs.”

Likewise, Peter Mann, co-chief executive officer at Grayhawk Investment Strategies Inc., says he has not seen much movement in the crypto space from family offices as there is just too much speculation. But he does acknowledge there is a lot of interest around it, as with anything that has periods of climbing in value at such a high rate. And people definitely have a fear of missing out, he adds, especially with Bitcoin, which has a finite number of 21 million in existence and almost 19 million have already been mined.

“I think, like every asset that appreciates, you have a lot of people for which this conjures interest and are trying to determine how best to take advantage of it,” he says.

An arbitrage play

Mann explains that, because cryptocurrencies have been around for several years, high-net-worth investors may now be looking at the arbitrage opportunities, which entails buying a currency on one exchange and selling it for a higher price on another.

“With all of these currencies, all of these platforms by which they can be exchanged, and this wall of undefined risk capital that has come in, that typically means there are a lot of things happening with not a lot of thought or diligence – that’s typically when margins are wide, spreads are wide, you can arbitrage those markets, the way you used to be able to do in the bond market 40 years ago,” says Mann.

“There are ways to be a part of the crypto market where the returns are very good,” says Mann. “But they’re not infinite.”

With so many unknowns in the cryptocurrency space, experts, like Henry Kim, agree that this is not a necessary part of a portfolio, particularly for those whose main concern is capital preservation.

He cautions anyone getting into the space to do their homework: “You don’t want to play with things you don’t understand.”

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