Bitcoin correlation with S&P 500 (30-day rolling average)

Source:Inva.com

A challenge for investors looking for exposure to crypto currencies is the dominance of BTC. It accounts for 63% of the entire capitalisation of the crypto currencies market as it can be traded physically, over the counter, via a fund or via futures contracts, all of which many other cryptos cannot. If BTC rises, as has been the case this year, then many other cryptos have tended to rise as well. Historically, this had equally been the case because many cryptos carried out Initial Coin Offerings (ICOs) and were funded by investors using BTC as opposed to cash. An example of this is Electroneum (ETN) which did an ICO attracting 112,000 participants (the largest ever number for an ICO) and ETN still holds a considerable number of Bitcoin

In the equity market the situation is potentially no better. There has been a vast amount of money flowing into index funds and ETFs, partially due to the lower fees they charge compared to active fund alternatives. Passive funds have also performed better in many instances. According to Morningstar’s (a funds rating and analytics business) reports in the last ten years, “just 23% of active funds managed to both survive and to outperform their passive peers. The likelihood and performance penalty for picking an underperforming manager tends to be greater than the probability and reward for finding a winner.” However, one of the downsides of buying a fund that tracks an index can also be the risk of being overexposed to a handful of stocks. For example, only 5 companies Apple, Microsoft, Amazon, Facebook and Google (which is quoted as Alphabet) account for over 40% of the capitalisation of the NASDAQ index. The S&P500, which represents the 500 most valuable equities traded in the US, is dominated by four stocks, Facebook, Amazon Netflix, Google. 

Source: Yardeni.com

These stocks account for over 13% of the entire market capitalisation, so hardly a great way to be diversified. What is worrying is, if you look at the FANG’s earnings, they only account for 4.7% of the S&P500. An even more extreme situation can be seen in China where only three shares in the benchmark MSCI China Index account for more than 38% of the index. These equities are China’s version of FANG - Alibaba, Tencent and food delivery firm, Meituan Dianping (otherwise collectively known as ATM).

Whether you are investing in a stock such as MicroStrategy, buying one of the increasing number of crypto funds that are being launched, many of which often have a large exposure to BTC or are buying an Exchange Traded Fund (ETF) linked to an index such as Nasdaq or MSCI China, ensure you know what you are really exposed to and how diversified your holdings really are.

The ability for cryptos to be tracked has proved very helpful, particularly when a crypto has been ‘forked’. One of the reasons cryptos may need to be tracked down is because their owners may have misplaced them when there is a ‘fork’ - a term used to explain when a Blockchain splits, often instigating the creation of a new crypto currency. Forks usually occur due to a significant change in a Blockchain’s protocol leading to splitting the Blockchain into an ‘old’ way of doing things and a ‘new’ way of doing things. It is claimed that between 2017-2019 there were 58 Bitcoin forks, resultant from which the original Bitcoin Blockchain has now spawned other versions, e.g. Bitcoin cash, Bitcoin Gold etc. In addition, forks can be categorised into either a ‘hard fork’ or a ‘soft fork’; a hard fork is when a Blockchain totally changes the way it functions so that those running the Blockchain need to change the software they use and, conversely, a soft fork means that although the rules of the network change the old software is still used to validate transactions. 

Chart of Bitcoin Blockchain and Software Forks

Source:Unhashed.com

Unsurprisingly, it can be a challenge to keep track on these different forks and the cryptos they create. However, there are websites to help one track and trace forks such as ForkDrop.io and Forks.net, and now there is a service called Reclaim Fork (from UK-based Coinfirm) which can also help. The crypto and blockchain analytics firm has looked into the digital wallet which was holding over $1.2 billion of Bitcoins (which the US government recently seized) that were allegedly linked to the infamous illegal Silk Road website. Coinfirm has discovered that there could be in excess of another $380,000 worth of different cryptos due to forks linked to the seized digital wallet that have, as yet, been taken under the control of the US government.

Another company active in tracking down cryptos is Chainanlysis which has just raised $100million, valuing itself at $1billion (up from only $266million in July 2020). Chainanlysis provides information and analysis to governments, exchanges and financial institutions using a range of compliance tools helping to track and trace the source of funds and lost cryptos. There are also other longer established firms such as Kroll (owned by Duff and Phelps) and Alaco, which this year launched Alaco analytics. These firms are employed by organisations such as banks, corporate brokers, accountants and law firms to help conduct background checks, due diligence and investigations on individuals and corporations including sources of funds. Henry Burrows at Alaco analytics has stated, “We are definitely seeing institutions warm to virtual assets.  There is far greater regulatory clarity than there was in 2017, and a far better understanding of the risks.  Services like ours provide clear and concise information on customers and customer’s funds – in more granular detail than traditional financial services.  As that understanding grows, we will continue to chip away at the misplaced perception of crypto as a refuge for financial crime.”

The ability to track and trace cryptos ought to offer traditional financial institutions greater comfort as they continue to embrace this asset class, together with the increased transparency and independent due diligence which are now available. Furthermore, as people understand what their transactions do, indeed, create a digital footprint, this should lead to more trust in cryptos as an asset class and possibly deter cryptos being used for illegal purposes - unlike the preferable ‘suitcase of cash’ which has historically been used so often for shady deals….