Our Head of Global Content Gerry O’Shea recently joined Head of International Product Dramane Meite, CFA and Senior Manager Europe Benjamin Ittah to discuss the state of crypto investing in Europe. Following are some of the highlights from that discussion, which covered the fallout from the FTX saga and the importance of creating indices suitable for institutional investors, as well as insights into what 2023 may present for crypto investors.
Gerry: The implosion of the FTX exchange has many people questioning how safe it is to use crypto exchanges. Can you share some perspective on what these events mean for crypto investing?
Dramane: The FTX situation was triggered on November 6 by rival exchange Binance’s plans to sell all of its exposure to FTX’s tokens (FTT). While we’re still learning about exactly what happened, FTX’s operational deficiencies, opacity, and relationship with Alameda Research (owned by FTX’s founder) are very troubling.
Hashdex had no exposure to FTX, FTT, or Alameda. This is because of the strict requirements we place on any crypto asset we invest in and the strict requirements we place on all of our third party service providers. But despite our lack of exposure, the failure of FTX hurt investors’ sentiment, contributing to worsening liquidity and falling market values for other crypto assets. As our CEO Marcelo pointed out in a recent note to clients, financial markets are built on trust and this event has significantly disrupted this trust.
Hashdex has always had an obsession with building robust and institutional-grade products and processes, so we are optimistic the current environment will help investors appreciate that it matters which providers you work with and which risks you take.
It’s important to note that FTX was not really a “crypto” issue. By that I mean every one of the major crypto assets has maintained its functionality since the onset of the pandemic. And this has remained the case even as central banks have shifted policy gears and the failures of Celsius, 3AC, and Voyager—all centralized platforms—have triggered volatility and negatively impacted crypto prices.
This latest episode is no different. Decentralized blockchain networks are working as designed in the face of uncertainty and fear. And, the fact that public blockchains are completely transparent allowed the market to become aware that withdrawals on FTX had been halted, hours before the official FTX announcement. So really crypto assets have lived up to their expectations, and we expect this to continue.
Gerry: Crypto has evolved to be much more than just bitcoin or digital payments. Can you talk about how ecosystem developments are creating investment opportunities?
Dramane: Since the launch of Bitcoin in 2009, the blockchain technology that powers its network has been adapted, expanded, and modified to solve a myriad of other problems and offer more than an alternative to traditional fiat currencies. This process has given rise to disruptive decentralized alternatives that promise to revolutionize how we execute contracts, invest, and consume art and entertainment, among many other solutions.
So yes, the crypto universe goes far beyond Bitcoin. In fact, BTC represents only about 40% of the overall crypto market today and its dominance is decreasing. There are DeFi projects, smart contract platforms, and NFT marketplaces, to name a few.
Crypto has tremendous potential to disrupt traditional industries as an emerging technology. Thematic strategies offer investors a great opportunity to invest in targeted areas of the crypto ecosystem, allowing them to gain exposure to a specific segment of crypto with an allocation that is still diversified.
Hashdex partners with index providers to offer investment solutions that provide access to baskets composed of the most promising protocols leading this blockchain revolution, across broad market, smart beta, and thematic strategies. One of the things that has become completely clear in light of recent crypto market events is that there needs to be a strict methodology behind any crypto index. Simply investing in the largest or fast-growing crypto assets is not an effective strategy. This is why all of our index partners must have robust processes in place for determining which assets are eligible for inclusion.
Gerry: How are investors currently getting exposure to crypto assets in Europe?
Benjamin: There are many ways to gain exposure to crypto, but a growing number of European investors are choosing to do so through exchange-traded products (ETP).
This is because direct exposure to crypto presents several challenges and investors have to do everything themselves: select the assets, deal with unregulated providers, and bear counterparty risk if the assets are left on the exchanges. Investors who outsource custody to exchanges risk having their assets frozen, misappropriated, or hacked, as has occurred several times in the past. Investors who choose to self custody their assets are subject to several risks, like forgetting their keys, electronic failure, theft, or loss. Additionally, direct investing is usually focused on getting exposure to single assets, which we don’t believe is the best way for most investors to allocate to an emerging asset class.
Professional investors are more interested in the ETP structure. Hashdex ETPs provide diversified baskets of exposure, each of which is regulated and traded on familiar channels and investment platforms. The ETP wrapper ensures a high standard for operational issues—especially custody. We want to remove the operational complexity and custody risks from the equation by using the same structure as physical gold ETPs, widely used by European investors, time-tested, and highly liquid. As a result, all of our ETPs:
- track diversified indices provided by independent and BMR compliant index providers and administrators such as Nasdaq, CF Benchmarks, and Vinter;
- are 100% collateralized with the underlying assets (we work with best-in-class Collateral Agents, Fund Administrators, and Audit Firms to ensure this is the case);
- rely on regulated crypto custodians for institutional-grade custody that is air-gapped from the internet and insured against fraud and hacks;
- are listed on regulated exchanges in Europe, and satisfy local regulatory requirements;
- have daily liquidity and are supported by tier one market makers and authorized participants.
One additional important advantage of index-based ETPs is that our allocation mirrors public index criteria. This transparency provides an additional safeguard against conflicting interests between asset managers and their shareholders.
Gerry: You mentioned that European investors are gaining more access to investment products that provide broad exposure to the various use cases within the crypto universe. Why is Hashdex focused on the index approach?
Benjamin: Less than 10 years ago there were about 50 cryptocurrencies, today there are thousands. Most of these protocols will never generate value or offer positive returns for investors. Recent events like the FTT collapse and the downfall of the Terra/LUNA ecosystem have shown that even mainstream tokens, with market caps in the dozens of billions, could be subject to market manipulation, poor risk-management practices, and outright fraud.
The multiplicity, complexity, and volatility of this market poses a daunting challenge to individual investors trying to separate the wheat from the chaff. That’s why Hashdex offers diversified basket index products that greatly reduce these risks through stringent eligibility criteria, while still offering attractive returns. These investment products range from strategies that select crypto assets based on their maturity and market cap to sector-specific indices that provide exposure to emerging themes of the crypto market. We have recently expanded to the smart beta space, with the first crypto momentum ETP that blends the momentum factor and risk-parity weights.
The reality is that single asset investing can be too risky for many investors. For many of the same reasons that most investors prefer not to be individual stock pickers, picking winners in a universe of 20,000 plus crypto assets is not an easy task.
So what we are seeing is really investors seeking to diversify through an index, either for the whole crypto universe or specific sectors, as well investors looking for a smart beta play. The former has been at the core of what Hashdex has done since 2018 (e.g., the Hashdex Nasdaq Crypto Index Europe ETP) and the latter is why we recently launched the Hashdex Crypto Momentum Factor ETP.
The Nasdaq Crypto Index Europe holdings as of 10/31/22. Source: Hashdex and Nasdaq.
Going forward, we’re bringing crypto thematic offerings to the European markets as well. This includes offerings built around projects focused on Web3 and smart contracts, DeFi, and metaverse-related platforms. We’ve had success with this in Latin America, and believe many investors want this type of segment-based exposure.
Gerry: Not all crypto investing approaches are created the same. What are the important features index investors should look for when considering allocating to crypto?
Dramane: In terms of the wrapper, we believe that ETPs offer a very convenient, familiar, transparent, and simple approach to investing in crypto assets: one ISIN, one trade booking, automatic rebalancing, no balance sheet risk to the issuer, and you can abstract from the custody and operational considerations. Some products entail credit risk to the issuer’s balance sheet, and investors should be aware.
Some investors prefer only allocating to Bitcoin and Ethereum; but this conservative approach will make them miss out on the projects that will drive the next wave of crypto adoption. The core of a crypto allocation should be a broad market index, such as the Nasdaq Crypto Index Europe (NCIE), that is dynamic to capture the evolution of the market and is diversified enough to provide exposure to the upside of emerging crypto themes. This strategy will perform better than cherry picking the top two or three projects. More advanced investors can augment this core allocation with a tactical smart beta allocation to the momentum factor or thematic exposure to express sector views, and then tilt their overall portfolio toward these approaches.
The importance of the quality of the index and its provider cannot be overstated. For example, the number of assets in the index should be based on market conditions and not arbitrary, subjective restrictions. This helps the index more closely track the state of value concentration among crypto assets at any given point in time. Additionally, many crypto index providers utilize capping and/or flooring when determining position sizes. This approach can distort the index composition in a way that does not accurately reflect relative market capitalization.
Gerry: You mentioned the NCIE index. Can you talk about why we believe its methodology is appropriate for financial professionals as well as individual investors?
Dramane: An index is only as good as its methodology. This is why we chose to create the NCIE with Nasdaq, a trusted brand with a long and successful track-record. The index was specifically designed to be dynamic, so that it quickly adapts to a rapidly evolving crypto environment. It’s also broadly representative of the market—which guarantees diversity and exposure to a wide range of sectors in the crypto ecosystem—and it is readily investable, which ensures that ETP shares reproduce the performance of its underlying assets.
A core tenet of the NCIE approach is the selection of the investable assets universe, which is rebalanced every quarter. We believe there is tremendous value in this institutional-grade approach. The NCIE only includes assets that:
- clear high regulatory and risk bars: we require that the assets be supported by regulated crypto exchanges and custodians, and that the assets be allowed on regulated European listing venues (this approach helped us avoid LUNA and FTT in our ETPs);
- meet liquidity and market capitalization criteria: this is important to ensure the index assets are easily tradable and meaningful for the universe.
- are approved by the Nasdaq Crypto Index Oversight Committee: the committee uses its discretion solely in the context of regulatory compliance, suitability, and exception management.
Gerry: This has been quite an eventful few weeks in crypto. What do each of you expect will drive this market in 2023?
Benjamin: I believe the regulatory clarity will help tremendously even as a bear market for risk assets persists. There is also a clear need for education in this space, which we believe will be very important in the new year. This is one of the reasons we recently expanded the Nasdaq Academy: Digital Assets to investors around the globe. We’ve found that financial professionals are becoming more comfortable with this asset class, and we think this will continue, especially as regulatory guidelines become clearer with the adoption of MiCA by 2024. Investors generally don’t have the infrastructure to trade and custody crypto themselves, but they want to make an asset allocation within this space. I expect to see more traditional index providers moving to offer solutions for the crypto market.
Dramane: I agree that the regulatory component is a huge one. As a global asset manager with products across three continents, we have a good line of sight into how the regulatory landscape is impacting product offerings. Relative to the US in particular, Europe (broadly speaking) is and will continue to benefit from a more welcoming environment.
Institutional adoption is growing with the index launches from large players like MSCI and Euronext, while many European banks are tangentially or directly working on blockchain and tokenization projects. Crypto is growing within portfolios among institutional investors and the Fear of Missing Out (FOMO) is also keeping interest strong. A recent survey by Fidelity Digital Assets found 86% of institutional investors in Europe believe digital assets should be part of portfolios.
Institutional investors that believe digital assets should be part of a portfolio
Source: 2022 Institutional Investor Digital Assets Study, Fidelity Digital Assets
Additionally, Europe is a leading voice in ESG investing, and I believe there will be additional progress in the overlap of crypto investing and responsible investing. This should remove one additional roadblock for further institutional adoption.
This is an asset class that is here to stay. Crypto is close to 1% of the total global asset allocation, so investors are also realizing that there is a cost for waiting: by not holding crypto, you are underweight in the asset class versus the average investor. So I think 2023 will be another important year in the development of the ecosystem and access for investors.
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