Trends Watch: Digital Assets

EisnerAmper’s Trends Watch is a weekly entry to our Alternative Investments Intelligence blog, featuring the views and insights of executives from alternative investment firms. If you’re interested in being featured, please contact Elana Margulies-Snyderman.  

This week, Elana talks with David Lifchitz, Managing Partner and CIO, ExoAlpha.

What is your outlook for digital assets?

ExoAlpha being an asset management firm specializing in digital assets quantitative trading, we will answer that question under the angle of digital assets seen as investment vehicles, independently of their underlying business purpose.

So to answer to the question, tokenization, i.e., the digitalization of traditional assets, will open a new world of investment opportunities, making liquid what are nowadays illiquid assets such as real estate, private equity or collectibles (art, wine, jewelry, cars, etc.) through the emittance of fractional ownership titles which could be traded on dedicated exchanges.

And even more innovative investment products may come to life, such as National Basketball Association (NBA) Brooklyn Nets player Spencer Dinwiddie’s efforts to tokenize his professional athlete’s contract, which would allow -- for the first time -- accredited investors (for now) to buy shares of his contract as tokenized shares, opening the doors to many other entertainers of all stripes to provide similar uncorrelated to traditional assets investment opportunities.

But tokenization of traditional assets on a large scale will take some time to be implemented as it will revolutionize the way traditional assets are being traded today, which will turn some business actors into legacy, while new ones will emerge.

Down the road, we see all traditional assets (stocks, bonds, commodities, etc.) becoming digital and traded in the same way as native digital assets are today.

Where do you see the greatest opportunities?

Looking today at digital assets through the investment vehicle prism, we see a new asset class with interesting properties from an investment point of view. Essentially:

• They exhibit an asymmetric return/risk profile.
• They are uncorrelated to traditional assets.

 Our main conclusion is that digital assets are great investment vehicles to be included in a diversified portfolio of traditional assets. Their huge asymmetric return/risk profile allows them to be included in small portions in global portfolios, thus limiting their downside risk, while still enabling the investor to benefit from their potential huge gains on the one hand. On the other hand, their uncorrelated nature to traditional assets make them a great risk diversifier.

However, an asset with an asymmetrical return/risk profile doesn’t mean a risk-free asset. Digital assets have posted stratospheric returns in the past, such as Bitcoin’s +1,400% return in 2017 followed by a 75% correction the following year.

As with every investment, its downside minimization is the most important thing, and this is when holding digital assets not passively but through an actively traded strategy designed to minimize the downside risk of the asset while capturing as much as possible as the upside, becomes essential.

Another major advancement in the digital assets space is the upcoming of derivative products linked to them, which considerably ease the burden of getting exposure.

What about biggest challenges?

Again, regarding digital assets from a pure trading of digital assets point of view, their liquidity, i.e., the daily volume of exchange transactions taking place, is essential in order to insure the possibility to buy or sell whenever one’s desire and at a close price.

Also, they tend to be highly volatile, swinging up and down way more and way faster than traditional assets, on top of being active 24x7.

All of these hurdles make digital assets investing and, even more so their trading, a challenging task for non-specialized individuals or investment firms.

In the early days of digital assets (e.g., 2009-2015), they were just geek-talk and very few people were involved. Regulators were not involved. But then they became more mainstream in 2016 with ICOs allowing investors of any kind to invest in such projects, followed by a frenzy comparable to the dot.com bubble of the late nineties in 2017. Regulators became involved but seemed to still be behind the curve, and nowadays (2020) they are likely to overshoot, which will pose a risk to digital assets providers with the risk of regulation becoming too stringent due to efforts to weed out bad actors. This could also prevent legit projects from taking off because of a too heavy burden to carry.

What keeps you up at night?

Most investors in digital assets will tell you that their wild swings are what keep them up at night, especially as they are active on a 24x7 basis.

But exchanges security is what keeps ExoAlpha up at night. Many small digital heists have taken place at different exchanges worldwide. Smaller players were more heavily hit, but some major ones have also being partially hacked. The larger exchanges have set aside a sort of insurance fund to cover losses resulting in such hacks, but smaller, less-equipped exchanges don’t provide such insurance.

Another reason to trade on large exchanges is also the deeper liquidity they provide vs. smaller exchanges: the more traders on an exchange, the deeper the liquidity and the better the trading conditions. This leads to a virtue spiral: the more traders, the better the liquidity, and the better the liquidity, the more traders.