Three Cryptocurrencies to Avoid as Initial Coin Offerings (ICOs) Enter Into a Frenzy

Bitcoin, cryptocurrencies, and the underlying technology that have enabled the growth of the cryptocurrency and the token market, Blockchain, have exploded into the public consciousness over the last six months. Since the beginning of the year, the price of a Bitcoin rose from $900 to nearly $3,000 at its peak a month ago. The surge of the price of Ethereum, the second most popular cryptocurrency by circulating market capitalization, was even more impressive. From $10 in the beginning of 2017, the price of Ethereum surged to $400 a month ago. Ethereum is currently trading at around $200, half its price of a month ago but still up 1,900% since the beginning of 2017.

Cryptocurrencies’ underlying technology, the Blockchain, originated from the concept of “linked timestamping” to better secure documents as first proposed by Stuart Haber and Scott Stornetta in 1990. The rationale was to create a more secure system than the public-key signature based time-stamping. This made the document’s timestamp impossible to change after the fact. A subsequent improvement replaced the concept of linking documents individually into a collection of blocks, all of which were then linked together in a chain. Instead of a linear connection, the documents within each block are linked together in a tree structure, which utilizes less resources for the positioning verification of a document in the history of a system. Bitcoin combined the idea of linked timestamping and the usage of computational puzzles to regulate the creation of new currency units. Under the Bitcoin regime, a hacker cannot realistically change the history of transactions unless he or she can compute computational puzzles faster than all Bitcoin participants combined. This ensures the security and integrity of the Bitcoin regime. This was a breakthrough in that for the first time, it solved the dilemma of potential “double spending” within a decentralized, digital payments system.

The idea of a secure, frictionless, and decentralized system for settling cross-border payments and storing/sharing information is beginning to gain momentum for global businesses. This is especially the case for emerging market countries, where there is a profound lack of large, reliable centralized financial clearing/payments systems.  E.g. a group of Indian banks that includes the State Bank of India and ICICI Bank recently agreed to use Microsoft’s Azure blockchain-as-a-service solution to host their distributed ledger systems.  Similarly, Bajaj, the Indian subsidiary of Allianz, just began to implement a Blockchain solution to speed up insurance claims for travelers and motorists. Similar Blockchain-based initiatives which aim to expedite international, cross-border capital transfers include:

  • 60 banks are now commercially deploying enterprise software developed by Ripple, a San Francisco startup. In April, BBVA successfully completed a series of money transfers between Spain and Mexico through the company’s proprietary distributed ledger technology. According to American Banker, the transfers took seconds, compared to the four days they normally take. So far, Japanese banks have had the greatest uptake, with a consortium of 59 Japanese banks having successfully completed a pilot with the software. 40% of all Japanese customer banking accounts will have access to the Ripple-based blockchain solution by October this year;
  • Backed by Goldman Sachs and Baidu, Boston-based Circle Internet Financial launched an international money transfer service last month allowing zero-cost, cross-border transfers between the U.S. and Europe through its Blockchain-based peer-to-peer payment network;
  • In May, Bank of Tokyo-Mitsubishi UFJ began testing its own cryptocurrency (MUFG coin), which will allow users to instantly transfer money on a peer-to-peer basis via the app or to purchase goods and services at affiliated stores. Currently, around 200 of the bank’s employees are testing the MUFG coins; the bank has plans to expand the trial across its branches by the end of 2017.

Despite my long-term constructive outlook on Blockchain, however, I believe the recent surge in prices and the number of initial coin offerings (ICOs) represents significant exuberance (for this article, I will use the terms “cryptocurrency” and “tokens” interchangeably). As shown in the following chart, the total market capitalization of all cryptocurrencies embarked on a parabolic move beginning in January 2017. From $5.6 billion as of January 1, 2015 ($4.4 billion of which is Bitcoin’s market capitalization), the aggregate market capitalization (based on circulating supply) of all cryptocurrencies surged to $115 billion as of June 14, 2017. As of this writing, the aggregate market capitalization (encompassing the value of 811 cryptocurrencies) totals $80 billion.

marketcap

In addition to the influx of capital and the rising number and size of ICOs (the record $232 million Tezos ICO being the latest to take advantage of such investors’ exuberance), there are other red flags which suggest that investors should be cautious of the cryptocurrency space:

  • Lack of transparency: In a regular U.S. initial public offering (IPO), the SEC requires the company issuing shares to file a Form S-1, where information is provided regarding the use of IPO proceeds, the company’s business model and competition, as well as a prospectus disclosing the names of the company’s principals and financial information. There is no similar process in the cryptocurrency space. E.g. Tezos published an 18-page position paper and a 17-page white paper describing Tezos as a “generic and self-amending crypto-ledger” and that it “supports meta upgrades,” i.e. “the protocols can evolve by amending their own code.” In other words, Tezos aims to be the be-all and end-all of the cryptocurrency world, but details are lacking. Even during the “irrational exuberance” days of the technology bubble, there was much more disclosure. Presumably, the founders of Tezos will get filthy rich once the token starts trading;
  • The ease of new ICO creation: A recent article asserts the “hard cap” on the lifetime supply of Bitcoins (21 million) and Litecoins (84 million) is inherently deflationary, i.e. both Bitcoins and Litecoins may be considered a long-term store of value similar to gold, New York real estate, or farmland. While Bitcoin and Litecoin have been in existence since 2009 and 2011, respectively, such track records are still comparatively short in the context of monetary history. With new and more innovative cryptocurrencies being created all the time, there is no guarantee that either Bitcoin or Litecoin will retain their value over time. The creation of truly anonymous cryptocurrencies such as Zerocoin may also render existing cryptocurrencies such as Bitcoin and Litecoin less attractive over time.
  • Lack of recourse: An investor that has purchased the debt or equity of a company has a legal claim and resource on the company’s assets in the event of a bankruptcy filing. Should the value of a cryptocurrency plunge to zero for whatever reason, there is no legal resource whatsoever.

The excitement of the future impact and practical applications of the Blockchain technology has no doubt driven the latest exuberance in the cryptocurrency market and the hunger for new ICOs. While I believe Blockchain will change the way we fundamentally do business, store/exchange information, and move capital across borders, history has demonstrated that most early investments into a new technology typically do not work out. E.g. the vast majority of start-up auto companies in the early 20th century/internet companies in the late 1990s went out of business, leaving investors with nothing. Specifically, based on my research, I would avoid the following three cryptocurrencies/tokens:

Ripple (XRP): XRP is designed as a “bridge currency” for use when a transaction between two currencies on the Ripple protocol cannot be made because one or both currencies are rarely traded. In other words, the Ripple protocol is designed primarily to be a currency exchange, enabling “secure, instant and nearly free global financial transactions of any size with no chargebacks.” Should liquidity between currency pairs on the protocol increase over time, there will be a decreasing need for XRP. In addition, of the 100 billion XRPs issued, more than 60 billion is being held by Ripple Labs. While Ripple Labs has locked up 55 billion XRPs through a series of 55 “smart contracts” (with one contract expiring every month for a period of 55 months), it does not change the fact that the creators of Ripple still own the majority of XRPs and would stand to benefit the most from a surge in the cryptocurrency.

Numeraire (NMR): In February of this year, one million Numeraire tokens were issued to 12,000 data scientists as an incentive to create a profitable global long-short equity fund constructed with algorithms via a collaboration between the 12,000 data scientists. According to the issuing firm, Numerai, financial data is “transformed and regularized” and is then fed to its data scientists through an encryption process. This idea has three major red flags. Firstly, there are hundreds of quantitative funds which have been designing algorithms utilizing financial data for global equities for many years, if not decades. Financial data is a commodity and is readily available through Compustat or FactSet; unstructured data such as granular, real-time weather forecasts (which is highly valuable if one was speculating in agricultural futures) or Twitter feeds gauging real-time traffic at Starbucks’ locations are unique, but based on public information, Numeraire is purely using financial, and thus, commoditized data. Secondly, there is an asymmetry of information between the data scientists and the public, the latter of which could also purchase NMR. Presumably, the data scientists working on the algorithms should have a better understanding of their utility, and could buy or sell NMR in advance to take advantage of this information asymmetry. Finally, the top data scientist on the platform is currently limited to a $54,000 annual payout, which is hardly an incentive for the most talented data scientists to work on the project, even on a casual basis..

Litecoin (LTC): While the Litecoin protocol has lower transaction fees and faster times than that of Bitcoin, many speculators bought LTC recently due to an expected August 1st launch of an MIT project related to LTC. My sense is that this countdown page purportedly created by MIT is a hoax and its primary purpose is to pump up the price of LTC going into August 1st. The cryptocurrency space is unregulated. This means there is no process for prosecution if crypto-investors find out on August 1st that MIT isn’t launching a product, after all. Secondly, it is out of MIT’s character to create such suspense when they know this will lead to greater speculation in LTC ahead of the August 1st date. The group behind MIT’s Digital Currency Initiative, along with Charlie Lee, the creator of Litecoin, have said they do not know anything about the countdown page. Since any MIT student can create a subdomain on MIT.edu, the perpetrator may be an MIT student or someone related to an MIT student who is speculating on the price of LTC. Buyer beware.

EU-Wide Stress Test Results Adding to Systemic Risk

As professional investors, we have been trained by the markets, the CFA Institute, and business school professors early on to avoid certain kinds of investments. Examples include scams such as Florida swampland (if it is too good to be true, it usually is) and obsolete businesses such as U.S. textile mills (by far Warren Buffett’s worst investment in his storied career) or newspapers & magazines whose revenues are still dependent on print advertising.

As I previously pointed out, Italian banks, along with systemically-important Deutsche Bank, have the distinction of fitting into both categories. Deutsche Bank’s core investment banking & trading businesses are obsolete in the post-crisis, capital-constrained world (think Basel III, Basel IV, Solvency II, and IFRS9), and yet Deutsche’s leadership remains in denial. Meanwhile–as I pointed out in two earlier blog posts (“Strengthening the Global Banking System’s Weakest Link” published on April 12, 2016 & “Italy’s NPLs Still the Global Banking System’s Weakest Link” published on July 7, 2016)–Italian policymakers have for years refused to reform or even acknowledge the growing NPL problem within the Italian banking system. It wasn’t until this year that investors finally forced Italian policymakers and banks to act; more than 7 months into the year, they have yet to provide a stronger or more comprehensive solution that will likely involve a combination of (hugely dilutive) capital raises, offloading NPLs to foreign investors, along with some kind of “bail-in” steps for the Italian bank with the worst balance sheet, i.e. Banca Monte dei Paschi di Seana (BMPS).

The publication of the 2016 EU-Wide Stress Test last Friday was intended to alleviate solvency concerns and to halt the vicious cycle of declining European bank stock prices that began early this year. 51 large European banks holding 70% of all European banking assets were covered. These banks were domiciled in the following countries: Austria, Belgium, Denmark, Finland, France, Germany, Hungary, Ireland, Italy, Netherlands, Norway, Poland, Spain, Sweden, and the UK. Banks in two of the Euro Zone’s most troubled economies, i.e. Greece and Portugal, were not included in the stress test.

Key macroeconomic assumptions/projections of the 2016 stress test (see Figure 1 below) were similar in severity relative to those in the 2014 stress test. E.g. the 2014 stress test assesses a 3-year cumulative real GDP “shock” of -7.0% in the Euro Area, vs. a 3-year cumulative -7.1% shock in the 2016 stress test, as shown in Figure 1 below.

Figure 1: Key Macroeconomic Assumptions/Projections of the 2016 EBA Stress Test
eba2016stresstestassumptions

The 2016 stress test, however, did refine its overall framework by adding two explicit assumptions relative to the 2014 stress test: 1) explicit bottom-up treatment of FX-related trading losses to entities in central and eastern Europe in the event of EM currency depreciation, and 2) cumulative losses of 71 billion euros driven by the concept of “conduct risk,” with 15 of the 51 banks tested having a conduct risk liability of more than one billion euros.

On the surface, the results of the 2016 stress test were relatively benign. The 51 banks in the sample had a weighted average fully loaded CET1 capital ratio of 12.6% as of year-end 2015. This starting point was 150 bps above that for the 2014 and 400 bps over that for the 2011 stress test. Since December 2013, the fully loaded CET1 capital for the 51 banks sampled has increased by 180 billion euros. Under the “adverse scenario,” the 2016 stress test estimates a decline of 340 bps in the weighted average CET1 ratio to 9.2% by the end of 2018, driven mostly by projected credit losses, conduct losses, and losses stemming from counter-party risks. More importantly–out of the 51 banks sampled–only 10 banks finished with a fully loaded CET1 capital ratio of less than 8.0% by year-end 2018 (post any mitigation measures enacted after year-end 2015). They are: BMPS (-2.44%), Allied Irish Banks (4.31%), Raiffeise-Landesbanken-Holding (6.12%), Bank of Ireland (6.15%), UniCredit (7.10%), Barclays (7.30%), Commerzbank (7.42%), SocGen (7.50%), Deutsche Bank (7.80%), and Criteria Caixa (7.81%). Figure 2 below shows the EBA’s projected fully loaded CET1 capital ratios as of year-end 2018 on a bank-by-bank basis:

Figure 2: Fully Loaded CET1 Ratios at Year-End 2018 Under the EBA’s Adverse Scenario
(source: Goldman Sachs, EBA)
CET1 Ratios

Unfortunately, as I have asserted in my weekly global macro newsletters and my last two blog entries on the Italian banking system, what investors are looking for is not a “rubber stamp” approval by bank regulators on the integrity of European banks’ balance sheets or a halfhearted fund-raising effort by BMPS, but a strong, decisive, and system-wide capital-raising effort with government backing, along with a multi-year reform plan to rebuild the sustainability of long-term profits currently being impeded by: 1) prevalence of negative interest rates across much of the Euro-wide yield curve, 2) slow structural growth rates, especially within countries such as Italy, Portugal, and Greece, and 3) obsolete business models where certain business operations (e.g. trading) are being quickly replaced by hedge funds and fintech companies.

Over the last two trading days, European banks’ stock prices (ETF ticker EUFN) have fallen by nearly 3%. In particular, BMPS is down by 13%, UniCredit by 15%, Barclays by 5%, and Deutsche Bank by 7%. Major criticisms of the framework/results of the EBA’s 2016 stress test have been as follows:

  1. Banks in the region’s two most NPL-challenged countries, Greece and Portugal, were not included in the stress test;
  2. Under the BMPS rescue plan conceived last Friday, the bank will securitize its entire bad loan portfolio (face value of 27.7 billion euros) at a price of 33 cents on the euro. A securitization at this price is below investors’ expectations; this means if other Italian banks are forced to take similar haircuts on their NPLs, their capital ratio position would be less than what the 2016 stress test currently implies, thus requiring a more substantial (and dilutive) capital raise on the part of Italian banks;
  3. The stress test did not include the impact of regulations that are likely to be implemented over the next several years. Known collectively as “Basel 4,” KPMG estimates that these would lead to an extra 350 billion euros of capital requirements for the world’s largest 100 banks.

Bottom line: The publication of the EBA’s 2016 stress test results have failed to quell investors’ concerns of a systemic meltdown of the Italian banking system. Moreover, a successful recapitalization of BMPS is far from assured, as its capital raise is contingent on the sale of its 27.7 billion euro NPL portfolio, the latter of which will likely result in a larger-than-expected haircut on the Italian-wide 360 billion euros of NPLs. Continue to underweight European financials, especially Deutsche Bank and Italian banks in general.

Italy’s NPLs Still the Global Banking System’s Weakest Link

I last discussed the vulnerabilities in the Italian banking system in our April 12, 2016 blog post (“Strengthening the Global Banking System’s Weakest Link“), where I asserted that–given its global inter-connectivity  today–the world’s financial system can only be as strong as its weakest link. Typically, a liquidity or solvency issue can linger on indefinitely, simply due to the absence of external shocks or because the overall global economy is doing well. In the case of the current NPL issues with the Italian banking system, an effort in January to encourage sales of NPLs by providing government-backed guarantees unfortunately attracted investors’ attention to Italian banks’ NPL issues. When we last covered this issue three months ago, Italian banking stocks were “only” down 20% YTD; today, they are collectively down by 55% YTD.

The vulnerability of the Italian banking system–and by extension, that of the Western European banking system–has come under increased scrutiny over the last several months, exacerbated by: 1) the unexpected, ongoing deflationary malaise in much of the developed world; the May 2016 Italian inflation reading was -0.3% year-over-year, worse than market expectations of -0.2%. June 2016 Italian inflation is expected to hit -0.4% year-over-year, resulting in six straight months of deflationary readings, 2) the dramatic flattening and downshift of the Western European yield curve; globally, nearly US$12 trillion of government bonds now have negative yields, and 3) an unexpected vote for “Brexit,” equivalent to a negative growth shock within the EU, as well as heightened political and economic uncertainty.

The Italian banking system in particular is saddled with 360 billion euros of NPLs, equivalent to about one-third of all of the Euro Zone’s NPLs. Moreover–as efforts since January have demonstrated–a concerted sales effort in NPLs in Europe is not a simple task. Firstly, EU rules explicitly ban the use of government-backed guarantees to cushion NPL losses. Secondly, the average restructuring period for Italian bad loans is an abnormally long 8 years; a quarter of cases take 12 years. Finally, the European market for NPLs is small and underdeveloped relative to the overall stock of NPLs in the banking system. In other words, the market for selling Italian NPLs is relatively small, and is almost non-existent without government-backed guarantees (e.g. A proposal by Apollo to purchase 3.5 billion euros of NPLs held by Italian bank Carige back in March made no progress). Italy’s NPL issues are especially concerning given the lack of core profitability of the Italian banking system (see Figure 1 below).

Figure 1: Return on Regulatory Capital of European Banks by Country – June 2015 (source: EBA, Goldman Sachs)

returnoncapitalEBA

It is generally agreed upon that an Italian government-led recapitalization of 40 billion euros into some of Italy’s largest banks (Unicredit, BMPS, and Intesa, for example) would be adequate to resolve the Italian NPL issue, as long as Euro area growth re-accelerates; at the very least, the immediate probability of a Euro-wide banking contagion would be reduced by an order of magnitude. There are two real obstacles to this “happy scenario,” however: 1) the EU, backed by Germany, is resistant to any Italian government-led efforts to recapitalize the banks at no cost to Italian bank debt holders, as this directly goes against EU rules. Any attempt to “bail-in” Italian banks would increase contagion risks among all of EU banks as both depositors and debt holders will likely take their capital and flee to either the U.S. or other safe haven asset classes, such as gold, and 2) Italian Prime Minster Matteo Renzi has promised to resign if he loses the constitutional referendum to be held in October. Recent opinion polls suggest Renzi’s campaign will fall short; this will likely lead to significant Italian and EU-wide instability given the surge of the populist Five Star Movement in recent opinion polls. Seen in this light, the fragility of the Italian banking system is an ongoing cause for concern.