Investors want regulations to assuage crypto concerns

Though many public pension funds have shied away from digital assets tied to cryptocurrencies and the blockchain, some are nevertheless moving forward with small investments in this potentially transformational yet volatile sector.

Last year, for example, the $5.3 billion Houston Firefighters' Relief and Retirement Fund decided to establish a $25 million portfolio in crypto assets. The $199.9 billion Teacher Retirement System of Texas, Austin, and two different Fairfax County, Va., pension plans have also invested in this space.

These investments range from direct investments in cryptocurrencies to stakes in venture capital funds that hold a portfolio of cutting-edge startups tied to building out the infrastructure of a faster and less costly alternative payments system not tied to fiat currencies and the commercial banking system.

But most public pension funds and other institutional investors need to see more to like about the sector before building sizable stakes. For investment officers contacted by Pensions & Investments, rising confidence won't occur until stomach-churning volatility and falling prices give way to more stable returns over time. And that won't likely happen without greater technological advances including improvements in account security, more real-world applications, and coordinated oversight by government regulators, they said.

"Regulation will probably bring in more institutional (investors), which would have the effect of dampening volatility," said Andrew Spellar, the chief investment officer of the $5.1 billion Fairfax County Employees' Retirement System. "As to whether regulation in the grand scheme of things is a good or bad thing, we have no comment."

Starting in 2019, Mr. Spellar said the retirement system has made six different investments totaling $85 million in the digital-asset space, mostly through venture capital vehicles with expected life cycles of 10 to 12 years. Among them are two investments in "yield farming," in which crypto investors are willing to lock up their cryptocurrency for a period of time in exchange for more cryptocurrency.

Ajit Singh, chief investment officer for Houston Firefighters, thinks crypto and related investments will gain added legitimacy when major custodians launch custody services for digital assets. He also said that "regulation clarity is certainly important and opens the door for various investment vehicles designs suitable for investment objectives and risk tolerance."

Currently, the crypto industry comes under the oversight of a patchwork of agencies including the Securities and Exchange Commission and the Commodities Futures Trading Commission. But it's clear that regulators, the White House, and some lawmakers on Capitol Hill feel that regulation needs to be expanded and clarified to keep pace with the industry's expected growth.

An executive order from President Joe Biden in March outlined a national policy for overseeing digital assets across six areas including consumer and investor protection, financial stability and illicit finance. And members of Congress have introduced various bills designed to regulate digital assets such as bitcoin, though these measures have differing views about which agency should take the lead.

SEC Chairman Gary Gensler has argued that the majority of cryptocurrency tokens are securities and thus should be regulated by his agency, but he said recently that he is open to expanding the role that the CFTC plays. The commission also announced the addition of a new office to review filings that involve crypto assets on Sept 12.

Still, much of the sector's growth as an bona-fide investment class will be tied not to regulation but to expanding technological applications for digital assets. "Our fund's investment in digital assets is motivated by taking a foothold exposure in upcoming disruptive (Web3)," added Mr. Singh in an email, a reference to the next iteration of the internet in which blockchain technology will play a role in creating a more decentralized medium. Currently, all of the fund's investments are in bitcoin and ether, the two leading cryptocurrencies.

Jase Auby, CIO of Texas Teachers, also believes that a bullish case for digital assets such as crypto and the blockchain is tied to progress toward what he refers to as a "true" Web3.

"Credibility will be built over time as investment successes pile up and the market for end user cases expands tangibly." Thus far, Mr. Auby says his pension plan has made some initial venture capital commitments to digital assets-focused managers, though he refrained from discussing specific amounts.

As the New York-based CIO of digital assets at the Forest Road Co., an asset manager with institutional clients, Chris Solarz is an admitted crypto bull. But Mr. Solarz concedes that a number of conditions need to take place before this sector can gain true acceptance among investors.

"There are currently over 300 million crypto users globally, and the three things we need to see before we add the next 300 million users are increased regulatory clarity, more user-friendly front-end interfaces for trading digital assets, and more security," Mr. Solarz said. "The number of hacks and frozen accounts have adversely affected the trust users place in the security of the overall crypto ecosystem, and trust will ultimately be restored through increased security."

Speculation about the future of digital assets comes at a time when investment sentiment regarding this sector has been decidedly bearish. After jumping more than tenfold in market value in a three-year period to an all-time high of over $68,000 last November, bitcoin has since fallen by more than 70%. Even a more diversified crypto play, the actively managed Amplify Transformation Data Sharing ETF, has also fallen by close to 70% since its November high. By contrast, the Invesco QQQ Trust, a proxy for tech stocks, has fallen by 28% from its all-time-high reached in late December.

As prices of digital assets have fallen, the criticism of these investments has accelerated. Once lauded for being relatively uncorrelated to the U.S. stock and bond markets, crypto investments like bitcoin and even stocks like crypto-trading platform Coinbase Global Inc. have become more closely correlated with speculative technology stocks. Even the process by which units of bitcoin are created has come under attack by environmentalists and sustainable investing advocates because of added demand on fossil fuels used in the electricity that powers "mining" efforts.

All these concerns make it easy for most public pension funds to sit on the sidelines — at least for now.

"For pension funds to commit to an asset class, they would need more of a track record of performance and a greater level of assurance about future performance," said Keith Brainard, the Georgetown, Texas-based research director for the National Association of State Retirement Administrators.

Crypto naysayers, however, may be missing an opportunity to gain exposure to technology that transforms the way business and finance is conducted, said Joe Marenda, San Francisco-based partner and global head of digital assets investing at investment consultant Cambridge Associates LLC.

Mr. Marenda has a simple counterargument to the criticism that crypto investing has become highly correlated with the speculative technology stocks.

"Blockchain is a disruptive technology and if you have that view, you never bought into the uncorrelated asset argument in the first place," he said. He also contends that environmental arguments against crypto mining will subside over time as the process becomes more energy efficient, thanks to the increasing use of renewable sources such as wind, solar and hydroelectric power.

Mr. Marenda said most crypto-related investments are best suited for investors that have the patience to watch a new financial-system paradigm play out over the next decade or longer. "Like the internet, this is a transformation that will take many years to come to full fruition," he said. "We're still early in the second inning."