Why one money manager avoided FTX before the storm: Bitwise Q&A

(Bloomberg) – The cryptocurrency industry has been rocked by the implosion of the once-popular FTX exchange, whose demise has brought down a number of firms and maimed or destroyed many others. Investors and those even marginally connected to the events of the past few days are still sifting through the debris, waiting for the next domino to fall.

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Matt Hougan, CIO at Bitwise, a crypto-focused wealth manager who has witnessed other crypto winters, is joining this week’s What Goes Up podcast to share his observations and thoughts on how long the recovery process might take.

Here are some highlights of the conversation, condensed and slightly edited for clarity. Click below to listen to the full podcast, or subscribe to Apple Podcasts or wherever you hear it.

Life in Crypto after FTX (Podcast)

Q: Tell us about Bitwise and how you were affected by all the events.

A: Bitwise is a specialized crypto asset manager. Crypto is everything we do. We primarily serve professional investors – financial advisors, family offices and institutions. We’ve been in the market since 2017, so this isn’t our first bear market in crypto. And we’re best known for creating the world’s first crypto index fund, the Bitwise 10 (BITW), which holds the top 10 crypto assets weighted by market cap. On the crypto asset manager scale, we’re on the very conservative side – long-term investors in diversified index funds.

The last few weeks have been exhausting. As a money manager, we have not traded on FTX. We almost never actually trade on exchanges. We don’t hold any assets with FTX, so we don’t have any losses on that. But of course we are part of this broader crypto industry and it has had a huge impact on this market.

Q: Custody was in the news. As far as I know, you guys have custody of Coinbase, right?

A: We keep different funds with different custodian banks. So our flagship fund is held at Coinbase Institutional. Our Bitcoin fund is held at Fidelity. We have another fund that is held with Anchorage, a government-approved digital bank. What ties all three together, and how I feel about this custody landscape, is that they are all US-based, regulated, and insured custody institutions. When you think of the different ways crypto investors can hold assets, it’s a dumbbell of sorts — on one end of the dumbbell you hold your crypto keys directly, one at a time in a safe on a ledger or whatever. At the other end of the spectrum, Bitwise works with some of the largest institutions in the crypto space, companies like Fidelity, companies like Coinbase, which has been in the market for 10 years, a publicly traded company.

And then there’s that fuzzy center. And in the blurry middle all the bad things happen. What the fuzzy middle looks like are centralized institutions that are unregulated and often offshore. And that’s not a place you should keep crypto assets. Either go to regulated incumbents based in the US, or yes, if you have excellent security hygiene, do it yourself. I would argue that the regulated side of the spectrum is safer for the vast majority of investors. But you can be on either end of the bar, you just can’t be in that fuzzy middle. This is where good crypto ideas die.

Q: When it comes to stock index funds, they often keep costs down and bring in a little extra revenue by allowing the securities they hold to be lent to short sellers essentially through various brokerages. Does that even play a role in the custody of your crypto? Does anyone lend it?

A: We never lend our custodial crypto assets to investors. We’re one of the most conservative crypto asset managers in the world, which is frustrating during bull markets but feels pretty good right now. There are other money managers who do what you call securities lending – lending client assets. But we think that’s too risky and not what investors want. If you think about what cryptocurrency investors want, bet Bitcoin is worth half a million or a million dollars. You are looking for asymmetrical top. We don’t understand why anyone would try to get an extra 1% or 2% or 3% return by lending their bitcoins along the way given the risks involved. So we don’t trade on exchanges, we don’t lend our assets. We buy assets and immediately hold them and let them sit there.

Q: You look at the Bitwise Crypto 10 Index Fund, the Net Asset Value (NAV) is around $15 per share, the share price is around $7. So we’re talking a 55% discount on the actual assets you hold in that fund. Why do you think that?

A: We have three different ways investors can get access to Bitwise 10. One option is a private placement for accredited investors, available with weekly access to NAV – meaning no premium or discount. Another option is a separately managed account that a financial advisor can set up that will hold the assets held directly at NAV. And the third way is the BITW you mentioned, which is a publicly traded over-the-counter OTCQX security. These securities operate like closed-end funds given the regulatory restrictions in the crypto space, meaning they can be traded at premiums and discounts. And, unsurprisingly, given the volatility of the crypto market, they trade at greater premiums and discounts than you would see on a closed-ended muni bond ETF, for example.

So this discount reflects more sellers than buyers over a given period. What we’ve said publicly to investors, and what I hope, is the long-term outcome: once we’re authorized to do so, we’ll convert this fund into an ETF that will likely eliminate much, if not all, of this discount. The SEC has not allowed a crypto ETF to exist. I think this is another good example of regulators not helping investors by pushing regulatory clarity. Investors want access to Bitcoin, they want access to other crypto assets. If they could do that in an ETF, there wouldn’t be this issue of premiums and discounts. Wealth managers like Bitwise are trying to help investors get exposure to this space within the regulatory constraints we face. And so we have these OTCQX traded securities that can trade at premiums and discounts.

Q: On BITW – it holds the 10 largest digital assets but it is sifted out FTT even if this token which is the FTX utility token if it would have been classified for inclusion. Can you tell us something about this process?

A: I think in a frontier market like crypto you can’t have a simple index fund. You need a lot of rules that sort out assets. If you went to CoinMarketCap.com and looked at the list of crypto assets by market cap, you would have to get to asset about 21 or 22 before you find the 10th asset in our funds. So we filter out a large number of assets. We eliminated FTT, we eliminated Luna, we never held Dogecoin, we didn’t hold Tron. There are a variety of screens that protect us from these examples. We look at the basic tokenomics of an asset. That protected us from Luna. We saw the potential for the death spiral that this “stablecoin” was claiming. We review assets that present an excessive risk of violating federal securities laws. FTT fell into this frame because we thought it was likely or possible to be classified as a security by regulators. It was largely controlled internally. We think it could potentially pass the Howey test, which is why we will not be holding it in our fund. There are other screens that are really important – screens centered around liquidity.

This is just an excerpt from the conversation. Click here to hear the rest.

–Assisted by Stacey Wong.

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