Why One Asset 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 downfall has brought down a number of firms and maimed or destroyed many others. Investors and those even tangentially related to what’s happened in recent days are still sifting through the rubble and awaiting the next dominoes to fall.

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

Here are some highlights of the conversation, which have been condensed and lightly edited for clarity. Click below to listen to the full podcast, or subscribe on Apple Podcasts or wherever you listen.

Life in Crypto After FTX (Podcast)

Q: Tell us about Bitwise and how you’ve been affected by all the events.

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

The last couple weeks have been exhausting. As an asset manager, we did not trade on FTX. We actually almost never trade on exchanges. We did not custody assets with FTX, so we have no losses associated with that. But of course, we’re part of this broader crypto industry and it’s had huge effects on that market.

Q: Custody has been in the news. From my understanding, you guys custody with Coinbase, right?

A: We custody different funds with different custodians. So our flagship fund is custodied with Coinbase Institutional. Our Bitcoin fund is custodied with Fidelity. We have another fund that’s custodied with Anchorage, which is a federally chartered digital bank. The thing that connects all three of them, and the way I think about this custody landscape, is that they’re all US-domiciled, regulated institutions with insurance in place on their custody. If you think about the various ways that crypto investors can custody assets, it’s kind of like a barbell — at one end of the barbell is where you hold your crypto keys directly, individually in a safety deposit box on a ledger or whatever. On the other end of the spectrum is what Bitwise does, working with some of the largest institutions in the crypto space, firms like Fidelity, firms like Coinbase that have been in the market for 10 years, a publicly traded entity.

And then there’s this fuzzy middle. And the fuzzy middle is where all the bad things happen. What the fuzzy middle looks like is centralized institutions that are not regulated and often offshore. And that is not a place you should custody crypto assets. Either go toward regulated US-domiciled established institutions, or yes, if you have great 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 barbell, you just can’t be in this fuzzy middle. It’s where good crypto ideas go to die.

Q: When it comes to equity index funds, a lot of times the way they keep costs down and bring in a little extra revenue is to allow the securities they hold to be loaned out to short sellers basically through various brokerages. Is that at play at all with the custody of your crypto? Is anyone lending it out?

A: We never lend out our crypto assets that are under custody for 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 asset managers that engage in what you describe what amounts to securities lending — lending out customer assets. But we consider that too risky and also not what investors want. If you think about what investors who are allocating to crypto want, they’re betting that Bitcoin is worth half a million or a million dollars. They’re looking for asymmetric upside. We don’t understand why someone would try to earn an extra 1% or 2% or 3% yield by lending out their Bitcoin in route to that, given the risks that are associated with it. So we don’t trade on exchanges, we don’t lend out our assets. We buy assets and put them in custody immediately 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, share price is around $7. So we’re talking about a 55% discount to the actual assets that you’re holding in that fund. Why is that, do you think?

A: We have three different ways that investors could gain access to the Bitwise 10. One way is through a private placement for accredited investors that’s available with access on a weekly basis at NAV — so no premium and discount. Another way is a separately managed account that a financial advisor can set up that holds the assets directly held at NAV. And the third way is the one that you mentioned, which is BITW, which is a publicly traded, over-the-counter OTCQX-traded security. Those securities operate, given the regulatory limitations in the crypto space, like closed-end funds, which means they can trade at premiums and discounts. And given the volatility of the crypto market, not surprisingly, they trade at larger premiums and discounts than you would, say, see in a muni-bond closed-end ETF.

So what that discount reflects is more sellers than buyers over a period of time. What we’ve stated publicly to investors and what I hope the long-term outcome is, is once we’re allowed to, we will convert this fund to an ETF, which is likely to largely, if not entirely, eliminate that discount. The SEC has not allowed there to be a crypto ETF. I think that’s another good example of regulators not helping investors by pushing forward regulatory clarity. Investors want to gain access to Bitcoin, they want to gain access to other crypto assets. If they could do it in an ETF, there wouldn’t be this question of premiums and discounts. Asset managers like Bitwise are trying to help investors gain exposure to the space within the regulatory limitations we face. And so we have these OTCQX-traded securities that can trade at premiums and discounts.

Q: On BITW — it holds the largest 10 digital assets, but it’s screened out FTT even when that token, which is the FTX utility, token when it would have classified for inclusion. So can you tell us about that process?

A: I do think in a frontier market like crypto, you can’t have a simple index fund. You need to have lots of rules that screen out assets. If you went to CoinMarketCap.com and looked at their list of crypto assets by market cap, you’d have to get to asset about 21 or 22 before you found the 10th asset in our funds. So we’re screening out a large number of assets. We screened out FTT, we screened out Luna, we’ve never held Dogecoin, we don’t hold Tron. There are a variety of screens that protect us from those examples. We look at the fundamental tokenomics of an asset. That’s what protected us from Luna. We saw the potential for the death spiral that claimed that ‘stablecoin.’ We look at assets that are at undue risk of being found in violation of federal securities laws. FTT fell into that framework because we thought it was likely or possible to be deemed a security by regulators. It was largely internally controlled. In our view, it could potentially meet the Howey test and so we won’t hold it in our fund. There are other screens as well that are really important — screens around liquidity.

That’s just a snippet of the conversation. Click here to listen to the rest.

–With assistance from Stacey Wong.