Could Lykke’s LyCI index product be the gateway retail investors are waiting for?

Could Cryptocurrency Index Products such as Lykke’s LyCI be the Retail Gateway to Crypto Investing?

The danger-fraught journey of retail investors into Cryptocurrency

Retail investors looking to participate in cryptocurrency markets are faced with seemingly insurmountable obstacles. While the prospect of becoming the next crypto millionaire might seem enticing, entering the world of cryptocurrency, even in 2019, is a daunting task. Can Lykke and LyCI take meaningful steps towards changing that? This article investigates…

While the average retail investor is familiar with stocks and bonds these assets are usually made accessible to them via banks and financial advisors, as well as kept secure in insured safekeeping accounts. These services come at a price but with limited expertise required and with regulations that keep financial intermediaries acting on their client’s behalf and assets where investors left them.

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In the crypto world, however, investors must navigate an unregulated environment where they must become their own bank. While crypto exchanges often act on their client’s behalf, many have not, and many have been the subject of hacks. This has resulted in many investors being defrauded of their funds. Crypto security experts offer stern warnings regarding the fact that you don’t fully own cryptocurrency until it’s in a wallet that you hold the keys to. These experts advocate for hardware wallets which look like USB sticks and are custom designed to securely store cryptocurrency offline away from prying hackers and collapsing exchanges. These precautions are a necessary part of the learning curve for crypto investors yet they present another major roadblock toward mass adoption of cryptocurrency.

A typical hardware wallet

Transferring funds onto cryptocurrency exchange can also cause anxiety as this often requires the transfer of traditional fiat currency to bank accounts in small less regulated countries which are unrelated to the domicile of the cryptocurrency exchange itself. This is because the majority of countries and banks would rather err on the side of caution and not give cryptocurrency-based businesses traditional accounts. The most common reason for this is clients of the cryptocurrency exchange may not have gone through rigorous enough “know your customer” processes and exchanges might not be perceived to have enough safeguards against anti-money laundering, particularly given Bitcoins history with the dark-web and illegal marketplaces. In fact, the majority of cryptocurrency exchanges have been so ostracised by the traditional finance world that they do not offer fiat currency deposits and will only accept cryptocurrency.

The next set of issues come when individuals get comfortable buying bitcoin and Ethereum and go in search of the next hot cryptocurrency. This leads to opening up accounts across multiple exchanges to be able to access other coins but also, in turn, provides more gateways for hackers to take advantage of security holes. Additionally by venturing into the wild west of small-cap cryptocurrencies, investors are faced with pump and dump schemes that try to sweep up retail investors into their coins’ hype, pump the price as high as possible before removing the rug by selling as much as they can at the highest point while leaving everyone else with coins that are essentially worthless. Similarly, investors can get caught up in glossily documented initial coin offering white papers which are dressed up to be the next bitcoin but have none of the expertise or infrastructure needed to make a breakthrough and exist only to make the creators of such cryptocurrencies profit.

How Lykke and LyCI mitigate many of these obstacles for retail investors

Unlike many exchanges and actors in the crypto world, the Swiss-based cryptocurrency exchange, Lykke has pursued a mission of seamlessly integrating into the traditional financial system and sought to simplify the process of buying and selling cryptocurrencies for retail investors. Rather than fighting regulation Lykke has ran towards it, hoping to seek harmony with government and financial intermediaries to make their business sustainable and give their clients the same protections they have come to expect from traditional financial institutions. Through this approach, Lykke has mitigated many of the challenges faced by retail investors described above, while not alienating banks by adhering strictly to “know your customer” and “anti-money laundering” regulation to allow them to keep gateways to financial institutions open for both themselves and their clients.

The latest evolution of this mission has been the development of the LyCI index product. Borrowing from ideas that have long flourished in traditional finance, Lykke’s LyCI product is a passive index investment product that allows investors to participate in the broader cryptocurrency market without needing to hold the underlying assets themselves. Traditional Index products have been so successful that Warren Buffet even made a 1’000’00 USD bet with a hedge fund manager that a passively managed SP500 index fund would outperform sophisticated hedge managers over a 10-year period. He won. Why such products have been so successful is they are not dependent on any given company or member of the index, but rather profit from the success of all companies as a whole while discarding unsuccessful companies and including successful ones as they enter and exit the index.

While being an outspoken critic of crypto, Warren Buffet has long advocated passive investment vehicles as being one of the safest and profitable ways to invest in the long term

Lykke has now brought this concept to the cryptocurrency market. Concretely LyCI invests in the top 25 cryptocurrencies in terms of their market capitalization and also weighs them in the index by their market capitalization. Market capitalization being the number of coins available times the price of a coin which gives the value of the total coin supply. The index is the price is calculated every minute and constituents are added or removed on a daily basis, further protecting investors from losers and missing out on winners. LyCI has built in a few other mechanisms into the index to protect investors, such as the discretion to deal with unnatural pumps and dumps as well as technically unsound hard forks whereby rebel factions try to replicate a currency but do not have the same integrity of intentions or infrastructure as the original currency. Both of these issues can see coins erroneously finding themselves in the top 25 coins by market cap. This was recently the case with Bitcoin when many exchanges including Lykke chose not to support a contentious fork called Bitcoin SV that is still a top 25 coin.

LyCI discards the need to hold multiple accounts across many exchanges, rebalancing helps manage wildly fluctuating positions and no longer do investors need to keep up with smaller cryptocurrencies rapidly shooting up the market capitalization charts. While some might hesitate at the risk of holding positions in more volatile smaller coins, a feature of the cryptocurrency market is most funds are still concentrated in Bitcoin. LyCI currently holds over 64% of the index in Bitcoin and large positions in Ethereum and Ripple the 2nd, and 3rd largest coins by market cap respectively. While Bitcoin and these top coins still hold the potential to make the parabolic leaps that catapulted them into the limelight, their volatility tends to be less than coins in the 10th to 25th market cap positions. Thus the risk of having small positions in the smaller riskier coins is greatly reduced.

LyCI’s index weighting as of January 26th 2019

Bitcoins unique premier place in the crypto market also means that it tends to act as a rudder for the whole market, guiding the general direction but also providing somewhat of a volatility buffer in bear markets and a springboard for promising new projects and currencies during bull markets. Thus a market cap weighted index is great for reducing volatility while still allowing investors to take advantage of smaller cap coins which can post gains of several 100 percentage points.

Holding the 25 top coins vs just holding Bitcoin also provides diversification benefits. In other asset classes diversification has been proven time and time again to increase returns for the same level of risk that an investor takes on. When engaging with an asset class as volatile as cryptocurrency, reducing risk is a no brainer for most investors and using cryptocurrency index products rather than buying one or a few individual currencies is a much safer way to enter into the market, particularly over longer time horizons. In fact prudent diversification means that most investors should still be holding the majority of their assets in traditional instruments such as stocks, bonds, and cash; however if there is some space in their portfolio for a small allocation to cryptocurrency, LyCI is a great way to use that allocation.

Should LyCI be market cap weighted?

LyCI is a great starting point for index products, however, the product might be improved by moving away from a passive approach which weighs the individual currencies in the index based on coinmarketcap.com’s market capitalization metric towards a hybrid approach which takes market capitalization as well as other factors, including qualitative expert opinions into account.

The top 10 according to coinmarketcap.com

The advantage with weighing only on market capitalization according to a publicly available website is it gives investors and Lykke a common set of expectations with regards to how the product will be managed and transparency. The disadvantage is that cryptocurrency markets are far less regulated than traditional ones and inclusion on coinmarketcap is not based on meeting regulatory requirements. Compare this to the SP500, a US equity index, which requires index members are listed on the NYSE, NASDAQ or CBOE BZX, highly regulated exchanges subject to scrutiny by the SEC, a hugely powerful regulatory body which forces public companies to file independently audited financial statements and make them available to investors. These statements are prepared in a way that financial analysts and investors can pick them apart as they are standardized according to regulation, cryptocurrency websites and cryptocurrency exchanges have no equivalent regulatory body.

While it is partially the increased risk and informational inefficiencies that allow for the large gains in cryptocurrency relative to stocks, higher due diligence is required. Cryptocurrency specific knowledge and research can generate much higher above-market returns (alpha) than other assets where more information is easily accessible and understandable by the public. This feature of cryptocurrency poses a dilemma to market capitalization indices that blindly include or exclude constituents without experts deciding whether a new index member has the right to be there.

Cryptocurrency market capitalization numbers are also highly subject to their underlying algorithms as well as how coins are distributed. For example, Ripple, the 3rd largest cryptocurrency by market capitalization has 60% of its total supply in reserve and more quarantined for its founders, supply which is not publicly available. This poses a dilemma when weighing such a coin in a market cap weighted index and also means that the value of investor holdings could significantly be devalued if Ripple released those funds to the market. Similarly, some cryptocurrencies are deflationary in nature as they automatically release more coins decreasing price while others are inflationary as they burn the existing supply increasing the price to give back profits to investors. The field of cryptocurrency design known as crypto economics gets complicated quickly, however, its implications are that it has the potential to skew an unadjusted market cap weighted index. I would argue however that the complexity of crypto economics leaves an opportunity for a company like Lykke who undoubtedly have the asset specific expertise to take a more active approach in weighing their constituents to accurately reflect the cryptocurrency market and potentially give investors a better chance of profiting from the overall market.

Potential Cryptocurrency Index Product Innovations

High market capitalization does not guarantee the technical or economic validity of a cryptocurrency nor most importantly its longevity. A semi-active alternative might be that 20–30 index constituents are chosen from the top 50 coins based on adjusted market cap rankings. Inclusion or exclusion would be based on multiple qualitative and quantitative factors which an investment committee would review and publish on a monthly basis. This would potentially reduce trading costs and the need to rapidly switch constituents as index participants would be switched only monthly, except potentially for special circumstances and entering the top 25 would not guarantee inclusion in the index.

Another adaption could also be to move away from a market cap weighting to an equal-weighted index or fixed weight index where Bitcoin, Ehtereum and Ripple constituent 50% of the index and the other constituents of the index are equally weighted. While these would be higher volatility products than the current LyCI, they would let investor take fairly large stakes in smaller cryptocurrencies which greater potential for gains. After all, only 3 of the top 25 coins from 2014 still remain in the top 25 in 2019. Taking a 4% rather than the 0.14% stake, as LyCI’s smallest constituent has, might make a huge difference if such a currency one day overtook bitcoin. If such a product was also coupled with Lykke’s discretion to pick the constituents, this could be a great way to buy the cryptocurrency market but with the greatest potential for gains.

For the risk-averse on the other hand, there may be features from traditional financial products that could also be applied to a cryptocurrency index product. For example, some rebalancing techniques include insurance (CPPI in the table below) whereby when the value of the portfolio increases more funds are invested into risky assets away from cash, whereas decreases cause a shift from the risky assets towards cash. Such a product might suit investors with the common concern that they might “lose all their money” by investing in cryptocurrency. However, if an 80% capital retention threshold could be tolerated, this might give more risk-averse investors a gateway to the market as the worst they could do is lose 20% of their initially invested funds.

How different rebalancing techniques affect performance, CPPI is a natural candidate for crypto products

There are many other forms of innovation that can be brought to cryptocurrency products and Lykke has already begun to do so by creating sub-indices based on coin function such as their payment coin, smart contract coin and service coin indices. Further investigation could be fruitful in the area of integrating short positions in a systematic manner into managed products. This way the violent bear markets cryptocurrency is prone to could be taken advantage of rather than just letting investors hodl through them waiting for an overall increase in the market.

The future for retail cryptocurrency investors has never looked brighter

While there exist endless possibilities for innovation, perhaps most exciting is that cryptocurrency index products and companies embracing regulation are paving the way towards broader adoption of cryptocurrency and for more funds to flow into this exciting new asset class. Products which are easy to invest into on user-friendly platforms that are easily understood are the next step towards democratizing the potential wealth gains cryptocurrency represents. Products such as LyCI are a huge step forward in legitimizing cryptocurrency as an asset class that regular investors can invest in securely with limited expertize. No longer does cryptocurrency have to be the niche preserve of a few early adopters, instead its bright future can be shared by many.

The following article is written from an independent perspective as an entry into Lykke’s LyCI’s writing competition. The above does not constitute financial advice and independent financial advice should be sought before deciding whether to invest in any financial product.

Andrew Douglas, CFA

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Could Lykke’s LyCI index product be the gateway retail investors are waiting for? was originally published in Data Driven Investor on Medium, where people are continuing the conversation by highlighting and responding to this story.