How the Crypto Crash is Affecting Advisors

Ric Edelman and a digital asset CIO analyze the volatility and what advisors should make of it.

It wasn’t long ago that Ben McMillan, chief investment officer of IDX Digital Assets, had a conversation with a CIO of a very large multifamily office about cryptocurrency.

“She said, ‘You know, even if Bitcoin is only a 1% position in the family’s portfolio, if it’s down 50% or 60% or 90%, it’s obviously not going to move the needle, but it just looks bad. It’s a bad line item. It’s something I have to explain,’” McMillan recalled.

“And that’s a sentiment that I think we’ve heard time and time again from the advisors we talked to,” he continued. “There’s the practical element of actually being down 50%. The math requires you to, of course, double your money to get back to even. But then there’s what I’ll categorize as the headache factor of dealing with clients and the volatility.”

That view is what McMillan is hearing from investment advisors across the country: It doesn’t matter if cryptocurrencies would be a big or small part of clients’ portfolios; the volatility is “stopping advisors and family offices from getting involved,” he said. Meanwhile, more clients have been asking about the asset class.

McMillian, whose company offers digital-asset strategies, shared those perspectives with longtime advisor Ric Edelman, founder of the RIA Digital Assets Council, during a webinar June 28 on advisor concern over the inherent risks of cryptocurrencies.

“Crypto Winter?”

It’s no secret that the volatility of Bitcoin and other digital assets has been on the mind of investors. Bitcoin hit an all-time high of more than 64,000 in April, but lost more than 50% of its value when it plummeted below 30,000 in May. Late in June, it was trading around 36,000.

The questions, said Edelman, are whether digital assets are in the middle of what some are calling another “crypto winter,” and does this represent a buying opportunity or a market peak? What does this mean for the future of this asset class?

In McMillan’s view, the main catalyst for the massive selloff was hawkish news from China that it would be cracking down on cryptocurrencies, plus leverage.

“This isn’t new for China,” McMillan noted. “They’ve threatened to ban Bitcoin, several times in the past … What was different this time around and which was interesting to observe was the news coming from very senior officials within the Communist Party and they were very explicitly denouncing crypto mining as well as crypto trading as a financial risk that could destabilize their entire country’s economy. Basically immediately after this, we saw very large crypto mining firms, of which there’s a huge concentration in China, immediately halting operations.”

He added there was an extreme amount of leverage in the system, with some people estimating it at more than a trillion dollars. “A lot of people don’t realize that Asian-based exchanges offer insane amounts of leverage by Western standards,” he said.

Others are cracking down, too. The U.K., and Japan recently restricted operations of Binance Holdings Ltd., the world’s largest crypto exchange, in their countries. Binance does a huge business in crypto derivatives, which regulators oversee and are fueled by leverage. The U.K. earlier this year banned individual investors from trading in those derivatives.

Edelman and McMillan noted leverage has often led to crashes in different asset classes, including in 1929 and 2008. “Leverage has often times been a culprit in these big selloffs, so that’s nothing specific to Bitcoin or digital assets. But I do think it portends a future in which regulators are going to start focusing more on the trading on the exchanges. We’re even seeing that now with the SEC signaling to Robinhood that it’s going to potentially delay its IPO.”

Another Selloff?

Will there be another massive selloff in digital assets? McMillan thinks it’s doubtful. “There’s been some degree of capitulation among investors. Now the question is, how long does it take to come back? If you look at the last crypto winter, it took three years — a lot of people don’t realize that — for Bitcoin to get back to the all-time highs of 20,000.”

He added one could make the argument that it could again be at least a couple of years before Bitcoin hits all-time highs. One interesting difference between 2017, the last crypto bull market before the 2018 crash, was that it was led mainly by Bitcoin and to a lesser degree Ethereum, McMillian said.

In 2020, “DeFi” (decentralized finance) protocols began to eliminate the need to go through third parties to buy new crypto tokens, the number of which has exploded. “I think that’s a critical difference this time around. It’s not just Bitcoin as a store of value or as a speculative asset class. We’ve seen a kind of broader maturation within the digital assets landscape, specifically as it relates to these DeFi protocols,” McMillan said.

Behavioral Finance

At any rate, advisors have been refraining from investing in digital assets because of the volatility and doubts that Bitcoin will return to its high anytime soon.

“It’s behavioral finance. A 100% loss feels a lot worse than 100% gain feels good,” Edelman commented.

McMillan agreed. “I make that same point time and time again to advisors, and I also remind them that Daniel Kahneman won a Nobel Prize for demonstrating the importance of that. People always think that they and their clients have a higher risk tolerance than they do. That’s one thing we’ve seen emerge as a real risk factor. ”

Edelman questioned what McMillan says to advisors who tell him clients can’t stomach the volatility and it’s not worth their time explaining crypto investments, especially when they would only be 1% or so of portfolios?

The first issue is for advisors to be very thoughtful about for whom crypto investments are suitable, McMillan said. He noted that was the impetus for IDX launching two trusts – one for Bitcoin and one for Ethereum — that manage risk and bring down crypto volatility. The trusts, which require a $25,000 minimum investment and are for accredited investors, are illiquid for 12 months and will convert to OTC securities that could trade at premiums or discounts, as closed-end funds do. IDX plans to launch a “DeFi” trust shortly, he added.

Edelman noted other clients insist on putting a big percentage of their portfolios into digital assets. How does a fiduciary advise that kind of client?

“That’s a question we started seeing from the advisors we work with back in 2018 or 2019,” McMillan said. “We had a handful of advisors in particular that were saying, ‘We’ve got these high-net-worth folks that want to come in big. I don’t want to tell them no because I risk losing the account, but I don’t want to put them in something long only because I know when the rails fall off then I’m really in trouble. I’m going to lose the account or be on the phone 80% of the time.’”

The risk-managed strategies of the IDX trusts can work for advisors with those kinds of clients, too, McMillan said. It’s very important for advisors to manage client expectations for digital assets, and they probably will have to put more effort into it than they’ve had to do for other asset classes, he added.

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