An unpopular #timesup argument on why retail restrictions need to be imposed.

by Edmund Yong & Kevin Wong

This article was first published by Smart Investor Magazine at the following link:

Should Digital Assets be Restricted for Retail Investors?

During the recent Singapore Fintech Festival 2022, which saw record turnout, a new digital asset was launched in the form of vouchers called “purpose-bound money”. They are powered by the Singapore Dollar backed stablecoin (XSGD) and processed on the Grab superapp, and piloted to 5000 participants with much fanfare. The vouchers were sponsored by Temasek, the best-managed sovereign wealth fund in the world.

Many thought that digital assets were gaining the public recognition and adoption it deserves. They enthused that the year-long ‘crypto winter’ is turning into spring, as November is usually a great month for the markets.

Two weeks later, Temasek made a shocking announcement that it had written off over RM1.2 billion in losses as its investee FTX went bankrupt. FTX was among the largest digital asset exchanges (DAX) in the world, peaking its owner’s net worth at RM430 billion. It is licenced in multiple jurisdictions and owns a licenced US bank. Its books were reportedly audited by one of the largest accounting firms in the US and advised by the Big Four global audit firms. But here we are.

Temasek explained that it spent 8 months on “extensive due diligence” before making the investment. Fellow investors include Tier 1 venture capital (Sequioa, Softbank), hedge funds (BlackRock, Tiger Global), and multi-billionaires (David Loeb, Paul Tudor Jones) to name a few. Ordinary Singaporeans were caught in the same boat, as they were the second biggest traders globally on FTX pre-collapse, averaging 240,000 visits a month.

The markets went nuclear. Business Insider summed up wryly: “Up-vember has turned to Nope-vember!”

Can Retail Investors Really Manage Ultra High-Risk Assets?

Digital assets are extremely volatile. They have crashed so many times that there is a website dedicated to counting the number of times that “bitcoin is declared dead” by news outlets. At time of writing, there are more than 460 “obituaries”. Bitcoin has dropped by 75% from its high this time last year with about RM9 trillion in value destruction across the crypto market!

Take bitcoin for example: It has a very high level of residual risk i.e., risks that cannot be attributed to normal factors. This means that there are risks which are specifically unique to this asset class, and it is nearly impossible to be aware of or to address all risk factors. Based on studies, 91% of bitcoin’s risk is unexplained. In comparison, broad-based equity indices like the S&P 500 have only <1% residual risk. Individual stocks typically carry higher residual risk, but much lower than that of bitcoin.

Investors might take on such residual risks to serve the notion that digital assets can hedge against global market downturns, but unfortunately, this could not be further from the truth. Bitcoin might not act as a safe haven against downturns such as during the pandemic. Instead findings show that it might even amplify losses.

Therefore, when you invest in digital assets, accepting high risk is not an option – it is par for the course. You stand to lose everything you have, and you shouldn’t be surprised by it. When a large sovereign wealth fund can lose its entire investment despite all the information access and investing tools at its disposal, what can we say for small-time investors?

Many non-professional investors are oblivious of taking large amounts of residual risks but are unable to sufficiently diversify them away. Please ask yourself:

  • Do you know how to manage crypto exposures, optimize position sizes, and have the level of sophistication to do so?
  • Do you fully understand how price discovery in crypto works, and the outsized role which futures markets play?
  • How frequently should you rebalance your portfolios and what assets can you rebalance to?
  • How are you going to hedge risks when there are literally no hedging instruments offered by the DAXes in Malaysia?

Awareness of Risk is Not Equal to Suitability of Investment

Investors are taught to allocate between the four main types of asset classes according to risk. You may put some into cash which tend to have the lowest risk, followed by bonds or properties, and finally into equities, which carry the highest risk.

Some consider digital assets as the fifth asset class though it is far riskier than equities. Often there are no financial statements or real fundamentals behind them, so investors have to rely on technical analysis. Furthermore, due to the lack of regulations, ‘information asymmetry’ remains a serious and unresolved problem – investors seldom have full or fair access of the information required. Under these circumstances, value investing is very difficult.

In the absence of corporate disclosure requirements, investors aren’t duly notified of the legal and technical threats that unfold. When all they see is the quotation board (as corporate news isn’t announced to DAXes), their decisions won’t be as informed as they should be.

For instance: They won’t know that the latest digital asset approved for trading in Malaysia, Solana is closely related to FTX, which is currently being investigated for large-scale fraud. Or that it suffered at least five major outages since its launch, rendering it ‘unusable’. Or that Ripple is facing ongoing prosecution by the US SEC and has been delisted in leading foreign DAXes such as Coinbase. Or that Uniswap gets maliciously hacked every now and then, without any investor recourse.

Digital assets bound to a single corporate entity such as FTX present a big due diligence headache as investors won’t know what hit them before it’s too late. The performance of these entities directly correlates to the performance of their tokens. They may behave like equity, but they are not beholden to their token holders! They are neither required to report or be transparent. Corporate controls take a backseat while their ‘moon-talk’ takes the wheel, right until the inevitable car crash.

Nevertheless, crypto has changed the investment dynamic. It has become a touchstone of pop culture. When you ask Millennials and Gen Zs, their first investment product is crypto even though it is the riskiest asset class! They’d place their life savings to buy illiquid artworks (in the form of NFT) even though that’s the last thing a normal portfolio will consider.

When you ask what their objectives are, it sounds like they want to chase unicorns or catch lightning in a bottle (expect prices to magically pump). Their investment strategy is mainly to hold until it hurts – while those who sell are shamed as weak hands. It’s a ‘donut’ approach: Do nothing as it tracks to zero, just stare at the hole. Solana may have plunged 95% from its peak last year with no bottom in sight. But to Solana fans, it is the hill they die on.

The point is: It is not enough to be aware of the risks – most investors already are. Awareness is one thing, but the assessment of product suitability is quite another. But are DAXes making such assessment? Are investors being risk profiled? When it comes to a prolonged downturn like what see now in the crypto market, these investors become captive or stuck in their spot positions without ways to neutralise them or products to rotate out to.

Will the situation worsen once IEOs (initial exchange offering) start proliferating the market? IEOs share similar characteristics with private securities offerings, which are generally reserved for accredited investors. In Hong Kong, these are classified as “complex products” which warrant additional investor protection measures (HK SFC: Guidelines on Online Distribution and Advisory Platforms 2019).

In Singapore (where FTX is the latest storm to volley the island in a squall line from Terra Luna to Vauld to Three Arrows Capital to Hodlnaut), regulators have been repeatedly advising retail investors to stay away from crypto but was anyone listening? Tough restrictions are now being mulled for users to access and businesses to offer crypto (SG MAS: Proposed Regulatory Measures for DPT Services 2022). Meanwhile, HK authorities expressed relief for having “dodged the bullet” as retail investors there were barred from FTX.

Should we take notes from our neighbours before something goes wrong?

When Investors Treat Crypto as Their Retirement Plan…

According to a Charles Schwab survey, nearly half of all millennials and Gen Zs see crypto as a viable retirement plan. This is not just a generational trend but a tech-driven one (Guardian). They use digital tools like robo-advisors (Accenture) and prefer to pick their own stocks (Wall Street Journal). They think financial planners are for their parents (“OK Boomer!”) and rather get their fix from social media influencers.

Asset managers have been eager to gratify this demand. One of the world’s largest retirement funds, the Ontario Teachers’ Pension Plan for 330,000 working and retired teachers, decided to invest in FTX and is now among the biggest loser on record. Fidelity Investments, which administer pension plans for 23,000 companies in the US, has allowed contributing employees to choose bitcoin in their 401K retirement accounts. Here in Malaysia, there are news reports that EPF funds were taken out during the Special Withdrawal rounds to invest into crypto – despite the looming retirement security crisis. DAXes are even talking up ‘monthly deposit features’ into crypto like regular savings plans!

There is increasing pushback, in the wake of FTX which fooled the most brilliant and vigilant asset managers. New York’s Attorney General cautioned, “investing hard-earned retirement funds in crashing cryptocurrencies could wipe away a lifetime’s worth of hard work”. US Congress is being asked to ban digital assets for individual retirement accounts as most of them “have no intrinsic value and are too unstable”. The same goes for investing in “digital asset companies which are a breeding ground for fraud, crime and theft” and “do not operate with sufficient guardrails to protect retirement savings” (US NYAG: Prohibiting Retirement Investments in Crypto 2022).

If Investors Can’t Be Protected, They Should be Restricted

Investors must learn to see behind the smoke and mirrors of crypto. It is 90% marketing and 10% innovation, with a probability not promise of long term value. Many are over-confident of their own research and unaware of confirmation bias. Even Temasek had to admit that their trust was “misplaced” in FTX. In an interview with Bloomberg, the FTX owner admitted that the concept of high returns in crypto was like a Ponzi scheme, which left the reporter utterly stunned!

Investors need to grow up and admit that they would have missed it too.

FTX is an unbelievably complex organization. Even the defunct Lehman Brothers which triggered the 2018 global financial crisis was less complex. FTX printed monopoly money, made investors buy it, then printed more monopoly money as collateral and took out real money loans – which it gambled away through a sister company.

If digital assets are high-risk products that require sufficient knowledge, experience and capital, why are they not restricted to sophisticated investors – but marketed widely including to the pensioners, the poor, the uninitiated? The unwary masses are bombarded with outdoor billboards, online banners, radio spots, and roadshow trucks designed by award-winning agencies. Influencers are freely promoting crypto ads in the guise of financial education and luring their ‘followers’ into backroom deals.

At the end of the day, a good investment thesis should have a strong balance sheet, risk management practices, corporate governance, and recovery mechanism. Unfortunately, this basic hygiene is nowhere there in the crypto sector. Until this is done, if we cannot adequately protect vulnerable investor groups, then we ought to in good conscience restrict them from digital assets.

Crypto is here to stay but regulators should ensure it’s here for good. Where there are no suitability guidelines, digital assets are not considered an alternative investment but will become the new staple.

Edmund Yong and Kevin Wong are the partners of Celebrus Advisory, a regulation-focused consultancy for blockchain technology and digital assets.