Digital Assets – an economic resource, with positive value, represented in binary form.
The digitization of assets (also known as tokenization) can be achieved by representing physical assets by unique identification characters allowing the ownership rights to be transmitted and traded on a digital medium. Whereas securitization is the process of converting an illiquid asset or group of assets into a financial security, tokenization is the next step which allows for digital trading of that security. Digital assets are also nothing new… the Depository Trust & Clearing Corporation (DTCC) was created in 1973 to alleviate the amount of paperwork needed to process securities transactions by holding all paper stock certificates and keeping electronic records of all transactions. Digital Dollars and Euros are stored on centralized ledgers controlled by their respective central banks. In the modern financial world, a majority of portfolios hold things (stocks, bonds, currencies, commodity futures) which can be considered digital assets, but the ownership rights of these assets are managed by some central governing authority.
For the rest of this conversation, we will focus on decentralized digitized assets and particularly cryptocurrencies and digital commodities. Distributed Ledger Technology (DLT) – a database that is synchronized and consensually shared – has made this decentralization possible by creating a new ecosystem with the capacity to manage digital assets on a network, authenticated and validated by collective collaboration. The blockchain protocol is a DLT, and its most popular applications have been Bitcoin and Ethereum. The decentralization feature is achieved by rewarding users with cryptocurrency for computing a hash value (a function that is easy to validate, hard to compute) for a set of new transactions (a block) and then appending it to the end of the chain of all historical blocks once a majority of users have validated it.
There are more than 600 other cryptocurrencies at this time, as anyone with a laptop and a dream (and perhaps accompanied by an understanding of DLT) can create one. For starters, Bitcoin happens to be the name of both the protocol (uppercase “B”) and the currency (lower case “b”). Ethereum is the protocol name, and ether is the cryptocurrency token which can be transferred and allows one party to compensate another for computations performed. Ethereum is a newer protocol, with the potential to replace Bitcoin as the standard due to faster transaction processing speeds and its more widespread usage in smart contracts – a self executing protocol stored on the blockchain to promote and validate conditions of a contract (will be discussed in a later blog post). Bitcoin has a market capitalization of $40 billion USD and ether has $26 billion. Regulatory bodies are scrambling to classify these assets: The Commodity Futures Trading Commission (CFTC) asserts that it’s a commodity, the Internal Revenue Service (IRS) deems it property, and the U.S. Securities and Exchange Commission (SEC) has decided to approach it on a case-by-case basis.
As a digital asset, bitcoin and ether have been on a tear recently, rising 150% and 3,400% respectively year-to-date as of June 30. This appreciation is part of a longer term trend stretching back to the two previous years: bitcoin was up 39% and 128% in 2015 and 2016. Ether has had a much shorter lifespan, with its Initial Coin Offering (ICO) priced at around 40 cents in July 2014 with trading commencing at the end of July 2015.
While returns to date have been astronomical, the volatility cannot be overlooked. Bitcoin prices dropped 84% peak to trough when the initial bitcoin bubble popped from late 2013 to early 2015; ether experienced a 78% peak-to-trough decline in 2015 over three months and a two-day 45% drop in 2016 due to the Decentralized Autonomous Organization (DAO) Hack. Monthly correlations over the past five year period against other traditional asset classes showed that bitcoin had low historical correlations with most other asset classes. Surprisingly, the correlation between bitcoin and gold was slightly negative. Gold is generally considered a safe asset that appreciates during periods of “risk-off” and can be used as an inflation hedge for the US dollar. In the five year historical period, we actually found that bitcoin appreciated in periods of “risk-on” and had a positive correlation to US equities.
As bitcoin’s proof of concept matures, the industry is rapidly moving into digital commodities. Commodities have been, and currently are used to store wealth and retain some sort of economic value. Digital commodities have the possibility of eradicating complexities around physical ownership, with the benefit of receiving spot pricing. The newly launched Royal Mint Gold (RMG), a collaboration between Britain’s Royal Mint and the CME is one of the latest applications. RMG gives the purchaser the ownership of physical gold in the British Royal Mint vault. Smart contracts are addressing issues around paperwork, post execution settlement and fulfilment of preconditions required for title transfer. In March, Natixis, IBM and Trafigura “pioneered the first blockchain solution in commodity trade finance for US crude oil transactions… major steps in a crude oil transaction [were] digitized on the blockchain… [with] the buyer, seller and respective banks all on the same ledger, all parties simultaneously [viewed] and [shared] data on the status, from the time a new trade is confirmed and validated, to when the crude oil is inspected, to its final delivery and cancellation of the letter of credit.” AgriDigital, ZrCoin, Bilur are just a few more emerging digital commodities to watch.
Bitcoin may have caught our collective attention as an asset because of its exponential growth in a low asset return environment, but the technology behind it has potential to disrupt the asset management landscape. As Digital Assets continue to evolve, asset managers will need to address their incorporation in the investable universe and also into business infrastructures.
Stay tuned for our next blog post: “Modern day applications off the chain”.
 For a list of all cryptocurrencies and market caps: http://coinmarketcap.com/currencies/views/all/
”Bitcoin: Ringing the bell for a new asset class,” Chris Burniske & Adam White, January 2017, http://research.ark-invest.com/hubfs/1_Download_Files_ARK-Invest/White_Papers/Bitcoin-Ringing-The-Bell-For-A-New-Asset-Class.pdf
 Historical prices from GDAX: https://www.investing.com/currencies/btc-usd-historical-data
 $50 Million of virtual currency was “stolen” from Ethereum owners by exploiting a loophole in the smart contract code. Controversy over whether or not the hack should be rolled back has created an alternate universe of crypto-currency known as Ethereum Classic, in which the exploit was not rewound.
 Data provided by GDAX and Bloomberg. Other indices used: S&P 500 Index, US Bonds (Bloomberg Barclays US Aggregate Bond Index), Gold (Bloomberg Gold Commodity Index), WTI Oil (Bloomberg WTI Crude Oil Commodity Index), REIT (Dow Jones Equity REIT Total Return Index), and EM Currency (MSCI Emerging Markets Currency Index).
 “Natixis, IBM and Trafigura introduce first-ever Blockchain solution for U.S. crude oil market”, News Room, http://www-03.ibm.com/press/us/en/pressrelease/51951.wss
At the June FOMC meeting, the Fed established a gradual reduction of its treasury and agency holdings with initial caps of USD 6B for treasuries and USD 4B for mortgage backed securities (MBS) per month. Furthermore, the Fed will increase the runoff over time to a maximum of USD 30B per month for treasuries and USD 20B per month for MBS. Adding those numbers up, the Fed will reduce their MBS balance from roughly USD 1.8T to USD 1.0T by the end of 2021 (depending on your interest rate forecast). This reduction was somewhat in line with what the market had priced in, and gives the Fed flexibility to stop runoff if economic conditions were to deteriorate. What does this mean for mortgage valuation?
As you can see from the exhibits above, mortgage spreads on an option-adjusted basis have been steadily rising since 2016, but you can also see that Z spreads (TZV) have steadily gone down. For the investor not familiar with MBS, this sounds counterintuitive, however in a low interest rate volatility environment, this can happen. But, why does it happen? If you look at Exhibit 2 above, you will see the interest rate vega and gamma, which are measures of the change in the option cost of the instrument underlying the option (vega), and the measure of the convexity of the instrument, also known as the delta of the delta or the second derivative of the underlying option (gamma).
If you didn’t understand those last two sentences, you are not alone; in more plain English the call option an investor sells when owning MBS has been going down in cost. And the rate of change in price of that call option has likewise gone down to the lowest levels seen over the past 10 years.
Bringing the discussion full circle means that absolute spreads can go down, but option adjusted spreads can go up as proven over the past year.
Now to the point, it’s the classic bulls versus bears argument, are mortgages cheap or rich? A bull may say mortgages are cheap relative to all other asset classes, as most asset classes are at their tightest spreads over the past few years. Some bulls may mention the OAS steadily rising as a sign of value. Additionally, bulls may point to the fact that money managers have bought USD 60B in outright agency MBS YTD, or that foreign buyers see agency MBS as the highest yielding government guaranteed asset class.
The bears will make the case that the mortgage basis (spread above similar duration treasury blend) is at the tightest levels since late 2012 and OAS is at the tighter end of the range since 2003. Bears may also state that correlations are ever-increasing between treasuries and MBS, following the path of past rate hike cycles that could potentially widen the basis. More headwinds include the largest buyer (the Fed) stepping back, and potential increases in interest rate volatility, increasing vega and gamma, which in turn widens MBS spreads.
As of right now, we look at the underlying fundamentals, combined with a difficult technical backdrop, and feel there could be a better entry point. With plenty of investors on each side of the fight, tapering will create a dynamic second half of the year in MBS no matter what side of the argument you are on.