Digital Assets and Commodities: A Comparison of Institutional Portfolio Allocation

Introduction

Today, a growing number of institutional investors say many digital assets have the distinct characteristics necessary to be considered a new asset class. Parallels between the current digital asset markets and the commodity markets 20 years ago are striking and may make the case for why digital assets can be considered an asset class of their own – albeit a nascent one.

Before the early 2000s, most traditional investment portfolios did not have a commodities allocation. A series of product, regulatory, market access, and infrastructure developments occurred around this time, opening these markets up to new institutional participants and leading to significant institutional inflows over the following decade. Digital asset markets appear to be following a similar path to maturation, judging by its infrastructure transformation, improved market access and evolving product suite over the past four years.

A Background of Commodities Markets

Given that agriculture was human's first organised activity, it is not surprising that commodity markets pre-date all others. The first derivative contracts can be dated back to the Sumerians in 4500-4000BC, where clay tokens were used to represent deliverable quantities of various commodities. These tokens are akin to physically settled futures contracts^1,2. Modern standardized futures contracts became more commonplace in the 19th century, again with agricultural commodities³. In the 1970s, swaps were introduced. The 1980s saw the introduction of today's crude oil futures markets and producer countries moving from a system of absolute fixed pricing to price discovery via futures of the world's largest commodity market⁴.

Despite all this growth, innovation, and development, commodities markets largely remained the domain of corporate hedging participants with little to no institutional investment interest. A confluence of developments in the 1990s and early 2000s changed all this.

Developing Product Suite

The Goldman Sachs Commodity Index (GSCI) was created in 1991 and was the first practically investable commodities futures index. For the first time, a broad-based price exposure to a balanced basket of commodities could be achieved via a financially settled swap written by Goldman Sachs (or other investment banks with the capability). This development was ground-breaking as it negated the need for investors to construct these complex portfolios themselves, which would entail managing an array of physically delivered futures contracts with varying expiries on different exchanges in different time zones and the operational burden and execution risk that came with it. GSCI swaps packaged up these operational intricacies into a single contract and created commodities-exposure-as-a-service.

In the 2000s, single asset commodity ETPs were also introduced. These new regulated products trading on exchanges offered investors cost-effective price exposure to commodities through existing market access channels, eliminating the storage complexities of physical exposure, expiration risk on futures exposure, or counterparty credit risk to a bank on swap exposure.

In addition, the late 1990s and early 2000s were generally a time of significant developments in technology and financial engineering, which enabled unique risk and payoff profiles to sophisticated investors through (sometimes complex) derivative structures.

Improved Regulatory Environment and Market Access

In the U.K., the term "Big Bang" is used to refer to the radical overhaul of the rules governing the London Stock Exchange. Financial market deregulation, started by Margaret Thatcher in the 1980s, is in no small part responsible for the U.K. subsequently retaining its position as the pre-eminent financial capital of Europe and arguably the financial centre of the increasingly globalised economy over the next 25 years⁵.

Similarly, the U.S. went through a trend in the 1980s and 1990s which saw the deregulation of markets (specifically in commodities: oil from 1981-1988, U.S. Natural Gas in 1985, U.S. electricity in 1992) and of market participants (culminating in the Financial Services Modernization Act of 1999)⁶.

These deregulatory shifts helped London and New York became global financial capitals. On both sides of the Atlantic, the financial services sectors experienced enormous growth, and investment banks set up ever-larger trading desks to capture the ever-increasing value on offer. Banks expanded into different asset classes and developed more investment products. From a commodities perspective, this resulted in a transition from a small minority of investment banks offering services in the late 1990s to the majority of banks by the early to mid-2000s. The growth in product offerings created healthy competition and improved market access for institutional investors.

Transformed Infrastructure

In the early 2000s, many markets began a paradigm shift from largely open outcry/voice brokered order execution to screen-based systems. In commodities, a then small electronic trading start-up called the Intercontinental Exchange (ICE) acquired the International Petroleum Exchange (IPE) in 2001. Electronic trading of the IPE's futures contracts commenced shortly thereafter side-by-side with open outcry pit-based trading. In 2005, the physical exchange was shuttered. This example was repeated across multiple other commodities exchanges around this time.

The advent of screen-based trading removed the information and data asymmetries that had long existed. The opacity that had discouraged broader market participation in the commodities markets was replaced with transparency. As such, not only was market access democratised but so was market data.

Portfolio Allocation

It is hard to imagine now, but, in 2000, commodities were generally not considered a true asset class for the purposes of traditional portfolio allocation. Commodities were largely corporate hedging markets in which wholesale producers transacted with wholesale consumers (often intermediated by investment banks). For the purposes of risk-managing their future revenue streams, producers would sell a proportion of their forecasted production at a fixed price, guaranteeing a certain level of income. Similarly, consumers of the same commodity would buy a proportion of their forecasted demand in order to lock in a certain proportion of their input costs. Both of these activities would allow each company to make better assumptions about their future revenue/cost profile, which in turn would enable more accurate budget forecasting and financial planning. There was little to no passive or active institutional participation in these markets.

As a result of the developments outlined above, the commodities markets opened up to a new segment of market participants. With more transparent data, better market access, a suite of investment products and a host of investment banks now servicing the asset class, institutional investors began to pay attention and the investment case was extremely compelling.

The Investment Case

The market structure and price characteristics of commodities gave rise to several investment thesis within a traditional investment portfolio:

Diversification – Commodities had not historically traded alongside traditional financial markets and exhibited little to no correlation to these asset classes, even over short time horizons. According to the basics of modern portfolio theory, the introduction of an uncorrelated asset to a diversified investment portfolio improves the efficient frontier and increases the risk-adjusted returns. As Nobel Prize laureate Harry Markowitz said in 1952, "diversification is the only free lunch in investing."

Positive expected return – Notwithstanding the diversification benefits of commodities to an investment portfolio, the market structure of a healthy commodity market is backwardation. That is to say that the promptest contracts are generally more expensive than longer dated contracts when the market is not in near-term oversupply. A corollary of this is that commodity indices such as the GSCI that "roll" their positions on a monthly basis (i.e. sell prompt contracts and buy forward contracts in order to keep their exposure from maturing), collect a premium each month when the market structure is favourable. This is known as the "roll yield" and it was in the mid-high single digits on an annualised percentage point basis⁷. Thus, even if the price of commodities did not rise, there was a positive expected return owing to the inherent market structure should this term structure persist.

The case for price appreciation – In addition to the above two technical characteristics of commodities price exposure via derivatives, there were very supportive forward supply and demand balances for commodities generally in the early 2000s. These dynamics were largely due to the urbanisation and economic expansion aspirations of the Chinese Communist Party outlined in the tenth Five-Year Plan released in 2000. The Five-Year Plans of China are a series of social and economic development objectives issued going back to 1953. The tenth plan contained targets that were both extremely ambitious and would be very commodities-demand intensive if they were to be realised. One objective was to increase the number of urban employees by 40 million and transfer 40 million surplus rural labourers to cities⁸. This would have been an increase in the urban workforce equivalent to the whole of Germany at the time⁹. This alone would require an enormous expansion of the industrial and social infrastructure including factories, power stations, roads, housing, hospitals, schools, etc.

It was clear that the extent of the program would require an enormous amount of resources and would create highly probable forward demand pressures in the commodities markets, the likes of which can only be seen in centrally planned economies.

The actual increase in China's urban population from 2000 to 2005 was over 100 million people¹⁰ and, as can be seen below, China's total primary energy consumption, as a proxy for its demand across the entire commodities complex, nearly doubled over the same period.

Chart Source: "Application of the Novel Fractional Grey Model FAGMO (1,1,k) to Predict China's Nuclear Energy Consumption" by Wenqing Wu, Xin Ma, Bo Zeng & Yong Wang. Recreated with Updated Date Source: BP Statistical Review of World Energy. Date Accessed: 08/15/2021.

This increased forward demand profile created a very compelling standalone investment thesis irrespective of the beneficial allocation properties described above.

The macro support – This positive commodities narrative also coincided with a multi-year bear market for equities (1Q20-4Q02) following the bursting of the tech bubble in 2000. This stock market underperformance created an environment in which investors were open to exploring other sources of return. Indeed, this proclivity has persisted and grown stronger over time as can be demonstrated by alternative investment allocations, which according to estimates published by the CAIA Association were 6% of global investable markets in 2003 and as high as 12% in 2018¹¹.

The diversification benefits, positive expected return, and implied supply/demand fundamentals created a near perfect investment thesis for an allocation to commodities in the context of a traditional diversified investment portfolio just at a time when investors were receptive to increasing their exposure to alternative investment assets in general.

Build It and They Will Come

Improved market access, increased transparency, development of investable products, the unique portfolio-contribution attributes of commodities, and the future price outlook for the asset class at large piqued institutional interest and prompted very rapid institutional investment over a relatively short period.

The below chart shows institutional commodities investments from 2000 to 2010 derived from futures' position reports data. It can be seen that in the 2000-2002 time period, there was really very little in the way of institutional involvement in the commodity markets at all. From 2003-2010 there were substantial investments made each year, taking total assets allocated to commodities to nearly $400b by 2010.

Data Source: Barclay Commodities Research. Date Accessed: 05/01/2021.

It is now received wisdom that commodities are a separate asset class for traditional investment purposes and a good proportion of advised portfolios have some exposure to commodities as an asset class.

A Digital Asset Comparison

Today, a growing number of institutional investors say many digital assets (which some refer to as digital commodities) have the distinct characteristics necessary to be considered a new asset class. In our 2021 Institutional Investor Digital Asset Study of more than 1,000 institutional investors, 23% said they believe digital assets belong in an independent asset class.

Below we cover some of the parallels between the emerging digital asset markets and the institutionalisation of commodities markets 20 years' ago.

Developing Product Suite

Similar to the commodity markets in the mid-1990s, the digital asset market is still in its early stages of product development. That being said, significant progress has already been made already over the last several years.

Around the world, the pathways of exposure for institutional investors to bitcoin and other digital assets are growing. In the U.S., there are a number of competing trusts that provide passive price exposure to bitcoin such as Grayscale's GBTC product, which dates back to 2013. In December 2017, the CME launched its bitcoin futures contract. Over the last 12 months, through the purchase of 121,044 bitcoin 12, MicroStrategy has also created both equity and bond vehicles that offer indirect price exposure to bitcoin as its original business intelligence activities are now dwarfed by the size of the bitcoin position held on the company balance sheet. For investors without a mandate to invest in Bitcoin directly but able to purchase corporate debt or public market equity, this is an important product development.

The first exchange-traded fund (ETF) was approved in Canada and began trading on the Toronto Stock Exchange (TSX) in February 2021. In Europe, there are multiple ETPs/ETCs approved by regulators in Germany, Sweden, and Switzerland with the CoinShares products dating back to 2015. Globally, there are now numerous private funds that track the price of bitcoin.

Multiple regulated exchanges around the world have also introduced leverage to sophisticated investors. Leverage and capital efficiency are key inputs in terms of maximising returns for hedge funds and assessing the viability of trades and allocations.

Improved Regulatory Environment and Market Access

As with commodities in the late 1990s and early 2000s, market access to bitcoin is improving dramatically. From a retail standpoint, Paypal, Square, Venmo, and Revolut alone have given market access to over 500 million users since 2018.13,14,15,16 Additionally, Mastercard recently announced that it would start supporting select digital assets directly on its network. Similarly, Visa announced that it would use USD Coin (USDC), a stablecoin backed by the U.S. dollar, to settle transactions over Ethereum. The two companies facilitate payments around the world and are accepted by more than 40 million merchants globally.

For institutions, the number of market access channels has increased significantly. For example, Fidelity Digital Assets launched its own execution capability in June of 2019. This allows clients to access liquidity direct from secure cold storage. Many other third-party custodians have subsequently followed suit. In addition, the reliability, professionalisation, and feature/functionality of digital asset exchanges over the last 3-5 years has improved dramatically and many are now consistent with the expectations and demands of institutional investors.

Dedicated institutional liquidity venues such as LMAX Digital have also launched and seen major traction. TP ICAP, one of the largest interdealer brokers in the world, is set to open a wholesale trading platform for digital assets, working in collaboration with Fidelity Digital Assets to provide secure post transaction settlement services.

Many traditional banks and prime brokers now provide access to CME futures, which was not the case at launch in December 2017. That being said, the curve structure and negative roll yield makes futures a cost-inefficient vehicle for long-term bitcoin price exposure and physical bitcoin remains largely inaccessible through the vast majority of prime brokers. Thus far, regulation has stymied greater involvement from banks and other traditional financial intermediaries.

It was described above that deregulation acted as an enabler to greater institutional activity in commodities (and across the entire financial industry more broadly). With regard to digital assets and bitcoin specifically, a lack of regulation has acted as an impediment to the provision of services in and market access to this asset class. This variance in catalysation can be explained, to a great extent, by the measures taken by regulators in the aftermath of the global financial crisis. From 2009 to 2016, Boston Consulting Group estimates that European and North American banks were fined $321b in aggregate17. In response, banks have tightened regulatory compliance programmes and, therefore, tend to require a higher degree of regulatory clarity before engaging in new activities or supporting new assets. Until recently, that clarity had been absent, but there is now increasing input from regulators.

In the U.S., the Office of the Comptroller (OCC) has given very clear guidance regarding the custody of digital assets. On July 22, 2020, the OCC published an interpretive letter authorizing national banks and federal savings associations regulated by the agency to custody digital assets. While the OCC has not prohibited the institutions it regulates from engaging in digital asset custody, this is the first time it has provided a formal statement and clear guidance allowing banks to engage in the activity. The lack of guidance to date is a core reason that nationally chartered institutions have remained on the sidelines when it comes to providing digital asset services.

In Europe, there have also been meaningful developments on the regulatory front. In September 2020, the European Commission's legislative proposal to cover digital assets was released, called the Markets in Crypto-assets (MiCA). MiCA focuses on rules to regulate currently out-of-scope assets and currently unregulated crypto-asset service providers (CASPs) such as custodians and exchanges. If adopted, MiCA could take some years to implement, but the will to provide greater clarity is present and the proposed regulation is supportive of future innovation, adoption, and commercial activity in the space.

Since the OCC guidance last year, Bank of New York Mellon, US Bank, Morgan Stanley, JP Morgan, and Goldman Sachs have all announced their intentions to launch services or provide market access to digital assets18, 19, 20, 21, 22. In contrast, European banks have lagged behind in their support for digital assets, which might be explained by the lack of clear, implemented regulation.

There are many other banks and intermediaries that remain on the sidelines and it is therefore expected that there are still significant gains possible in terms of market access. Importantly, the regulatory clarity and/or changes required to enable those gains has already been given or is in proposed form.

Transformed Infrastructure

In recent years, market infrastructure has improved dramatically. In 2017, it was not uncommon to see 5-10% price differences between different exchanges in periods of high market volatility. Since then, many traditional programmatic market-makers have entered the space and inter-exchange price discrepancies have collapsed to the cost of transaction and working capital rebalancing. The introduction of these liquidity providers has also improved liquidity and depth of order book. This has been well evidenced by the minimal market impact of several large-scale corporate treasury purchases from the likes of MicroStrategy and Tesla.

On the custody front, the announcement of Fidelity Digital Assets' custody offering in October 2018 was a watershed moment for the institutionalisation of the industry. Since then, there have been great improvements in the service offerings of many custodians, which has created several credible options for institutional investors.

In addition, there have been meaningful developments in the ability of market participants to borrow and lend digital assets. Whereas this capability did not materially exist other than on a peer-to-peer, bilateral basis in 2017, there are now many providers that enable market participants to borrow and lend digital assets or borrow fiat currency collateralised against digital asset holdings. Fidelity Digital Assets announced its own collateral agency offering in November of 2020.

Lastly, the number of data providers and credible research teams focusing on digital assets has increased significantly over the last several years. High quality price data, blockchain data, fundamental asset data, and asset-specific research are prerequisites for institutions to make substantial investment decisions.

Portfolio Allocation

Fidelity Digital Assets' 2021 Institutional Investor Digital Asset Study found that 52% of surveyed investors in Asia, Europe, and the U.S. have an allocation to digital assets. Whilst the institutional adoption of digital assets is seeing continued year-over-year growth, there is still room for significant growth. Whereas in 2017, the product suite, market access, and digital asset infrastructure were not yet at a level sufficient to enable or accommodate broad-based institutional investment, the developments since have been transformational. Whilst inconveniences may remain, for example, not being able to access the market through a preferred prime broker, it is now difficult to argue that there are structural blockers to institutional participation nor could it be argued that the infrastructure or service providers are not of an adequate quality. As with the commodities markets in the early 2000s, these developments all represent an incredibly relevant shift.

The Investment Case

It is beyond the scope of this research piece to put forward a comprehensive investment case for bitcoin. Nonetheless, it is worth noting the similarities of the various components of the investment case to those of a commodities allocation in the early 2000s.

Diversification – As bitcoin demonstrated strong correlation to traditional financial assets during the pandemic-induced market crash in February/March 2020, this prompted some commentators to question the narrative that bitcoin is an uncorrelated asset. The reality is that, in periods of market stress, all cross-asset correlations tend to 1. This is due to investors seeking to move to cash as portfolio volatilities spike. This broad-based risk-off selling pressure therefore impacts all markets simultaneously and creates inter-asset correlations that are not typically seen in normal market conditions.

During this same period, gold declined by 15% in a move that was also counterintuitive when considering its typical investment premise and price correlations. This phenomenon was also witnessed in the market stress during the global financial crisis. From March 2008 to September 2008, gold declined from its local high faster than equities (29% versus 19%) before outperforming until the equity market bottomed in March 2009.

Correlations should be viewed over the long term as short-term aberrations can and will occur. Since peaking in October 2020, bitcoin/equity 30-90d correlations have declined to levels that were seen previously (0.15-0.20) and levels that would be consistent with diversification benefits to inclusion in an investment portfolio.

Positive expected return – As discussed previously, the lending market for bitcoin has developed rapidly. For passive holders that wish to earn a yield, the options are increasing and the sophistication improving with time. With proof-of-stake assets, this positive expected return is even more obviously demonstrable and interesting in a yield-starved macroeconomic environment.

The case for price appreciation – As Fidelity Investments' Director of Global Macro Jurrien Timmer highlighted in his recent research piece "Understanding Bitcoin," Metcalfe's Law may offer some S-curve demand perspectives.

The two charts below show the raw number of worldwide mobile phone subscribers overlaid against the raw number of bitcoin addresses. The S-curve on the left is set to a linear scale; the one on the right, to a log scale.

Chart Source: "Understanding Bitcoin" by Jurrien Timmer. Recreated with Updated Date Source: World Bank Phone Subscribers & Coin Metrics BTC Addresses. Date Accessed: 08/15/2021.

According to Timmer's analysis, it appears that the bitcoin growth curve may still be in its early phase and could remain so for a number of years. "Thus the bullish case for bitcoin: Price is at the intersection of supply and demand, and demand is growing exponentially while supply (per BTC stock-to-flow) approaches its limit. Bitcoin can act as a store of value because of its scarcity, but it’s also an integral part of a technological revolution (blockchain encryption) with potentially explosive demand growth," wrote Timmer.

This type of analysis is an interesting framework for investors attempting to model future demand and would suggest that significant future demand is still possible if bitcoin continues to track this level of growth and adoption.

The macro support – Recent global monetary policy, and increasingly fiscal policy, have created a positive macro backdrop for future bitcoin investment allocations. Many investors remain concerned at the rate of central bank balance sheet expansion, the scale of the budget deficits being run in many developed economies, and the potential for inflation as a result. Bitcoin is seen by many as being an asset that will have a leveraged return profile in an inflationary environment and see it therefore as a portfolio hedge against this outcome.

Conclusion

There are striking similarities between the digital asset market of today and the commodities markets of the early 2000s. The commodities product suite, market access, and market infrastructure all went through dramatic improvements. These shifts helped enable institutional participation, but the timing also coincided with an incredibly strong investment narrative and a very supportive macro environment. It was the simultaneous marriage of all these factors that prompted such rapid investment growth in commodities.

The digital asset markets today are going through, and in some areas have arguably completed, a similar transition from the viewpoint of product suite, market access, and market infrastructure. Over the last four years there have been massive advances in these areas and the importance of this as an enabler of institutional participation cannot be understated. As with commodities in the early 2000s, these developments are occurring at a time when many view the investment narrative and macro backdrop as also being particularly compelling.

There are certainly differences between the facts and circumstances of the digital asset markets of today and the commodities markets of the early 2000s. The most notable is that no one in 2001 argued that copper or iron ore were illegitimate assets. Whilst these views are becoming increasingly rare and atypical, digital assets are still a new technology and success of individual projects is far from preordained. This was not the case for commodities, which had, in some cases, been in active use for several thousand years, dating back to pre-historic times.

Notwithstanding, the sequence of events and conditions that are unfolding in the digital asset markets today are strikingly similar to that of the commodities markets in the early 2000s. In commodities, these conditions resulted in an enormous amount of capital flowing into the asset class in the years immediately succeeding. Whether the same will be true for digital assets remains an open question.