Mainstreaming Cryptocurrencies

June 29, 2018 01:00 PM
Trade Wars & Markets

As cryptocurrencies grow as an asset class, their constituents and potential investors need a benchmark to measure their performance, and also to invest with. 

The creation of bitcoin a few years ago has led to an explosion of cryptocurrencies of various types and with various purposes. While bitcoin itself was initially viewed as a currency capable of being used as a frictionless way of transacting business across borders, the onset of the broader cryptocurrency spaces — there are well over 2,000 individual cryptocurrencies — is less clear. 

For many, the onset of thousands of initial coin offerings has been an innovative new way to raise capital. While perhaps useful in its own right, venture capital is a distinct purpose far apart from the creation of a currency used for the transfer of goods and services. 

One of the goals of a currency is stability, the faith that the value of dollar will be the same, or at least relatively the same in value today as it was last week, month or year. The value of currencies fluctuate versus each other based on the economic fundamentals of the nations they are drawn on, but there is an element of faith in their value. Sometimes that faith is broken as has been the case with multiple currencies during the last decade, such as the Venezuelan bolivar. 

While for many in the United States and Western world cryptocurrencies are a novelty, there are many places in the world without a stable currency; and cryptocurrencies are a product that can serve as a relatively stable and secure mode of accepting and transferring payment and they are in great demand. It is in these places were cryptocurrencies are not a novelty or potential high-returning investment, but a necessary tool of doing business.  

For the most part, money is not an investment, it is a tool we use to measure our investments. In the wider trading world, cryptocurrencies are growing into an asset class. And while there might not be a need for U.S. individuals and businesses to transact in cryptocurrencies, any asset class that shows the type of growth potential cryptocurrencies has is something many investors would like to gain some exposure to (see “A year in bitcoin,” below). 

As you can see by the performance of bitcoin during the last year, there were many opportunities to trade it from either side. Bitcoin rallied by a factor of 10 from mid-July 2017 to mid-December 2017 and then dropped by more than 60% in the three months following its 2017 high. If you bought bitcoin in July 2017, you would be very happy, but if you purchased a high-ticket item utilizing bitcoin as a currency in July, you would not be happy six months later as the money you spent increased by 10x and what you purchased, likely depreciated. 

Building a Benchmark 

Hehmeyer Trading + Investments has recently created the Hehmeyer Cryptocurrency Index (HCI) and has launched a Commodity Pool to track the index: Hehmeyer Cryptocurrency Index Fund, which allows investors to make a generic investment in the sector that is based on the overall growth of the sector instead of any one particular coin.  

“Cryptocurrencies has characteristics that are more like commodities,” says Chris Hehmeyer, founder and CEO of Hehmeyer Trading Group (HTG), creator of the index. “We created an index designed to allow for constituent coins to go in and out of the index. The fund is designed to mimic the index.” 

There are 14 cryptocurrencies currently in the index, which is rebalanced monthly. The coins in the index are market cap weighted, according to Hehmeyer’s proprietary methodology. HCI tracks more than 1,000 cryptocurrencies in selecting the coins to go in the index. 

While Hehmeyer acknowledges the huge volatility in the space, he says, “Every portfolio needs a little exposure to cryptocurrencies.” 

The index is market cap weighted after a 72-hour rebalance period before the end of every month to determine its constituents and calculate the different allocations to those constituents. 

Hehmeyer posts on its website the top 16 coins in terms of its proprietary market cap weighting, 14 of which are in the index (see “Making the grade,” below). 

You can see by the table that there is a fairly significant change in the market capitalization of each component cryptocurrency on a daily basis. The table shows the market cap of each cryptocurrency on May 22 and May 24. Some have risen or fallen in ranking, Bitcoin’s market cap dropped roughly 7% and Ethereum more than 10% in just two days. 

While HCI initially looks at a broad swath of cryptocurrencies, only 124 passed the initial rule set to potentially be included in the index at its last rebalancing. Constituent cryptocurrencies must make up 1% of the overall market cap (based on that set number) to be considered for the index. 

“At each rebalance period — the first of every month —that calculation is redone,” says Morgan Culbertson, head of Cryptocurrency Research and Development at Hehmeyer. “We look at coins that are supported by a specific number of exchanges, so it may not include [certain coins that may qualify purely on] market cap. 


Playing Favorites

A cryptocurrency must account for 1% of the market cap of the universe of cryptocurrencies they look at on each rebalancing. “We try and keep coins that stay within that 1% level in the index, whereas coins that are going in and out of it reduce their stage value and their allocation in the index. It prevents us from buying a lot [of cryptocurrencies] as coins enter and exit that 1% threshold,” Culberson says. 

Each coin is weighted within the index based on a 72-hour rebalancing period where pricing and supply data is used to build an average market cap value. The actual number of coins in the index will change based in these fluctuations. 

“If bitcoin dominance grows in the future, the number of coins in the index may decrease, whereas if bitcoin dominance continues to decrease [and] more coins enter into this 1% window, our index will collect more and more coins over time,” Culbertson says. 

Currently, bitcoin’s market cap is roughly 40% of the sector and makes up 45% of the index. 

The metrics for how HCI calculates each coin’s market cap are proprietary and are only one measure they use in selecting and weighting the index. 

“We have a few other rules,” Hehmeyer says. “We make sure they aren’t fiat pegged. We have a committee that reviews coin validity, meaning if there is a large amount of suspicion around a coin, we can manually override all those processes and exclude it from the index as well.” 

Currently, there is only a small allocation to the commodity pool base on the index. “We just launched it in April,” Hehmeyer says. We wanted to go through the process of rebalancing it and give the administrator the ability to go into the wallets and confirm the balances and make sure our security measures [are] fail safe before we start  soliciting outside money [in earnest].”  

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About the Author

Editor-in-Chief of Modern Trader, Daniel Collins is a 25-year veteran of the futures industry having worked on the trading floors of both the Chicago Board of Trade and Chicago Mercantile Exchange.