In October, the Houston Firefighters’ Relief & Retirement Fund (HFRRF) became the first public employee defined benefit pension plan to announce an investment in cryptocurrencies. The move offers significant upside potential, as well as substantial financial risk, for the $5.5 billion retirement system.
The Houston Firefighters’ Relief & Retirement Fund’s $25 million cryptocurrency investment amounts to about 0.5% of the pension fund’s total assets under management, so the risk to the overall portfolio is limited. That said, if the fund significantly increases its exposure to this risky asset class, there could be cause for concern.
Cryptocurrencies have been highly volatile since their inception, and they are not income-producing assets. Unlike bonds, whose interest coupons can be applied to pension benefits, cryptocurrency holdings must be partially liquidated to provide income to beneficiaries.
Cryptocurrencies also come with some unique risks. Individuals and organizations that manage their own cryptocurrency holdings (often in the form of a USB drive containing a digital wallet) might forget or lose the password used to secure them. In January 2021, a San Francisco programmer told The New York Times that he could not remember the password for his digital wallet and stood to lose 7,000 Bitcoins (then worth $220 million).
Those who store their Bitcoins with an exchange have also suffered losses due to fraud. Clients of the Japan-based Mt. Gox exchange lost Bitcoin now worth billions of dollars after the intermediary was hacked in 2011 and collapsed in 2014. In October, a majority of investors did accept a corporate rehabilitation plan for Mt. Gox under which they will recover a large portion of their lost Bitcoin. In 2019, investors lost $135 million of cryptocurrency when QuadrigaCX, Canada’s largest cryptocurrency exchange, collapsed in the aftermath of the CEO’s apparent death.
Recent developments for crypto promise a higher degree of investor security. Coinbase, the largest US crypto exchange, went public in April. As a NASDAQ-listed company, Coinbase will face a greater level of scrutiny from regulators and equity investors than earlier exchanges. In October, ProShares introduced the Bitcoin Strategy ETF, an exchange-traded mutual fund that aims to track Bitcoin’s performance by investing in Bitcoin futures. Individual investors can hold shares in the ETF in their brokerage accounts.
The Houston Firefighters’ Relief & Retirement Fund is using NYDIG to hold its cryptocurrency investment. The company, a subsidiary of alternative asset manager Stone Ridge, claims to “meet the industry’s highest regulatory, audit, and governance standards”.
But with the risk comes large potential rewards. Since the beginning of 2010, the value of one Bitcoin rose from a fraction of a penny to over $55,000. Much of Bitcoin’s appreciation has been recent, with its price almost doubling between January 1 and December 1, 2021.
Fiscal and monetary policy under both the Trump and Biden administrations has been very expansionary, and the results are now showing up in the form of increased inflation. During this recent inflationary period, gold has not performed its traditional role as an inflation hedge. The precious metal recently traded below the level at which it opened in 2021. Established cryptocurrencies, which have limited supply, could be supplanting gold as an inflation hedge. Thus, they may be a reasonable alternative for portfolio managers concerned about the risk of the federal government and Federal Reserve being unable or unwilling to control inflation.
So, for U.S. public pension systems that are tasked with delivering returns in excess of risk-free interest rates, cryptocurrency is an attractive alternative to public and private equity. According to the firefighter system’s most recent Investment Returns and Assumptions Report to the Texas Pension Review Board, HFRRF has an assumed rate of return of 7.25%, more than 500 basis points above risk-free long term Treasuries and slightly above the 7% median return assumption for large plans.
Lowering the plan’s assumed rate of return on investments and thus increasing actuarially determined pension contributions would reduce pressure on investment managers to embrace risky assets such as Bitcoin and Ethereum in the search for higher yields.
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