A Nascent Asset Class with Youthful Characteristics
What is the Investment Landscape for Cryptoassets?
The history of tradeable cryptoassets dates back to October 2008 when a computer scientist, or group of scientists, using the pseudonym Satoshi Nakamoto published a whitepaper describing a peer-to-peer electronic cash system called Bitcoin (BTC). A couple of months after the whitepaper, Bitcoin (BTC) was formally launched on January 3, 2009. Some hailed the digital currency as potentially foundational to a more decentralized and robust global financial system. Others simply saw a poor substitute for fiat currencies and precious metals.
Regardless of your viewpoint, the facts are that over the last 12 years BTC’s market capitalization has grown from zero to about $125B as of mid-April 2020 and the number of different crypto-assets is now in the thousands. BTC remains by far the biggest, though, making up about 64% of the $196B asset class. The next biggest coin, Ethereum (ETH), accounts for 9% and no other currency has more than a 5% share.
The emergence of dozens of crypto exchanges around the world has helped feed investor interest while also facilitating the adoption of digital assets for transactions. Combined daily dollar volume on these exchanges regularly exceeds $100B and can spike much higher during times of market stress.
Despite rapid growth, the marketplace for crypto investment funds is still in its infancy. Global consulting firm PwC reported that there are 150 active crypto funds collectively managing about $1B as of 2019. Over 60% of these funds have less than $10M in AUM and fewer than 10% manage over $50M USD.
Why Should an Investor Allocate to Crypto Investment Vehicles?
From an investor’s viewpoint, the crypto market is currently in a sweet spot of its evolution. It’s developed enough that it has the necessary liquidity to trade effectively and after several high-profile missteps exchanges are increasingly adopting industry best practices and developing reputations for reliability and security. At the same time, it’s still a relatively nascent asset class with youthful characteristics including high volatility, inefficiency, and fragmentation that can be profitably exploited by skilled traders with an institutional grade technology infrastructure.
Inefficiency. Due to the relatively small size of the asset class and regulatory constraints, crypto-assets have a much higher share of retail traders than traditional markets. This represents an opportunity for professional traders with traditional asset class experience and access to superior technology to differentiate.
Fragmentation. Market data and trading activity is distributed across dozens of exchanges and the off-exchange market is highly fragmented, with no major prime brokerages. This fragmentation can slow information and order flow creating an opportunity for systematic strategies operating on an advanced infrastructure.
What Type of Fund Strategy is Well-suited for Investing in Cryptoassets?
Regardless of the asset class being traded a multi-strategy approach has some advantages relative to other styles of investing. For instance, a multi-strat fund fosters competition among internal managers for AUM and incentivizes every manager to constantly improve by finding new sources of alpha or risk being left behind. It also provides another vector for managing risk through diversification.
But there are other aspects of a multi-strategy approach that make it particularly well-suited for crypto investing. The crypto landscape is rapidly evolving and market regimes can change quickly. Having a stable of strategies to allocate to can help ensure that the appropriate strategies are matched to the current market environment. Crypto is still a very small asset class relative to equities or fixed income and this can create capacity constraints for some funds and prevent them from being able to effectively manage enough AUM to generate the revenue necessary for building out human and technological resources. A multi-strategy approach addresses these challenges by increasing investment capacity.
What are the Risks Associated with Investing in Cryptoassets?
While the “newness” of the crypto market creates opportunities for outsized gains it also comes with an elevated risk profile. Some of the primary risks include:
Cyber-theft and Fraud. There have been several high profile attacks on crypto exchanges that have resulted in the loss of assets due to system vulnerabilities. There have also been a few instances where exchange operators have simply defrauded investors. The vetting of exchanges needs to be a core part of any investment vehicle’s risk controls.
Lack of Institutional Infrastructure. The vast majority of crypto investment vehicles do not have the funding to develop an institutional grade infrastructure. This can leave investors particularly exposed to the sudden and extreme price swings that characterize the cryptoasset market.
Regulatory. Because the asset class is relatively new, the regulatory environment is still evolving. New regulations could cause exaggerated price swings, up or down, in an already volatile asset class. It’s also possible that regulatory changes could render some crypto investment strategies obsolete creating a significant challenge for funds that rely on a limited number of approaches.
Large Draw-downs. The high beta of crypto fund indices relative to BTC suggests that many funds are heavily exposed to the price swings of the asset class. Given the extreme volatility of BTC and other crypto-assets, this positioning exposes investors to relatively frequent and potentially large draw-downs.
How Can These Risks Be Mitigated?
The challenges to long term success in the crypto market are material. An approach that mitigates risk by way of pertinent controls, processes, and systems to oversee the investment is critical to safeguarding a crytpo investment.
Cutting Edge Infrastructure. Given that crypto is rooted in technology, it makes sense that effective risk management systems also need to be heavily tech-oriented. An automated Portfolio Position Management System can respond to a volatile environment in real-time ensuring that position, strategy, and counter-party risks are managed optimally. A proprietary trading infrastructure can provide Authentication Security, Data Aggregation and Analytics, Smart Order Management, and other risk control functions.
Multi-Layered Diversification. An investment approach that offers diversification by exchange, coin, and strategy allows investors to reduce risk while at the same time increasing return potential through opportunistic allocation among coins and strategies.
Automated Trading. Crypto is traded around the world 24/7 and prices are often subject to both sharp swings and significant variation across exchanges. An “always on” systematic trading approach can help protect against and even exploit bouts of extreme volatility.
Strategy Stop-Losses. An automated, multi-strategy investment approach allows for the tactical allocation of funds across strategies. Thresholds can be applied to manage allocations and stop-out positions altogether when necessary.
Optimal Dynamic Portfolio Management. By using a combination of quantitative and qualitative analysis to apply a clear framework and rigorous process synthesised by the investment management committee’s experience in traditional and cryptocurrency markets. Applying systematic processes to define drivers for construction, including risk parameters for exceptions and thresholds management, and optimal portfolio and strategy level allocation bands.
Special Thanks to our Contributor
Virgil Quantitative Research is an investment manager and fully owned subsidiary of Virgil Technologies LLC, one of the largest investment companies specializing in the trading of crypto-assets. The investment manager employs fully automated, quantitative trading models that invest in crypto-assets around the world through its VQR Multistrategy Fund LP.
Virgil’s investment professionals draw on significant combined experience managing both crypto and traditional assets. Virgil Quantitative Research is dedicated to applying its cutting-edge technology to nascent, inefficient crypto-asset markets. It has invested heavily in its Trading Infrastructure Platform (“Metis”) which is an electronic trading system with key features such as smart order management, risk management, data aggregation and analytics, and market simulation that is seamlessly integrated into its Portfolio Position Management System.
Head of Investor Relations
VQR Multistrategy Fund LP
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