The crypto industry, as exciting and dynamic as it is, is still in its infancy and will have to face quite some challenges in the foreseeable future. High volatility, pressure from regulators, environmental debates, and systematic risks, just to name some factors, could impair the sphere’s growth and pose a severe threat. Simultaneously, we see that crypto funds enjoy increasing popularity. This article will discuss in detail how they can help mitigate some of the aforementioned risks and foster sustainable growth for Bitcoin and Co.
Author: Elias Mendel
The rise of the crypto sphere over the past 12 months has been spectacular and indisputable, as various figures underscore: We have seen the Total Value Locked (TVL) in DeFi (decentralized finance) protocols skyrocket from $22 billion to over $250 billion1, Ethereum’s active wallets triple2 and the crypto market cap temporarily exceed $3 trillion. However, there is no doubt that the industry still is in its infancy and has to overcome numerous hurdles and obstacles to compete with the traditional financial system at scale.
A viable comparison could be the Internet back in the 90s - a new, emerging technology capable of changing the world forever. Yet, companies without a clear and sustainable business strategy and purpose were just riding the “hype train.” Unfortunately, both retail and institutional investors followed the market exuberance and often lacked the technical know-how to evaluate a business at its core. We all know the result: the notorious burst of the dot-com bubble at the beginning of the millennial. Yet it is equally known that had one opted for the right investments - think about eBay, Amazon, Apple, Microsoft, and Booking Holdings - the reward now would be magnificent.
Similar applies to the blockchain industry. Its novelty and complexity keep skeptical yet intrigued investors on the sideline. Although we have recently witnessed a spike in institutional interest, there is still a lot of doubt about environmental, regulatory, and volatility issues, often justified.
In today’s article, we will address issues that investors face and propose ways of tackling those.
Obstacles for Blockchain to Overcome
With frequent weekly two-digit drawdowns and consequential price risks (see Figure 1 for a comparison between BTC's volatility and the MSCI World's volatility), institutional investors often refrain from either making investments at all or allocating a larger share of their capital to crypto.
Figure 1: Comparison of 30-Day BTC/USD volatility with 30-Day MSCI World volatility. Source: own calculations
The small size of the entire space, currently slightly above $2.7 trillion, is a reason the market is fairly prone to exaggerated price swings. At the current stage, oftentimes there is not sufficient liquidity to cushion minor price drops. High levels of leverage and subsequent automatic liquidations can compound the impact of low liquidity.
Another reason for the increased price risk in crypto markets is investor composition. Superficially informed, speculative investors panic and flood the market with their holdings as soon as there’s an indication of bearish patterns and negative news causing FUD (Fear, Uncertainty and Doubt) in the market.
Price risk is not the only barrier for new investors. A further barrier is that a deep understanding of the mechanics behind the numerous blockchain projects is necessary to make informed, justifiable investment decisions. Due to the novelty and inherent complexity of the space, it will take more time for the mass of institutional investors to accumulate the required knowledge. And even though we have seen more and more media coverage and interest from both retail and institutional investors, there is still a lot of catching up to do in terms of fundamentally getting a grasp of Bitcoin and Co.
Environmental debates, and critics decrying Bitcoin and Ethereum for their allegedly pointless waste of energy, have received much attention. Oftentimes, discussions surrounding this topic are held superficially and neglect crucial aspects. Governments, pressured by the necessity of ESG standards, might hastily follow China’s footsteps on cracking down on crypto by banning mining operations or restricting the usage of cryptocurrencies as a means of payment.
Another point to bear in mind is concerned with uncertain compliance. If cryptocurrencies are classified as securities, they would be bound by strict SEC regulations and attract more scrutiny than today. The SEC has devoted tremendous resources to get a deeper understanding of various projects. It looks like many cryptocurrencies, particularly those clearly linked to a software development company, can expect to be targeted by the SEC and other institutions. The Financial Action Task Force will probably introduce further measures against money laundering in 2022, targeting crypto exchanges and companies.
Also, the custody of crypto assets is a non-negligible aspect. Stories of exchanges or DeFi protocols being hacked and losing hundreds of millions of customers’ dollars, or crypto owners having lost access to their wallets worth millions of dollars have unfortunately made the rounds in the past. And although new solutions are making it increasingly convenient for users to transact with and store crypto, thefts and hacks will inevitably occur.
Lastly, one subject worth mentioning is crypto stablecoins, which remain closely observed, as regulators fear they could be a systematic threat to financial stability. Stablecoins, given that they are backed by real assets, such as US-Dollar reserves, are a key component of the crypto industry, allowing for fast and cheap money transfers and money parking often used by traders.
Without stablecoins, crypto most likely would not have been able to grow nearly as fast as it has been lately. However, with scandals about missing reserves to back the stablecoins, or the threat of a loss or value depreciation of those assets, regulators fear runs on issuers that would lead to major fire sales, potentially even causing a chain reaction among financial markets3.
While all this sounds rather unpromising, and there certainly is a bumpy road ahead, it is sensible to ask whether the tremendous past returns are worth assuming said risks, as Figure 2 shows.
Figure 2: A clear outperformance of Bitcoin in 3 of 4 years, with the same pattern unfolding again in 2021. Source: upmyinterest.com
Crypto Funds: A Suitable Solution?
Crypto funds can be considered investment vehicles poised to help solve and facilitate some of the aforementioned issues. They commonly comprise a team of experienced professionals with a deep understanding of the technology and practices to navigate this environment. Other funds leverage experience from traditional financial markets and focus on strategies such as spot-future arbitrage and statistical arbitrage.
For most strategies, the active selection and management of a fund’s holdings and, similarly important, quick reactions and readjustments to changing market conditions, are a prerequisite for investment success regardless of the current market cycle. A handy way of achieving this is by utilizing market-neutral strategies that have a beta of close to zero, thus helping to minimize portfolio drawdowns and offsetting losses incurred through mere long or short approaches.
One movement within the industry enjoying massive adoption is DeFi, which strives to provide various financial services in a decentralized manner, without any intermediaries being involved due to the use of smart contracts. DeFi, as an example, enables multiple ways of accomplishing low correlations with the overall cryptocurrency market:
- Lending: Funds can provide their assets to DeFi lending protocols, e.g. Aave4, and earn up two digits on interest annually. New protocols even allow yield farming strategies where one utilizes multiple protocols to maximize returns.
- Liquidity Pools: Funds can provide liquidity to DEXes (decentralized exchanges) which make use of sophisticated, smart contract-based automated market maker (AMM) protocols, and collect fees every time a transaction is made using the pool they supplied their assets to.
- Arbitrage: AMMs rely on arbitrageurs to offset price discrepancies of the same asset occurring on different exchanges.
- Market making: Certain centralized crypto exchanges, such as Binance, allow for the participation in market maker programs, for example on the futures and options markets, where one can earn a cut of the fees for keeping the markets sufficiently liquid.
A good indicator for assessing an asset’s historic risk-reward ratio is the Sharpe Ratio, a financial metric taking the excess return of the asset (relative to the risk-free rate) and dividing it by the standard deviation of the asset’s excess return5. The higher the ratio, the better. As one can see, both Bitcoin and crypto funds have significantly outperformed other asset classes - equities, bonds and gold - even when taking into account the extreme volatility.
Figure 3: Sharpe Ratio of different investments. Source: own calculations.
A steadily rising number of investors notice the vast potential cryptocurrencies, and hence crypto funds, entail, as the growth of assets under management - displayed in Figure 4 - in the last 3 years shows. In particular, the fact that crypto funds offer institutional investors a single access point tapping into the blockchain ecosystem, handling matters such as custody, portfolio construction, and compliance, explains this trend, which we expect to continue in the years to come. The crypto fund universe, which by now exceeds 1000 registered funds with a median of $22 million AuM, has led to a coverage of most alpha-generating investing strategies known in traditional finance - quantitative, discretionary long-only, discretionary long/short, and multi-strategy, and various arbitrage strategies.
In all sincerity, it should be noted that while crypto funds can serve as a one-stop-shop for crypto investing, they can not protect their investors from all threats the infant industry is still facing. They cannot impact government decisions, they cannot undo major sell-offs caused by systematic threats, and they cannot prevent single protocols from being hacked. However, what they can do is mitigate those risks, and, depending on the strategies applied, in some cases even profit in spite of panicked, bearish markets.
Figure 4: Crypto Funds Cumulative AuM has been spiking recently6. Source: cryptofundresearch.com
Investors considering such an investment vehicle should very carefully inform themselves about a fund’s management, background as well as strategy, and should beware of the unavoidable risks associated with such an investment. However, if they do so, crypto funds can be an ideal solution to participate in the industry’s success, and help investors navigate through turbulent markets.
21e6 Capital is a Swiss investment advisor, connecting professional investors with tailor-made crypto investment products. We focus on risk management of crypto and digital asset exposure for family offices and institutional investors. Our expertise in crypto asset management stems from a team combining decades of experience in traditional financial services with native and in-depth knowledge in digital assets.
21e6 Capital has analyzed over 1,000 crypto hedge funds across the world and condensed them into a selection that can yield crypto-exposure with minimized downside risk. Our risk management solution, provided by OpenMetrics Solutions, is also trusted by the largest Swiss pension funds.
The 21e6 Capital team builds upon strong academic roots with a track record of leading crypto asset and decentralized finance (DeFi) publications and research, ensuring state-of-the-art crypto investment solutions for professional investors, family offices and asset managers.
Elias Mendel studies International Business and Economics at the University of Applied Sciences Schmalkalden. Currently, he works on several projects dealing with DLT, digital assets, and blockchain. You can contact him via email or LinkedIn.
You May Also Like
These Related Articles