At a recent buy side event hosted by Profit & Loss and CME Group in New York, a panel of cryptocurrency experts discussed how institutional investors and traders should think about these assets within a portfolio. Galen Stops reports.

Interest in cryptocurrencies has skyrocketed amongst investors and trading firms over the past year, as the market capitalisation for this nascent asset class has increased dramatically and volatile price action has offered the potential for outsized returns compared to many traditional asset classes.

Yet some firms still consider cryptocurrencies to be too risky to include in their portfolio, a position that Ari Paul, managing partner and CIO of the hedge fund BlockTower Capital, took issue with on the panel.

He argued that if an investor or asset manager genuinely believes that cryptocurrencies are the next ‘tulip mania’, and that ultimately, they see negative returns going forward for this asset class, then this is a perfectly acceptable reason not to include these assets in one’s portfolio. But Paul rejected the notion that cryptocurrencies are too risky to be worth holding.

“What frustrates me, as a CFA and having taken MBA classes, is when people say that an asset is too risky. That’s a sizing question rather than about whether you should have that asset in your portfolio. So when investors or wealth managers that say cryptocurrencies are too risky, to me that means that either they didn’t take portfolio theory 101, or we’re actually referring to career risk here – and it’s usually the latter,” he said.

Gabriel Burstein, co-founder and CEO of KryptoIndex, a rule-based crypto index and benchmark company, agreed with the comments about appropriately sizing cryptocurrency exposures, explaining, without giving advice or making recommendations, that theoretically these “crypto” assets should be included in a broader portfolio on a risk-weighted basis as, in this case, volatilities may be easier to predict and more stable than expected returns.

“Our Token KryptoIndex 15, based on 15 of the largest tokens, has an annualised historic volatility of 152.7% for the June 2017-February 2018 period based on 365 days of trading annualisation while our Coin KryptoIndex 15, based on 15 of the largest coins, has an annualised historic volatility of 106.86% for the same period.There is a lot of volatility there, so the first question is: how do I combine these two and how do they fit into my existing portfolio with other asset types? And one possible, and perhaps the most simplistic answer, may be: on an inversely risk-weighted basis,” he said.

Diverse approaches

The other key to managing the risks associated with including cryptocurrencies in a portfolio, according to Burstein, is to understand the different crypto-asset types which exist in the “cryptocurrency” market and how they interact with one another in order to provide effective diversification.

“The worst thing you can do is basically take bitcoin, ethereum, litecoin and that’s it, because then you’re just exposed to cryptocurrencies. Diversification here has different sub-levels,” he explained.

Burstein continued: “When you build a portfolio of crypto-assets, you try to achieve diversification between the two crypto-asset types So you need to think in terms of coins and tokens – you can think of the coins as being “like currencies” (the stores of value for the protocols and their decentralised networks) and the tokens as some “crypto equities” (innovative decentralised new businesses using protocols and their networks as “infrastructure”). As such, tokens are denominated in a coin, most frequently in ethereum.

Burstein then talked about the different dynamics of crypto-assets in regards to diversification, explaining that over the last nine months the relationship between tokens and coins has decoupled and diverged only to then and then re-couple and converge.

“Then you have different sub-sectors within the token market, and basically you have to make fundamental judgments on the underlying value of these different sub-sectors within this new type of economy that is emerging. Then you have the coins, which you have to evaluate and compare. So you have to think dually, coins and tokens,” Burstein continued.

Delving into the coin-to-token allocation ratio for a portfolio, Burstein highlighted that, while a smaller number of coins have basically captured the most of the “coin market”, liquidity in tokens is more evenly distributed among more large tokens, which also make a large proportion of the overall “token market”.

In the same way that there is no one-size-fits-all approach to diversification within crypto-assets, Paul made the point that, just like in more traditional asset classes, there’s more than one way to skin a cat when trading cryptocurrencies, and how firms invest in the space will dictate their risk exposure and tolerance.

For example, some firms might take a more venture capitalist-like approach and look to invest more in initial coin offerings (ICOs), while others might want to just trade more mature products that are listed on exchanges. Some firms might have more of a classic discretionary trading sentiment-based approach, while others might just be looking to capture excessive volatility and market inefficiencies.

“So risk to a trader at a prop shop might be daily Sharpe ratio, daily drawdown risk, but risk to a long-term investor, an endowment investor or a VC fund is really the risk of ruin over a five-year horizon. It’s a very different kind of framework,” said Paul.

Liquidity challenges

James Radecki, the global head of business development at Cumberland, the cryptocurrency arm of principal trading firm DRW, concurred with this point, adding that liquidity is another critical factor to consider when analysing cryptocurrency risks.

“Our view is that the best risk management tool out there is to always understand what your liquidity risk is, because liquidity is difficult to come by andit’s very frictional to get at because of the bifurcated market structure that exists. And so constantly knowing where you have your outs and being able to grab liquidity when you need it the most, that’s a tool that we see our counterparties consider with their strategies,” he said.

Part of the reason why the market structure has made liquidity conditions challenging for firms trying to trade cryptocurrencies in size is because these markets have increased so rapidly in scale that it has far outstripped the ability of much of the underlying infrastructure to effectively support them.

In addition, with so many different exchanges popping up all over the world, it has become harder to aggregate the liquidity available. This is why, although Cumberland does trade on exchanges as well, Radecki says that the OTC market is still the best place to trade for someone looking to trade in institutional sizes.

But, as he pointed out, liquidity when trading between different cryptocurrencies isn’t the only challenge.

“One of the biggest hurdles that we’ve seen our counterparties looking to overcome  is getting out to fiat currency. This can really change the risk profile of your organisation, so you need to be managing this liquidity consciously and in real time,” said Radecki.

He added: “This is why we’re finding that most of our counterparties want to trade a major portion of their liquidity over-the-counter to avoid the friction of a disharmonious settlement. They want frictionless access to global liquidity at a price.”

Paul agreed that liquidity is “a huge problem” from his perspective. Giving an example of this, he explained that one month ago, he was looking at a crypto-asset that he anticipated would appreciate by 100% in a month, but found that even buying 1% of the total net worth value – or market capitalisation – of that network would have moved the market about 15%.

In that instance, Paul decided that, post-slippage, other crypto-assets would offer a better ROI and therefore didn’t invest. He noted though, that liquidity is in the eye of the beholder, and as such, there have been other occasions in which he has paid slippage that would be considered “insane” in traditional markets.

“There are definitely hedge fund traders who say: “How can you even trade in this market?” And the answer is, yes, I’m paying 5%, sometimes even 15% slippage, but the expected return on these trades is 50% or 100% or even 400% in some cases,” said Paul.

“Stay in the game”

Of course, everything in financial markets is, to a large degree, a trade-off between risk and reward. This is why the very risk factors that the panelists highlighted represent opportunities for firms able to trade effectively in the cryptocurrency markets. After all, a lack of volatility is precisely why returns in other asset classes – including FX – have generally been depressed in recent years.

“We have witnessed last year a collapse of volatility in almost everything else, including alternative assets and strategies,” said Burstein.

But even if volatility to comes back in traditional asset classes, he maintained that cryptocurrencies would maintain their attraction because they represent a fundamentally new economy

“Yes, there are technical reasons to trade these crypto assets, because they have volatility – perhaps too much of it which needs to be controlled – and have extremely small correlation with traditional asset classes, but the main thing at the root of all the excitement around crypto-assets is that this is basically a new market, we’re just at the beginning and firms have a chance to capture this opportunity,” explained Burstein.

Touching on the value of this “new economy”, Paul said that he remains very confident in the beta tailwind for cryptocurrencies going forward, although he did point out that, logically, that these assets will not see the kind of growth that occurred in 2017 replicated again in the future.

“I’m still very confident that cryptocurrency generates fundamental value and as a new economy in five years, the whole network value is likely to be higher. So I’m very confident in the alpha opportunities,” said Paul.

In terms of cryptocurrency liquidity, Paul predicted that it will continue to fragment on the exchange side due to the sheer demand for exchange access combined with the unclear regulatory status around these products that are allowing – for the time being – some exchanges to pop up with relatively little oversight. This, fragmentation, combined with the predominantly retail nature of the cryptocurrency markets at present, he said, has led to massive inefficiencies in the market that trading firms can exploit to generate sizable profits.

“Where this leaves me and where I think this leaves a prudent investor is: stay in the game,” Paul concluded.

When questioned about whether Cumberland views this fragmented liquidity landscape as a challenge or an opportunity for the firm, Radecki responded that it clearly represents both. However, he predicted that this landscape will continue to change at a rapid pace, and said that the key to success is to be adaptable to this change.

“This is a business where the ecosystem is evolving so quickly, which can be challenging, but through our parent company, DRW, we had the advantage of being early adopters in this space and this has helped us build global market share when it comes to providing block size liquidity. But as the industry continues to mature, liquidity will become more efficient and markets will naturally tighten. Wherever there is change, there is opportunity, as long as we are prepared for it and stay where the liquidity is,” said Radecki.

Different risk axes

It is worth pointing out though, that while some of the risks associated with cryptocurrency trading can be mitigated to a degree, there are others that are harder for portfolio managers to prepare for. In particular, Paul said that he views the latter of these risk sets across three main axes.

The first is market risk because the correlation between different cryptocurrencies tends to be very high and during downturns in the market there is a flight to quality.

“In a general market downturn, there’s kind of nowhere to hide in crypto and I think that’s likely to remain the case,” Paul added.

The second risk axis he highlighted was the actual engineering of the networks underpinning some of these crypto-assets. Some networks are more susceptible to engineering bugs than others, however.

According to Paul, the chances of a fundamental protocol risk destroying bitcoin is relatively low, because the code behind it has not been changed much in the past four years. By contrast, ethereum, which Paul described as “moving fast and breaking things”, has been rolling out hard forks that represent fundamental code changes.

This has significant implications for diversification because a lot of utility tokens are issued on top of the ethereum network, using a format call ERC20. This means that if a major flaw in the network is either discovered or accidentally introduced as part of these changes, all of these other tokens could potentially be destroyed, meaning that there is actually no diversification benefit to owning different ERC20 tokens.

“This is a very real issue. So many cryptocurrencies have been destroyed or narrowly thwarted destruction due to protocol risk,” said Paul.

And the final risk axis he mentioned was regulatory. It’s not inconceivable that regulators in major financial centres could decide that every single token issuance is technically an unregistered security offering. In such a scenario, no exchange would be allowed to list tokens and firms facilitating liquidity in these assets could face legal action.

“In my mind, there’s a tail risk that could affect all tokens, which is on a really scary regulatory announcement,” said Paul.

Galen Stops

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