Thus far, despite the hype and excitement around cryptocurrencies, most CTAs haven’t exactly been in a rush to start trading these assets. However, as Galen Stops reports, this might be about to change.
As Cboe and CME both prepared to launch bitcoin futures contracts in December 2017, the price of a single bitcoin roared upwards to peak at over $19,000.
For retail investors, the attraction of this particular cryptocurrency was that the price had been going up all year, having traded at around $985 per bitcoin in January of last year. For professional traders, the attraction of bitcoin was that it was an asset that was actually moving, it was uncorrelated to other assets and therefore offered diversification benefits and, on top of all this, was almost exclusively being traded by retail punters.
Given this, it perhaps wouldn’t have been surprising to see CTAs lining up to trade bitcoin futures once these two exchanges launched them. But instead of piling in, it seems that most CTAs continued to avoid trading cryptocurrencies, and indeed, a survey produced by BarclayHedge in January 2018 showed that there was significant skepticism amongst these firms about the value of these assets within a portfolio.
In the survey, 73% of respondents said that they did not believe that bitcoin futures were a valuable or useful addition to a diversified futures portfolio. By contrast, only 5% said they were already trading these contracts, although 19% said that they intended to do so within the next six months as the contracts developed.
Sol Waksman, CEO of BarclayHedge, speculates that these results were partially the result of a cautious mentality amongst CTAs.
“If you are a professional investor, be it a CTA or a hedge fund, despite all the risks you take in the market place and everywhere else, you’re very conservative about making changes to the markets that you may be trading or to the methodology that you may be using,” he says.
There are good reasons to believe, however, that this initial skepticism is likely to fade.
One is simply that, broadly speaking, CTAs have struggled to produce good returns in recent years, while at the same time the S&P 500 embarked on a consistent upward trend following the financial crisis that lasted until the beginning of this year and quantitative easing by central banks around the world was producing a massive tailwind, pushing asset prices up across the board.
As the managing director of one investment advisory service, points out: “You don’t need a hedge or portfolio construction when you just want to be long the S&P 500 and get a Sharpe Ratio of three.”
They add: “One of the reasons why hedge funds have underperformed in recent years is because volatility has been low, while institutional investors having been crowding out the space. It’s hard to compete with other hedge funds because everyone is smart and there’s no retail alpha donation, whereby you can get in front of some retail trading. But this is exactly what crypto has, high volatility, no institutional involvement and a lot of retail money. So the smart investors have an edge because, not only is the beta hopefully going to go up, but there’s alpha to be had in the space.”
Similarly, a senior figure at one CTA that is not yet trading cryptoassets, but is considering doing so in the near future, comments: “If you look at the CTA space, it’s been extremely difficult to generate the kinds of returns that investors are looking for. Markets have just become so efficient that there’s limited opportunities there, which is what I think makes crypto trading such an interesting prospect for a lot of us.”
Waksman predicts that more CTAs will trade cryptoassets in the future, although he qualifies this by adding that many of these firms might wait to see what sort of returns other managers trading these assets are posting before they get involved. In particular, Waksman says that currency managers might look to cryptoassets in order to help improve performance.
“The fact is that the returns for currency managers over the last three or four years have been very paltry, it’s been a very difficult space to navigate successfully and we’ve seen the number of managers that are currency-only has fallen in half,” he says.
Although it has never been specifically currency-focused, Systematic Alpha Management is one CTA that has recognised the potential of cryptoassts and is now trading the CME and Cboe bitcoin futures.
“Last year we were observing the crypto space from a distance but, when we realised that the US regulators were about to approve bitcoin futures, for us that was a very clear indication that we should be looking at these products more carefully,” says Peter Kambolin, the CEO of Systematic Alpha Management.
As a result, the firm bought four years of high-frequency trading data from the spot crypto trading platforms, began to analyse the data and started back-testing trading strategies.
“When we looked at the data, we were quite surprised at how strong trend following properties of the time series is,” explains Kambolin.
Because of these trend following properties, Kambolin and his colleagues developed a short-term momentum/trend-following trading strategy and then began trading personal funds, initially on the crypto platforms. Then, starting February 1, Systematic Alpha launched its crypto-focused fund, which was up 17.2% at the end of April, net of fees, despite the fact that bitcoin and other cryptoassets have generally trended down in price during this period.
“We’re not your typical crypto fund that is long biased; in futures we can take both long and short positions, and in fact in March most of our returns were generated on the short side,” says Kambolin.
He adds that the other advantage of only trading the bitcoin futures products is that there is very little operational risk involved, unlike the spot crypto platforms, where Kambolin says that there are concerns about hacking, platforms being shut down and ability to get fiat money out.
Operationally speaking, he comments, trading bitcoin futures on the CME or Cboe is just like trading any other futures product, albeit it with significantly higher margin requirements.
“The CME margin is about 40-50%, which is probably 10 times the margin of a normal contract. On top of that, our FCMs require us to post 100% margin, so basically we pay cash for whatever notional exposure we have in bitcoin, and on top of that we have our own risk management,” says Kambolin.
Typhon Capital Management is another CTA that trades cryptoassets, albeit with a very different approach.
The firm, which does not employ trend following strategies, operates in the spot market and was one of the first to trade the bitcoin futures when they were initially launched by Cboe.
“I think trading cryptoassets is a natural progression for CTAs because they’re used to trading volatile assets,” says James Koutoulas, the CEO of Typhon Capital Management.
Although his firm was already trading cryptocurrencies, Koutoulas highlights the significance of the futures launch in December for the development of this market.
“For any market having the ability to go long or short and having the ability to hedge with futures is really important. The next step is to develop options; we assume that futures for other cryptos are coming and so there will be an increasing number of ways to short. When you have those, it makes more efficient markets, tightens spreads and that’s important for the development of a mature market,” he says.
There are still operational challenges for CTAs wanting to trade cryptoassets, but seemingly the high margins required to trade the futures products are not amongst the most acute.
“We tell our clients that there’s enough volatility that we don’t want to be super leveraged. If you’re disciplined and scale down positions accordingly, then the margin requirements really aren’t that bad,” says Koutoulas.
Likewise, Kambolin comments: “We’re fine paying 100% margin because we recognise that these instruments are extremely volatile and we don’t want to have any leverage.”
Indeed, in the BarclayHedge survey, 67% of the respondents said that the high margins for these contracts are appropriate, with less than half this number saying that they are a disincentive to trade.
Rather than the margin requirements, Kambolin cites getting enough futures approved for trading by FCMs as the most challenging aspect of setting up his firm’s crypto trading fund.
“Not only do the FCMs require 100% margin, but they would also impose restrictions on the number of contracts that we can trade due to their own internal limits,” he says, adding: “Another issue is that you can’t execute at one FCM and give-up the trade for clearing at another – you have to execute and clear at the same place.”
Aside from margin requirements, another operational challenge for CTAs wanting to trade bitcoin futures is, in some cases, the lack of automated data reporting for these products.
“We have an automated reporting engine that takes data feeds from our FCMs that we then use for internal risk and daily P&L reporting to customers. Five months from launch and some of the FCMs we’ve used still don’t have the bitcoin futures contracts generating data automatically, and so we’ve had to deal with a lot of manual data processing,” explains Koutoulas.
He adds: “We build quant models to trade these products, but they’re highly dependent on data coming in, so if you don’t have great data feeds that slows down your execution – we’ve got humans executing even on our quant systems because we want to make sure the data we’re getting is accurate.”
On the spot trading side, Koutoulas highlights a different set of operational challenges, one of which is auditing.
Deloitte currently serves as the auditor of Typhon Capital, but it has yet to approve any crypto trading funds for audit. If it were to approve the audit of Typhon’s crypto fund, that would be a very positive development for the fund and would arguably help pave the way for more CTAs to begin trading cryptoassets, but if it declines to approve the fund, then Koutoulas says that his firm might have to switch its entire audit process to avoid having to go through two separate and concurrent audit processes.
Another problem pointed out by Koutoulas is that although many of the spot crypto trading venues, which aren’t yet directly regulated, offer view-only API access so that administrators can view CTAs’ positions on an intraday basis, they don’t provide them with a monthly statement.
“So they can’t send us a snapshot of a specific point in time showing how many bitcoins we have and how much they’re worth, instead they send us screenshots. The API is very accurate, but for accounting you always want two ways to check everything, that’s how you have good controls. It’s 2018, relying on a screenshot of a position instead of a statement is a joke,” he says.
Ultimately, it seems highly probable that these operational issues and others more broadly related to cryptoasset trading will be solved as the market matures.
The problem for CTAs trading cryptos, and especially for ones employing trend following strategies, is that as the market matures, liquidity grows and infrastructure improves, the potential for easy returns diminishes.
“We do believe that once institutional players start participating in these markets they will become more efficient, trends will start to disappear, but it will take time for this to happen,” says Kambolin. “The analogy that I give is that if you look back at the ‘70s and ‘80s, there were only a few CTAs at the time that traded markets such as GBP and crude oil and they were making incredible returns because the trends were strong and the participation from other investors was low. It’s a similar situation here – it’s a new asset class, it’s still immature, it’s biased and it’s more predictable than more traditional futures markets.”
Koutoulas agrees that it’s inevitable that more institutional-level trading will cause spreads to narrow as volumes increase, but adds that he thinks crypto trading will always have a strong retail element, pointing to the KOSPI 200 futures in South Korea as a potentially analogous example.
“At the end of the day, you can’t tell the market who’s going to participate in it,” he says.
In many ways, the inevitability of CTAs trading cryptoassets in the future is suggested by the BarclayHedge survey. Looking at all of the concerns that respondents listed regarding bitcoin futures and one fact immediately jumps out, namely that it is not investors that are holding these firms back.
In fact, the source at the CTA not yet trading cryptoassets states that investor demand for exposure to these assets is one of the main reasons why his firm is looking to get involved in the space.
Instead, the main concerns for now appear to centre around the lack of liquidity, the lack of market maturity and the volatility of the products available for CTAs to trade. As previously stated, it seems highly probable that these will improve over time and, even if the returns are subsequently reduced to a degree, crypto trading remains an enticing prospect for CTAs.