Gary Basin

@garybasin

Crypto investing for traditional asset managers

Why do traditional asset managers and investors care about crypto assets?

When they enter the market, how will they allocate across different crypto assets?

How will they trade in and out?

What are the potential pitfalls to be avoided?

Why Crypto? Alpha or Diversification?

To the extent that someone can reliably predict an asset will outperform, they will want to own more of it. In practice, this is exceedingly difficult to do. It’s even harder to do it at scale — often with deep analysis you can make predictions better than chance (alpha, rather than beta) but when you go to execute, your trades move the market back into fair value faster than you would like. Alpha, when you do find it, tends to be quickly exhausted.

Indeed, the median asset manager doesn’t have much hope for generating significant alpha. The savvy ones opt for the next best thing: maximum diversification. Diversification is the only free lunch in financial markets. And good diversification is all about correlation — you want to own assets that have low or negative correlation with each other. The best large asset managers, like Bridgewater, are hungry for low beta assets — or, more specifically, assets that aren’t correlated with the rest of their portfolio. This is not obvious to inexperienced investors, but a negatively correlated asset can improve the performance of a portfolio from a risk/return perspective even if that asset underperforms on average. You don’t need to bet on Bitcoin appreciating much, if at all, for it to be a valuable part of your portfolio.

This is crypto’s, specifically Bitcoin’s, biggest selling point to institutions: Bitcoin returns are not very correlated with other asset classes. Even without a view on whether Bitcoin will replace Gold, or the Fed, or whatever: smart money is interested in its uncorrelated returns. I predict this will be the primary driver of new money flowing into Bitcoin (and perhaps a few other top coins) over the next 12–24 months.

Source: “J.P. Morgan Perspectives: Decrypting Cryptocurrencies”

Of course, there are plenty of people who believe Bitcoin (and a few others) have a chance at dethroning Gold (and other precious metals) or offshore banking as a safe haven asset. Plenty of people have written about this thesis and it would indeed be a huge deal. The current market capitalization of the entire crypto economy is $250 billion whereas Gold is sitting at $3 trillion and offshore banking represents $20 trillion. In part driven by concern over central bank balance sheets, the more aggressive asset managers (like macro hedge funds) will be making this bet.

There is also the opportunity to make idiosyncratic alpha bets on specific coins, chains, tokens, etc. Currently this is the realm of dedicated crypto hedge funds and VCs. Likely this will stay that way for the foreseeable future.

Finally, securitized tokens. This is still a big unknown and to the extent that they become a Big Thing, the underlying platforms would likely benefit (e.g. Ethereum).

How will they allocate across cryptos?

Some major concerns an institutional investor may have when it comes to adding a new asset class to their portfolio:

  • Staying power — how likely is this to just be a flash in the pan?
  • Custody — how can I get it and hold on to it?
  • Liquidity — how likely are we to get stuck holding the bag when we need to exit?
  • Legal — can we legally put this thing in our fund? any chance we get sued or otherwise screwed?

From this perspective, Bitcoin is likely the best bet. Especially to the extent that an institution is interested in beta, as most other liquid coins are very highly correlated to Bitcoin (with less liquidity).

Source: Sifr Data (note: table also includes SPX = S&P 500, VIX = S&P 500 Volatility Index, GLD = Gold, TNX = 10 year Treasury Note)

Staying Power

From a lindy effect perspective, Bitcoin has the longest track record and the most user support. Some institutions will still allocate along the top few coins to hedge their bets and may even place small speculative allocations on promising new projects that seem to be sufficiently different (e.g. using DAGs or new types of DLT).

Beta is only valuable if you are pretty confident you aren’t taking on substantial negative alpha — if the asset loses most of its value, you’re still screwed.

Custody

Custody and liquidity, the details of how to acquire and hold a crypto asset, are still a mess. Contrary to the ethos of crypto, most institutions will be required to have third party custodians. They won’t be managing their own wallets. While Coinbase, Kingdom Trust, and a few others have institutional offerings (or soon will), most investors will be wary to be one of the early participants. It may take years of “battle testing” before these institutional-grade third party custodians are viewed as reliable and safe.

Liquidity

Even when you’ve figured out a custodial solution, exchange liquidity is still a real problem. While coinmarketcap may show billions a day in BTC volume, any large trader will tell you that it’s still quite expensive to get big trades done without substantial slippage. Standing liquidity in order books is quite low, not to mention issues with moving funds and custodying coin on these exchanges.

Needing to move large amounts of money in/out of something like Coinbase (let alone the less reputable exchanges) is still not convenient compared to what traditional asset managers are used to.

Legal Status

Also, institutions are very concerned about the legal status of the assets they acquire. The biggest concern is that a bunch of these coins, and especially ICO tokens, get classified as unregistered securities sales and the issuers, exchanges, etc. are hit by a wave of lawsuits claiming fraud.

Bitcoin and Ethereum have the least associated legal risk. In March of 2018, a judge ruled that Bitcoin is a commodity. The recent informal SEC guidance suggests they will view Ethereum as a commodity as well.

How will they trade in and out?

ETFs and CEFs

Many institutions will want to hold crypto exposure through a publicly-listed vehicle with relatively low fees: an exchange-traded fund or closed-end fund (like Grayscale’s Bitcoin Investment Trust). One of the few available options is Grayscale’s GBTC but fees could ideally be lower (2%). A bigger problem is it trades at a very high premium to NAV, about 50% as of July 2018, though it has traded as high as a 100% premium.

This indicates the tremendous demand for this sort of product but also makes it unattractive to buy into (at least for now.). An approval of an ETF would be a big help and would probably cause the NAV premium to collapse. The nice thing about enabling crypto ownership through an exchange-traded product is it opens up the playing field to a much wider set of participants: everything from a long/short equity hedge fund to an individual investor with an Interactive Brokers account. In the same vein, the existence of CFTC-approved futures products on major exchanges gives a wide set of participants access to hedging and speculation on Bitcoin prices.

However, the SEC recently postponed ruling on five bitcoin-related exchange-traded funds until September and most sources I’ve spoken with put the odds of approval at 10–15%. Atlantis Asset Management chief investment strategist Michael Cohn said an approval would mean “they’re putting a rubber stamp on [Bitcoin] as an asset, and I don’t think governments want to go there yet.”

Over-the-Counter

For now, most institutional trading is occurring over-the-counter (OTC) between friends, brokers, and trading desks (like Circle and Cumberland). My guess is this is largely because institutions aren’t comfortable transferring millions of dollars to Coinbase or Gemini (let alone their less reputable competitors) — perhaps the credit lines to do so aren’t even in place yet. As the regulatory environment matures, this is likely to change and more volume will occur on exchanges.

As the clearing and credit components get built up, the crypto trading landscape may start to look more like the existing space of Equities or Forex trading. In those worlds, mature infrastructure exists for executing large trades. The name of the game is hiding your hand to reduce slippage. There is a nascent world of players working on this infrastructure in the crypto space, specifically dark pools and order routers/execution algorithms.

Dark Pools

Presumably, many of the major OTC desks are developing, or even already operating, their own dark pools. The basic premise of a dark pool is to allow large traders to execute hidden orders at prices that are relative to a liquid exchange’s (the “lit” venue) — at a midpoint, for example. Lit markets are probably liquid enough for this mechanism to be relatively well-behaved, although perhaps it’s still too soon even for that. There are also efforts like Republic Protocol which aim to create decentralized dark pools. (A deep dive into how it works, and whether it has potential, will have to wait for a separate post. My initial impression is it may face the same hurdles and shortcoming that DEXs are experiencing as compared to their centralized exchange brethren. This may be fatal, even in the long run.)

What about navigating the exchanges themselves? Bitcoin is traded on dozens, if not hundreds, of exchanges. Being unregulated, these vary from fly-by-night operations to semi-mature institutions (with full KYC/AML and high performance matching engines) that may even offer colocation (I believe just Gemini right now). Prices are expected to differ, accounting for all kinds of factors ranging from capital controls (Korea) to risk of capital loss due to potential misrepresentation of financial condition (e.g. WEX at the moment). It’s quite difficult to “arbitrage” between many of these exchanges. Moving capital and coin takes time, and often comes with limitations and high fees.

Source: Coinmarketcap Bitcoin Markets

Order routers and execution algorithms

The traditional solution is smart order routing. Basically, you break up your orders into smaller pieces and spread them across multiple exchanges while accounting for: differing prices (buy low, sell high), liquidity (more is better), fees (we don’t like ‘em), and latency/likelihood of execution (high latency = bad; more uncertainty over getting filled).

There are a few players providing, or at least enabling something like, these services in crypto trading today: SFOX, Coinigy, CoinRoutes, and TradeBlock.

Some of these like SFOX and CoinRoutes are custodial — they hold your capital and use their own accounts at the various exchanges to provide quick execution. (Although, they seem to be doing something with DEX clients that I haven’t fully thought through to comment on). Others, like Coinigy, are just giving you API wrappers with a unified user interface, which means you need to have your own accounts at the various exchanges and move money back and forth as necessary. Finally, OmegaOne is a promising project looking to bring dark pool matching and order routing together in a non-custodial on-chain (with bank integration) mechanism.

Update: After reviewing how CoinRoutes works, I’ve realized it’s actually not custodial. It works more like a Coinigy model + consolidated order book — you’ll need to maintain accounts with the various exchanges, as well as capital there as necessary.

In addition to routing your orders more intelligently, traditional players (especially in equities trading) will leverage buy-side execution algorithms to reduce slippage and hide their intention to make large trades. Execution algos apply more complicated logic than just placing a limit or market order. Simple examples include VWAP (volume-weighted average price) and TWAP (time-weighted average price) which execute orders to keep pace with market activity or evenly over time (respectively).

There’s a whole world around adding pricing and trading logic to improve execution — and it really does add value, especially when making larger trades. Currently, SFOX is the main player that I can see providing algos, though I expect this to change over time.

Currently, the market may simply still be immature for an ecosystem of order routers and execution algos. Exchange liquidity is still very low compared to what you can get OTC, and will likely remain that way until clearing and credit systems are in place.

What are the Potential Pitfalls?

There are a few potential pitfalls when it comes to executing institutional-scale crypto trades.

Exchanges are risky, unregulated, and vertically integrated monoliths

In the traditional financial world, trading venues handle matching and typically provide central clearing and settlement. Exchanges then face off with clearing firms or prime brokers, who then interact with brokers and traders. These intermediaries aren’t just rent-seekers — they provide value. Contrast this with Coinbase who serves as both exchange, custodian, and broker. The crypto exchanges would benefit from taking some time to understand how the traditional trading world is designed rather than potentially assuming that a one-stop shop is the best structure for the market.

For example, imagine a world where clearing firms stood between traders and exchanges. Rather than the exchanges controlling all of the coin in their exchange wallet, they would rely on clearing firms to settle coin and cash balances within some period of time (e.g. within 24 hours). This allows clearing firms to extend credit to their traders across exchanges — arbitrageurs could buy BTC on Coinbase Pro and immediately sell it on Gemini and not worry about moving coin or cash.

OTC trading costs are high

That world is still a ways out, if it ever comes. For now, big trades will continue to occur over-the-counter. OTC is generally expensive — all-in cost of 2–5% is not unusual. In return, you can be more confident that you will get the coins (or cash, if you’re selling) quickly and securely.

Coin provenance is often unknown

Finally, one thing to consider is the provenance of your coins. Specifically, there is anti-money launder (AML) concern over taking possession of coins “tainted” by known criminal activity. If part of a coin you own has passed through the wallet address associated with money laundering or coin theft, you may have a hard time selling it in the future. This is a wide ranging topic that may be the elephant in the room for many crypto investors. A safe, but perhaps extreme, solution is to buy directly from miners that you can personally check for AML risk.

Conclusion

Many traditional asset managers want to get exposure to cryptoassets because returns are not correlated with other asset classes, thereby allowing them to improve the performance of a portfolio from a risk/return perspective (even if cryptoassets underperform). Others believe that Bitcoin (and perhaps a few others) have a chance at dethroning Gold and other precious metals as a safe haven asset.

Concerns over staying power, custodianship, liquidity, and legal risk will drive traditional asset managers to concentrate investments in Bitcoin, Ethereum and perhaps a couple other coins.

Trading in and out of crypto can be done through CEFs/investment trusts, and eventually ETFs, though they currently trade at significant premiums to NAV. For asset managers comfortable with custodying their own funds, OTC is the most popular option though all-in execution cost can reach 5%+. Dark pools, order routers and execution algorithms may offer better solutions in the future, though the market may still be too immature.

Finally, traditional asset managers must navigate the potential pitfalls of integrated exchanges, and unknown coin provenance.

Want to chat?

Lately, my good friend Taylor Pearson and I have been exploring the crypto space with the intent of building a company. One remark we’ve heard over and over is how inscrutable crypto investing is, even from the perspective of a professional asset manager. It’s still too difficult for even a savvy portfolio manager to get exposure to cryptocurrency. In this article, we’ve outlined what we see as the primary reasons why. We want to make it safe, easy, and low cost for anyone to diversify their investment portfolio with cryptocurrencies. As a first step, we are exploring helping accredited investors get crypto exposure through a very low fee fund. For more information, please reach out to us at Simple Coin Capital.

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