March 13, 2024

Insights and analysis for the professional investor

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Welcome to Crypto Long & Short!

This week, Connor Farley, CEO of Truvius, argues that relying too heavily on Bitcoin in your crypto portfolio may be unwise in the long-term.

Then, Phillip Moran, CEO of the Digital Opportunities Group, says that prime brokerages are likely a big source of new capital for crypto this cycle. The involvement of these players in the markets comes with risks.

As always, get the latest crypto news and data from CoinDeskMarkets.com.

– Benjamin Schiller, head of opinion and features at CoinDesk

From the Analyst

Why Diversification Matters for Crypto, Too

Long-standing and generally accepted financial theory shows that diversification is not only good, but improves expected returns per unit of risk. Unfortunately, the crypto space currently seems to be overlooking this principle.

A "TradFi" Equivalent

A timely post from the quantitative asset management firm AQR provides a direct "TradFi" equivalent to the problem of under-diversification. In the post, AQR co-founder and CIO Cliff Asness rebuffs a recent paper that effectively poses the question, "Why not 100% equities?" — a style of thinking that tends to resurface during bull markets.

The blog recounts certain tenets of introductory financial theory, largely amounting to "owning one asset is suboptimal":

"In finance 101 we are taught that in general we should separate the choice of 1) what is the best return-for-risk portfolio?, and 2) what risk we should take? This new paper, and many like it, confuse the two. If the best return-for-risk portfolio doesn't have enough expected return for you, then you lever it (within reason). If it has too much risk for you, you de-lever it with cash. Remarkably this has been shown to work."

Asness harkens back to the basics of modern portfolio theory to show that you can own a single asset, but don't expect that one asset to outperform a portfolio of diversified (i.e., not perfectly correlated) assets on a risk-adjusted basis.

Does Diversification Matter for Crypto?

Crypto investors should ask themselves a similar question: why not 100% Bitcoin?

Given Bitcoin's outsized media attention, market commentators often still equate "crypto" with "Bitcoin." The approval of spot bitcoin ETFs may be an important first step toward broad-based investor adoption, but a conspicuous departure from the golden rule of diversification has emerged.

Let's examine four hypothetical crypto portfolios going back to 2018: Bitcoin Only and Ethereum Only (no diversification), an equal-weighted allocation to Bitcoin and Ethereum (a little diversification), and a passively weighted portfolio of the top 10 non-stablecoin assets in any given month (better diversification).

The bottom line: diversification matters for crypto.

The Bitcoin Only and Ethereum Only portfolios produced highly similar annualized returns of about ~30%, but Ethereum Only exhibited higher volatility, resulting in worse risk-adjusted performance compared to Bitcoin. Annualized returns of this magnitude may satisfy "Bitcoin Bulls" and "Ethereum Maximalists," but could investors construct more efficient portfolios? Yes.

By combining Bitcoin and Ethereum in a simple equal-weighted basket of the two assets, we observe notably improved risk-adjusted returns. Compared to Bitcoin Only, the annualized risk increases somewhat but the increase in return is greater than the increase in volatility, resulting in superior risk-adjusted performance. If the slight increase in risk vs. Bitcoin Only wasn't acceptable to an investor, the investor could hold some cash alongside the portfolio to dampen volatility while still achieving better returns.

Adding more assets to the portfolio improved risk-adjusted returns even further. With a passively weighted, monthly rebalanced portfolio of the top-10 assets by circulating market capitalization, annualized volatility effectively remained constant compared to the equal-weighted BTC-ETH portfolio, while annualized returns increased meaningfully.

Broadening the digital asset universe to better capture the value proposition of differentiated blockchain technologies improved the portfolio's risk-adjusted return characteristics.

Conclusion

Despite crypto's brief and volatile history, recent evidence suggests what traditional markets have repeatedly demonstrated: owning a single asset delivers worse risk-adjusted returns over the long-term compared to a portfolio of diversified assets.

- Connor Farley, CEO of Truvius

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Institutional Outlook

Why Prime Brokers Could Be a Source of Crypto Contagion

Digital asset markets have been vibrant recently, and this has been a great respite after almost two years of crypto winter. I do not want to throw a wet towel on current sentiment, but it is good to remember that the seeds of the next crash are often sown during the good times.

Because risk management is the primary job of all portfolio managers, here I want to opine on one potential scenario if this bull market continues for another 18-plus months.

Here is why I think the potential nexus for future contagion could be prime brokers (PBs).

Why? Because 1) PBs are emerging as a major player and lender in crypto markets and2) The current lending standards of PBs are tight, largely lending to low drawdown strategies (like delta-neutral), and presents low systemic risk. But, 3), if expected returns of delta-neutral strategies decline, then PBs may move out the risk curve in terms of who they are willing to lend to and what services they offer, which could brew systemic risk.

During the last bullish cycle, lenders increased the violence of the implosions that we witnessed. Leverage was hidden across a network of entities (BlockFi, Voyager, etc.), with concentration at certain nodes (3AC, Alameda). The lenders of the old-world are largely gone, but there is a new source of liquidity: prime brokers (PBs).

Currently, PBs generate most of their revenues through 1) trading revenues from market access, and 2) lending revenues from lending, typically to delta-neutral strategies.

Funding arbitrage is a strategy which benefits from market demand to go long via derivatives. This exploits the funding interest rates paid out from perpetual swaps (a crypto derivative product) by going long on spot and short perpetual swaps (or vice versa). This generates attractive yields and exploits market demand to go levered long, while not exposing the strategy to directional market moves. If the strategy is implemented well, the risk is very low, which makes it a popular strategy for PBs to lend to.

While funding rates are currently elevated from recent upside price action, I believe it is reasonable to expect the returns to come down as more money flows into these lower-risk strategies. With returns declining in funding arbitrage, we will likely see returns in other lower risk strategies fall. If expected returns decline below the borrow cost from PB loans, then the PBs will be forced to make the decision to move out the risk spectrum or reconsider their product offerings.

What could this apocalyptic future fueled by crypto PB collapse look like? What could it be fueled by?

Here are a couple ideas:

Further aggregation of liquidity through PBs: Increasing volume requirements for better fee tiers at centralized exchanges, like Binance and OKX, will push most traders to access the market through PBs instead of their own master accounts.

Synthetics, swaps, other derivatives: If trading directly on exchange becomes restricted (either due to the exchanges themselves limiting direct access, or the PBs limiting access), this may create a market of derivatives for traders where the PB will clear the other side (usually this is a swap mechanism). This opens the door for accounting issues, or leverage shenanigans.

We should enjoy the good times while they are here, while also considering future disaster scenarios. Stay safe out there, everyone.

- Phillip Moran, CEO of the Digital Opportunities Group

Takeaways

From CoinDesk Deputy Editor-in-Chief Nick Baker, here is some news worth reading:

DREAMING BIG: I probably don't have to remind you that, not long ago, things were looking awfully grim in crypto. Prices were crashing, companies were broke, funding had dried up and on and on. Additionally, I probably don't have to remind you that, today, things are looking awfully bright. Bitcoin (BTC) just hit a record high above $73,000, but people are thinking much bigger than that. Take, for instance, the derivatives market, where, suddenly, BTC call options with a $200,000 strike price are hot. As CoinDesk's Omkar Godbole notes in his coverage, this is likely in part driven by expectations April's bitcoin halving will reduce bitcoin supply already drained by the wildly successful launch of spot ETFs. And we all recall what basic economics classes taught us about what happens to prices when brisk demand slams into shrinking supply. Future textbooks maybe should use the early 2024 crypto market as a nice, clear illustration of that.
SAYLOR ON GOLD: Speaking of bitcoin buyers gobbling up limited supply, Michael Saylor is also suddenly hot again. After bitcoin crashed post-2021, his massive bet on BTC was criticized by some – though he never wavered. Now that bitcoin is at record highs, his views are in demand again. After his company, MicroStrategy, revealed it'd bought 12,000 more bitcoin, he appeared on CNBC to discuss his favorite cryptocurrency. "It's going to eat gold," he said of BTC. "It's got all of the great attributes of gold, and it's got none of the defects of gold." If he's right, that's possibly many trillions of dollars worth of upside for crypto investors.

Want more? For the latest news affecting the crypto markets, listen to CoinDesk's Markets Daily podcast.