Vladimir Jelisavcic & Bill Xing
October 24, 2018
Blockchain technology has changed the way investors hold and trade their financial assets enabling a much higher degree of investor control. This control empowers investors and changes their relationship with advisors, exchanges, and custodians. Investors are increasingly turning to automated advisors and cloud-based services to manage their cryptocurrency assets.
Investors holding traditional assets have been attracted to financial supermarkets like Vanguard or Fidelity that offer brokerage, cash management, payments and other services. One reason for this is that traditional assets require a third-party custodian, and switching custodians is difficult and time-consuming. The inefficiency of custody is used to retain customer assets. For example, it is usually not possible for individuals to execute trades with one broker and have those trades settle in their account with another broker.
Moving traditional financial assets (e.g., AAPL stock) from one broker to another broker is a lengthy process. The ACATS system (Automated Customer Account Transfer Service, developed in 1985 by the National Securities Clearing Corp.) is initiated when the new receiving firm has the client sign the appropriate transfer documents. Once the document is received in good order, the receiving firm submits a request using the client’s account number and sends it to the delivering firm. If the information matches between both the delivering firm and the receiving firm, the ACATS process can begin. The process often takes the better part of two weeks to complete. Moving Bitcoin or any other cryptocurrency is faster and smoother by orders of magnitude. When people can do something cheaper, they will do more of it — ICOs proliferated in 2017, in part because writing smart contracts on Ethereum costs so little.
The inefficiency of custody gives institutions that control custody the ability to keep clients loyal by offering them the “one stop shopping”. Using blockchain technology, investors can self-custody digital currencies by using a digital wallet. The control over custody enables investors to select individual service providers. In this way financial services can be unbundled allowing investors to use only the services they need from the service providers they choose. This unbundling will extend to fund management. Investors don’t need a fund entity to hold assets, they can just build a portfolio of digital currencies that they hold directly.
To give us a framework for organizing our thoughts, we believe that the following principles of investor empowerment should provide guidance:
1. Control Portfolio Building
➔ build your own portfolio based on criteria you choose
➔ this includes selecting from an array of pre-set portfolios
2. Control Trade Execution
➔ trade with the exchange, or exchanges that you choose, independent of the wallet host
➔ be able to use order routing algos to find the best price
3. Control Custody
➔ be able to freely move Digital Currency to any other wallet
➔ keep Digital Currency in your wallet, hosted wallet, or exchange
4. Control all assets created from your Digital Currency
➔ all forked coins and tokens are the property of the investor
Empowered investors have a higher degree of control over their assets. Automated portfolio building lowers asset management fees because there are fewer layers of intermediaries and custodians. Portfolio transactions that are executed on an exchange can be left in the custody of the exchange, or investors can withdraw their entire portfolio from the exchange and hold their portfolio in their own wallets. Investors’ decision making depends heavily on transaction costs in the real world. API technology lowers costs and enables automated transactions controlled by software tools.
We classify two types of automation services as follows:
· Automated portfolio builders (manage a portfolio directly without a fund intermediary)
· Trading bots (signal-based trading)
Automated portfolio builders fall into two categories, captive or independent. Although the architecture of blockchains allows an individual to control a digital currency with a secret key (which can be written down on paper), the large majority of investors prefer a hosted wallet, such as Circle, or Coinbase for its convenience and array of applications. One application that is offered by hosted wallet providers is a captive portfolio builder.
The key aspect of captive portfolio builders is that investors are buying and selling digital currencies from the wallet host. See Table 1 on last page for a comparison of captive portfolio builders. The wallet host is earning an undisclosed (i.e., large) trading spread, and there is no assurance that their prices are the best available (hint, probably not). “When you buy Digital Currency using your Invest Account you are buying directly from Circle … and … Circle establishes the conversion rate for buying Digital Currency … Circle may add a margin or “spread” to the applicable conversion rate.” Circle also holds your coins captive: “You acknowledge that when you hold Digital Currency in your Invest Account your only means of selling Digital Currency is to sell it directly to Circle at the then current Conversion Rate, regardless of whether or not the Conversion Rate is less favorable than that of other platforms that allow for the buying or selling of Digital Currency.” This is worse than a traditional brokerage account! At least the SEC requires securities brokers to seek the best execution reasonably available for their customer’s order.
Coinbase takes three different fees; 1) Coinbase exchange rate (most likely inflated), 2) a spread of 0.5%, plus 3) a commission of 1.4%. “The price you pay on Coinbase Consumer to purchase or sell Digital Currency is determined by (1) (a) the market exchange rate on Coinbase’s trading platform for that Digital Currency, multiplied by (b) a spread, or surcharge (a “Spread”), of 50 basis points (0.50%) above the market exchange rate, calculated at the time we quote a price to you (the “Quoted Spread,” together with Coinbase’s trading platform exchange rate, the “Consumer Exchange Rate”), plus (2) a commission that is either a flat fee or a percentage of the transaction, depending on the payment method and amount you are purchasing (noted as the “Coinbase Fee” on the Buy/Sell page of Coinbase.com).”
The convenience and slick user interface of Circle comes at a cost, “Circle Invest does not currently support sending Digital Currency to external wallets or receiving Digital Currency from external wallets”. This means that your portfolio is not really portable. This limits some of the best characteristics of Digital Currencies and makes the Circle wallet work like a traditional brokerage account. Unlike Circle, Coinbase does allow for deposits and withdrawals of Digital Currency. We believe Coinbase is able to offer Digital Currency deposits and withdrawals because of its superior security technology.
Another unique aspect of a Digital Currency is that if it is forked (i.e., the software is copied), owners can retain their original Digital Currency, plus they also own the new forked Digital Currency. For example, in August 2017, holders of BTC (Bitcoin), received new BCH (Bitcoin cash) coins, in addition to being able to retain their old BTC. Some hosted wallets don’t allow investors to receive assets created as a result of a fork. “Circle Invest does not support any other Digital Currencies, tokens, coins or forked protocols…”
Trading bots, as the name indicates, are trading automation programs which can run non-stop, twenty-four hours a day, seven days a week. It is significant in cryptocurrency trading because the crypto market trades continuously on several exchanges across different time zones.
At the end of the day, both portfolio automation tools and trading bots are just computer programs. Generally speaking, they are designed for different purposes, the latter focuses on trading while the former examines investment practices.
To better understand what trading bots do, let’s analyze them from two high-level perspectives:
1. Trading Bots Strategy
· Pure arbitrage bots
‘Buy low and sell high’, these types of bots are able to fulfill this simple but powerful idea by scanning across different trading venues and finding arbitrage opportunities. Pure arbitrage bots rely heavily on the system robustness and need to be as fast as possible during the trading execution. Due to its simple nature as well as low barriers to entry, these trading bots are very competitive, and their margin is pretty low, most of the time.
· Market making bots
These types of bots are much more sophisticated than the ones in the first category. They generate profits out of the bid-ask spread with statistical methods and require good risk control over inventory. Usually, there needs to be some monitoring for these bots, since the crypto market can be very volatile.
· Technical indicators-based bots
This type is probably the most popular one. Day traders love charting, and they believe in technical analysis (e.g., Moving Average & Relative Strength Index). However, it’s not easy to implement all the trading ideas manually. People need to sleep while the market is still active and running, and the manual trading is pretty slow. That’s where technical indicators-based bots come into a play.
2. Open-source Trading Bots vs. Commercial Trading Bots
It’s easy to recognize the difference between open-source and commercial trading bots: the open-source bots are free of charge while the commercial ones are paid. However, it’s important to realize that they are designed for two different audiences.
Open-source bots, such as ZenBot, are designed for computer geeks who have general computer science knowledge and at least know what a terminal is. Normal users are always frightened by lengthy and complicated codes and tend to choose the commercial bots, which always come with a user-friendly interface, and sometimes customer support.
We are advocating independent portfolio builders where the investor uses independent software tools to build a portfolio. Investors should be able to easily build customized portfolios according to their own criteria, in addition to being able to choose from an advisor’s existing portfolios. Investors need powerful, institutional grade analytics to be able to analyze and stress test portfolios that they create or choose.
To enable portfolio automation, investors must provide the software with access to each investor’s trade-only API keys. Trade-only API keys give the keyholder the ability to buy and sell digital currency, but not withdraw digital currency from an exchange. As a result of this control, security is critical. We believe that leaving API trading keys in the investor’s local browser is the best approach.
Also, the settlement and transfer of digital assets are much smoother and faster than that of traditional assets. With the help of automation software, investors can easily decide when to enter or exit the market. These decisions can be implemented with one click of a button, ensuring better strategy execution.
We also believe that it is in the best interests of the investor to separate management and analytics from execution. This is especially true in the unregulated world of digital assets where exchanges can have opaque practices and proprietary trading firms exploit their detailed knowledge of markets. Many firms that integrate management and execution do not disclose fees and trading profits. This can lead to investors making poor choices and underperforming investable indexes.
In the world of digital assets custody can be separated from securities selection, analytics and execution. This enables subscription fee-based business models, rather than fees based on assets under management typical of traditional financial services. The implications of this new structure are significant. Investors will pay lower fees and benefit from increased customization through the disintermediation of several layers of traditional asset management.
Panda Analytics, Inc.
 Circle Invest User Agreement, last updated March 13, 2018,
 The New Physics of Financial Services, World Economic Forum, August 2018 http://www3.weforum.org/docs/WEF_New_Physics_of_Financial_Services.pdf
 Pending broker dealer registration. https://support.coinbase.com/customer/en/portal/articles/1496488-taxes-faq
 Will be provided to certain businesses and GDAX customers that have received at least $20,000 cash for sales of digital currency. https://cointelegraph.com/news/coinbase-acquires-financial-services-firm-to-become-sec-regulated-broker-dealer