The Crypto Traded Index™

In the earlier post we discussed why CTI can be advantageous from a cost standpoint compared to home-made diversification. Today we are discussing the mechanics of the instrument itself. Sharpen your pencils, dust off your notebooks, some more educational content is about to follow.

Much like its traditional counterpart, an Exchange Traded Fund, a CTI is intended to closely track its benchmark index. It can be traded at, or very close to its true value on the market, carries low fees, is automatically rebalanced along with the index itself and overall provides low-cost market-wide diversification.

Background

The idea about passive investing is old. Starting with academic authors such as Modigliani, Miller and continued with Fama and French, the idea of Efficient Markets was born: a preposition that an investor, on average, cannot beat the market, and is therefore better off to diversify his or her money across all available assets and refrain from frequent trading.

If your combined positions achieved a 50% return in the past year, but the overall market returned 100%, you are effectively losing money. There is a large body of research showing that frequent traders are notoriously bad in the market, on average losing money even before the fees. Cryptocurrency trading has very low fees compared to traditional financial instruments, these can, however, quickly accumulate when trading frequently. Moreover, an average investor is neither diversified, nor is hedging his or her position through some instrument. Non-diversification can have disastrous effect. Take, for example, now infamous DAO tokens, which promised a lot, for a while it looked like they will deliver, and then suddenly their value evaporated. An investor, who held all his or her money in DAO instead of diversifying it across the market, is now probably living under a bridge.

Properties

A Crypto Traded Index is a hybrid instrument, combining properties of traditional vehicles, such as redemption at the Net Asset Value (theoretical value of the underlying portfolio) typical for open-ended funds with the tradability of the units (not necessarily at the NAV, but normally with a significant discount or premium) common for close-ended funds, and usually tracks a market-wide index. Like its traditional counterpart, an ETF, a CTI combines best of both worlds: the units can be bought and sold at any time, for the value at or very close to the actual value of the benchmarked portfolio.

Mechanics

Small traders are able to buy and sell the CTI units from other traders like any other asset on exchanges. This property mirrors the tradability of close-ended funds and is by itself nothing extraordinary, and does not guarantee that a trader can buy and sell at the value that is at the NAV or very close to it. This is where authorized participants come into the picture. Authorized participants (large third-party institutions) can buy and redeem CTI units in large blocks directly from the issuer in kind, i.e. for the basket of underlying cryptocurrencies that the index, which the CTI is benchmarked to, tracks. This arbitrage mechanism ensures that the CTI units’ market price closely follows its Net Asset Value. Should the price of the CTI unit grow above the NAV, the authorized participant can deliver the basket of currencies, receive the CTI units and sell them in the market and vice versa. Investors are therefore protected from any significant discrepancies between the unit price and the NAV. The large institution engaging in this kind of arbitrage is rewarded with riskless profit; other CTI traders benefit from the price, which at all times closely follows the actual portfolio value.

Fees

This hybrid structure is the reason why CTIs are the cheapest passive investment vehicle available. The issuer does not need to hold cash on hand to redeem the units because they are freely tradable. The authorized participant takes care of the arbitraging away any discrepancies, and is rewarded for his or her activity with a riskless profit. In a sense, the authorized participant makes the issuer’s job a lot easier, which is why the management fees are low, and acceptable returns are achieved through economies of scale.

Shorting

Shorting is in essence betting against the market — i.e. profiting from the price decrease, and losing money when the price rises. Shorting still follows basic investment logic — buy low, sell high, however, the sequence is reversed. First you sell high, wait for the price to fall, after which you buy low.

To be able to do this, you need to borrow the assets you want to short — at a cost. The interest rate you pay for the privilege to be able to borrow the assets reflects the riskiness of lending directly to you, and the opportunity cost of not having the asset on hand if a more profitable investment opportunity arises.

Shorting can be very profitable if you think that the market is about to crash. Such large swings in a short period of time make this procedure very attractive. Obviously, the more time you hold the short position open, the more you will pay in interest for borrowing the assets that you are shorting in the first place. However, in a volatile market such as crypto with swings ± 25% in a single day not uncommon, shorting can be very profitable strategy if executed the right way. The marking-to-market and automatic liquidation minimizes the risk of unlimited losses.

Margot Robbie from The Big Short explains shorting probably better than we ever could. The concept refers to the Credit Default Swaps in this particular case, but is educational to watch nevertheless.

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