What is the Optimal Exposure to Blockchain Assets?
$10,000 in Bitcoin purchased and held on the day 1 opened (the day before the all time high bitcoin price in December 2017) would today be worth ~$2800 (as of May 2019).
If you had put that same $10k into Protos’ top performing trading strategy, Trend Index, our quant strategy that moves long/short as the values of each of the top 40 blockchain assets rise and fall, your $10k would today be $14,800 (as of May 2019).
Fund 1 traded six different quantitative strategies during the bear market, with varying results. Our overall fund returns would mean $10,000 invested in it the day after all time bitcoin high is today $6,100 (as of May 2019), which is well ahead of a simple Bitcoin investment.
The strategy described in this post takes our learnings and aims to combine trend-following plus a set of absolute return strategies as the optimal exposure to the market.
Some of the top performing crypto funds experienced similar returns to Protos during the bear market. We have all heard stories of traders who sold 100% of their assets at the top of the last market cycle. This article proposes strategies that will provide optimal risk adjusted returns over multi-year term with both up and down cycles. Trend-following provides a simple mechanism to select the top and bottom of the market cycle and has been proven to work well, but of course not perfectly.
We argue buying Bitcoin and just hodling is not the best way to be exposed to crypto. Not everyone can have their funds managed by an actively traded quant fund, but everyone can read about trading strategies. We think this is the best book written on trading strategies.
What is optimal?
Perfectly Optimal Exposure “OE” is a theoretical best outcome scenario we can use as a target to aim for. Currently Optimal “CO” is what we believe is what’s possible to get today, which is always improving.
Optimal Exposure
- Capture all gains, avoid all losses
- Earn “market neutral” returns that come in addition to price appreciation of your assets
- Your assets are held in bank custody
1. Capture all gains, avoid all losses
Over the past year, Protos deployed six strategies to be exposed to cryptocurrency markets. We shared them publicly here.
We settled on our leading strategy, Trend Index, and will be heavily trading it going forward.
The trend-following index aims to participate in bull markets, while dramatically reducing the down-side in bear markets. It can be applied to any number of assets where liquidity is available and where long/short positions can be opened.
Protos systematic crypto trading strategies:
Trend Index, derived from trend following strategies, is a strategy considered as one of the main strategies underlying the largest hedge fund class, Commodity Trading Advisors, CTAs. Originally CTAs came from commodity trading. Trend uses Time series momentum, a simple trend-following strategy that goes long a market when it has experienced a positive excess return over a certain look-back horizon, and goes short otherwise.
Trend let’s you move closer to capturing gains while avoiding losses, which leaves you with nearly optimal exposure to the long term trends of the markets.
CTAs also apply another interesting feature to manage their cash. Since the markets are usually traded using futures, the fund is sitting on 100% of cash or cash collateral. This cash is usually invested into bond markets to generate risk free returns.
The cryptocurrency markets have evolved to the point where it is easily possible to replicate strategies like trend-following using futures. Since you only have to fund 10–20% (for margin requirements) of the actual trading, what shall you do with the cash? You can add yield to your holdings in the following ways.
2. Earn “market neutral” returns that come in addition to price appreciation of your assets
Most probably you want to invest your free cash into risk-free or arbitrage type of strategies. Arbitrage strategies are interesting, because they generate risk free returns. Since cryptocurrency markets are inefficient, arbitrage opportunities are much more available than in traditional markets. Also the arbitrage opportunities have much higher yields.
Arbitrage opportunities
Arbitrage strategies are designed and intended to generate absolute return, that is independent of cryptocurrency market prices. Hence the strategies intend to collect yields from financial frictions, by taking long positions in cryptocurrencies that may generate a yield while taking a short position in future markets with equal exposure to the asset.
There are numerous new arbitrage opportunities emerging in cryptocurrency markets. Below are four attractive options:
- Mining Arbitrage: Collecting yield by structuring bitcoin mining revenues
- Exchange Arbitrage: Collecting yield by exploiting price differences of the same asset across exchanges
- Lending Arbitrage: Collecting yield by engaging in cryptocurrency lending
- Venture Mining: Collecting yield by staking and governing on POS networks
Mining-Arbitrage: Mining is the way a blockchain pays for participants to maintain its records and integrity. Miners are paid for their services in the blockchains own currency. Efficient miners can produce cryptocurrencies below the price at which they trade on exchanges. Mining-Arbitrage seeks to collect the excess return (about 5% per month) by hedging against the market risk of the individual cryptocurrency.
Lending-Arbitrage: Cryptocurrency lending platforms work by connecting borrowers of Crypto Assets to a network of registered lenders on the platform. The lending of Crypto Assets generates a yield (about 2% per month) in return for providing liquidity. Lending-Arbitrage isolates this yield by hedging the market exposure of the respective assets.
Venture-Mining: Venture mining is a new way to earn cryptocurrencies. Instead of providing hardware to maintain the networks, these networks reward actual participation in the system. Participants are rewarded a fee (about 3% per month) for maintaining the records and integrity within the cryptocurrency networks. This fee is paid in cryptocurrencies and has to be sold through exchanges. Hedging is not required as the strategy does not maintain a market exposure.
Exchange-Arbitrage: Exchange arbitrage is exploiting price differences in cryptocurrencies between different exchanges. The price difference can be collected by simultaneously buying cryptocurrencies on the cheap exchange and selling on the expensive exchange (about 4% per month). For this trade, fiat and cryptocurrencies have to be transferred and maintained at different exchanges and the overall market exposure is hedged.
3. Your assets are held in bank custody
From the very beginning Protos used external custodians like banks (at a time when many funds ‘internally’ custodied their clients’ assets). With external custodians, Protos does not hold any crypto assets itself, but a bank or broker does that for us. The downside of using custodians are costs. Although the costs were much higher in the past (>1% per year), they are decreasing fast toward traditional bank custody (<0.1 per year).
Summary
The trend-following strategy was very successful in managing the sell-off in crypto markets and is participating well in the recent recovery. This strategy aims to participate in bull markets, but dramatically reduce the downside risk.
The trend-following strategy can be replicated using future markets on the largest cryptocurrencies. Therefore the trend-following also has the advantage of holding mostly cash in the portfolio.
This cash can be invested in risk-free assets like US T-bills, but also in arbitrage opportunities in cryptocurrency markets. We have identified at least four arbitrage opportunities that can yield between 20–40% per year. To replicate the original idea of CTAs in cryptocurrencies, it seems logical to combine the arbitrage opportunities to manage the cash and use the trend-following strategy to manage exposure to the cryptocurrency market.
We believe these strategies will serve us well, in good times and like this past year, even in bad.
About Protos: Protos is a systematic hedge fund manager trading portfolios of blockchain assets based in Switzerland. Protos was founded by Thomas Kineshanko, Dr. Philipp Kallerhoff, and Matthew Shaw who have been actively investing in and trading crypto assets since 2013 and have extensive careers in banking and quantitative asset management. www.protosmanagment.com.
