Everyone Loves A Winner & Cryptocurrencies Are Winning Again
With the steady rise in cryptocurrency values in 2019, 2020 was a promising year for institutional interest in the nascent digital asset class. As prices of cryptocurrencies have risen, so has interest in investment.
When Adam Derschowitz was seven, he learned some hard lessons from his father, lessons which he could not understand at the time.
Derschowitz senior was a middle manager at a large oil services company located along the long oil-laden Gulf of Mexico but before that, he was a pro-football player for the now defunct Houston Oilers.
Derschowitz senior had been on the precipice of both sporting and financial glory before he was plagued by a series of injuries that saw him eventually sidelined and dropped.
Relegated to the drudgery of corporate middle management Derschowitz knew firsthand what it was like to be forgotten.
So when Derschowitz’s only son, Adam, showed some talent at football from a young age, the elder Derschowitz pushed his son in a manner that only someone with experience in professional sports could — hard and relentless.
And over time Adam started to resent his father for the constant browbeating, drubbings and strict adherence to discipline and schedule.
After a particularly grueling training session one day, the seven-year-old Adam, his body bruised and battered, choking back his tears, asked his father why he was so hard on him.
“Because this world only rewards winners. It only pays attention to winners. I could lie to you and tell you that it’s fair. It’s not.”
“People only care when you’re winning, they don’t care what you had to to do to get there. The sooner you learn this lesson, the better.”
Spring Thaw For A Crypto Winter
Which is why the present seems to be crypto’s moment again — because it’s winning.
While financial institutions were quite content to dance around digital assets over the last few years, put off by reputational risks, a lack of regulation and volatile returns — a spell of consistently better performance is piquing their interest in cryptocurrencies yet again.
Cryptocurrency funds dedicated to digital assets returned over 16% on average last year, according to a survey from Eurekahedge, versus traditional hedge fund strategies which delivered 10.4%, according to data from HFR.
To be sure, there were outliers in terms of performance across the board and averages can be misleading. But considering that cryptocurrency hedge funds focusing purely on digital assets deal in some of the most volatile assets on the planet, their returns far outshadowed those of their more traditional brethren, for which a far greater variety of risk-management tools exist.
And because Bitcoin now has a longer trading track record than say perhaps in 2017, it has consistently demonstrated a higher return on time horizons from 1 year to 10-years compared with any other asset class.
Yet these stellar results have not pushed financial institutions to jump in head first into digital assets — in particular because they’ve been here before and gotten burned.
Been There Done That Bought The Bitcoin
During the initial rush into cryptocurrencies in 2017, a move which saw Bitcoin rocket to over US$20,000, a plethora of banks launched projects to explore applications for Bitcoin’s underlying technology, blockchain as well as set up exploratory teams to investigate if eventual trading desks could be constructed around these nascent digital assets.
And while many of these initial projects stalled after the cryptocurrency crash of 2018, some such as JPMorgan’s JPM Coin persisted — JPM Coin allows blockchain-based internal payments between the bank’s clients — no financial institution has yet to set up a dedicated desk to trade cryptocurrencies on behalf of clients.
The reticence by legacy financial institutions to trade digital assets for clients led to a gap in the market, one that was quickly filled up by startup cryptocurrency hedge funds.
But these startup cryptocurrency hedge funds were faced with their own challenges — low levels of assets under management (AUM), forced founders to stump up many of the high hedge fund startup costs and the lack of adequate service providers proved just as challenging when trying to raise AUM.
Difficulties with procuring professional and financial services exacerbated the problem as well — access to fund administrators as well as auditors and accountants, who had yet to fully discover how to mark-to-market the nascent digital assets made the job of fledgling cryptocurrency hedge funds that much more tricky.
Then there was the issue of the undeveloped custody industry for cryptocurrencies as well — one which has seen a patchwork of solutions which till this day are evolving, but none of which are entirely satisfactory.
Not Ready Yet
To say that the piping to facilitate large scale adoption of cryptocurrency trading by financial institutions has been laid is premature, but it is certainly developing.
And as prices of cryptocurrencies rise, the plumbing that supports the traditional fund management industry has also risen to support this novel asset class.
According to one fund manager of a traditional hedge fund based in Hong Kong, which is exploring digital assets,
“What we’re seeing is increased client awareness that these assets can’t be pigeonholed to using the same set of services that we’re used to.”
“New assets call for new infrastructure.”
Already, new digital asset lending startups and those established by cryptocurrency mining rig manufacturing companies such as Bitmain, Ebang and Canaan have already moved into the emerging digital asset financial services space, offering a suite of products more commonly associated with Wall Street then Silicon Valley.
“We’re seeing crypto lending, crypto custody and perhaps eventually, the advent of the custodial service offerings found in financial markets — so that traders and investors need no longer site their digital assets with crypto exchanges, but can leverage custodized assets.”
And legacy financial institutions are taking notice, especially as digital assets start creeping into the traditional asset space.
A Deutsche Bank report published last month, noted that cryptocurrencies have “numerous advantages compared to traditional assets, which could lead more and more people to use (them).”
The German bank went even further, adding that plans by the People’s Bank of China, the Chinese central bank to issue its own digital currency could “erode the dollar’s primacy in the global financial market.”
The opinions expressed by the Deutsche Bank report stand in stark contrast to legendary investor Warren Buffett’s description of Bitcoin as “rat poison.”
But digital asset markets are not easily navigable, which is why it has led to substantial advantages for those with both access and expertise.
Professional Use Only
In early 2018, an employee at a large electronic trading firm claimed his company made as much as US$8 million a day, from capitalizing on price discrepancies in digital asset markets, where individual retail investors were pitting their wits against some of the most sophisticated electronic trading firms on hundreds of unregulated cryptocurrency exchanges.
But the high speed trading firms don’t always win out.
According to one cryptocurrency trader,
“There’s enough opportunities in the market and it’s decentralized enough that someone sitting in their parent’s basement in his underwear has just as good a chance of beating out someone sitting in Wall Street.”
Given the as yet untamed landscape of digital asset markets, that observation is still valid for now and is likely to persist for some time as unregulated cryptocurrency exchanges continue to play cat-and-mouse with regulators, jumping to more favorable jurisdictions at the drop of a Bitcoin candle.
And because cryptocurrency trading has been electronic from the get go, it was a natural fit for computer and algo-driven trading firms that make profits from buying and selling at speed.
High frequency trading (HFT) firm DRW for instance, established a dedicated cryptocurrency trading arm called Cumberland in the very early days, while other HFT powerhouses like Jane Street, Susquehanna, Flow Traders and Jump all followed suit soon after.
To be sure, to classify cryptocurrency trading as HFT would be misleading.
Most centralized cryptocurrency exchanges have rate limits that prevent excessive speed and trading volume to crash their servers and then there’s the issue of liquidity as well — there just isn’t as much of it to support HFT operations as there is in traditional financial markets.
For the most part, HFT in the cryptocurrency markets is more akin to “HFT-ish” and many HFT firms actually make their profits through market making, especially in the most liquid digital assets such as Bitcoin, Ethereum, Litecoin, Ripple and of course the world’s most favorite stablecoin — Tether (which is supposedly backed by dollars).
The Future Is Short
Adopting a “hybrid” approach to what is a rapidly evolving and developing market, veteran CME Group launched the world’s first regulated Bitcoin futures on a Bitcoin index as early as December 2017 — a factor which many suggest was the catalyst for sending Bitcoin prices soaring past US$20,000.
But the euphoria of institutional participation in digital asset markets in 2017 was premature — CME’s Bitcoin futures were cash settled, creating zero actual demand for the underlying digital asset they represented.
And worse, CME’s Bitcoin futures allowed traders to do something in a regulated space that was hitherto unavailable — short Bitcoin.
Considering that Bitcoin has no underlying asset to back it, except the very code which it is built on, traders saw the opportunity to short Bitcoin, which quickly sent the cryptocurrency’s dollar value plummeting, leading to 2018 becoming what many in the industry termed “crypto winter.”
Until CME’s Bitcoin futures came out, family offices and private individuals who were holding onto Bitcoin were lending it out to hedge funds to make short bets and charging handsomely for the privilege.
But when CME’s Bitcoin futures product came out, that carry trade quickly evaporated and for hedge funds waiting to short Bitcoin, it was off to the races.
Yet if 2018 was the so-called “crypto winter” then 2019 would be the “crypto spring.”
Because as large trading firms started expanding into cryptocurrencies, trading patterns started shifting as well.
Instead of arbitraging pricing inefficiencies and discrepancies, HFT-ish firms were now looking to supply prices to exchanges where most retail clients were trading and to make money from the BID / ASK spread on cryptocurrency exchanges — in other words, market making.
And to maintain those large amounts of liquidity for cryptocurrency exchanges, these market makers often negotiated deals for Bitcoin privately among themselves, in the opaque OTC or “over-the-counter” markets.
Some market makers are even known to share liquidity pools, allowing them to operate more efficiently.
If It Looks Like A Duck And It Quacks Like a Duck
For many ex-foreign exchange traders, cryptocurrency trading resembles the foreign exchange markets of the 1980s. According to one Singapore-based forex trader,
“There’s a lot of fuss over Bitcoin, but if you look at the trading pairs, they’re just like typical foreign exchange pairs.”
“BTC / USDT, ETH / USDT, resemble dollar / yen and dollar / pound.”
“The market may not be as developed as forex, but that’s why the profits are there. Forex isn’t what it used to be.”
The observation pans out because although costs for services such as custody have come down, as have trading spreads, they are still much higher compared with the markets for traditional financial assets.
But gaps in digital asset trading services still exist, such as the absence of clearing houses and affordable insurance, which has put off some mainstream financial institutions.
“What we need is a paradigm shift. We can’t expect to fit new assets into old molds.”
“Things like custodians, clearing houses — these are based on the assumption of a centralized financial market system — but the very nature of digital assets is decentralization.”
“The system infrastructure should embrace decentralization, using it as a means to reduce friction and cost, instead of raising new and unnecessary barriers.”
But the involvement of centralized intermediaries may be hard to avoid, at least in the medium term.
As bank profits start to become whittled away through low interest rates, increasing automation and thinning margins, it’s only a matter of time before they spy for themselves an opportunity acting as intermediaries between digital asset brokers, clients and market makers.
And while most investors recognize that the heady days of thousand-plus-percent returns from cryptocurrency hedge funds is probably over and unlikely to be repeated, many still see plenty of opportunities.
According to one family office manager,
“We’re looking at high double digits, maybe even triple-digit returns.”
But as time goes by and more institutional investors pour into cryptocurrencies, it’s only a matter of time before returns start to “normalize” to levels similar to other asset classes.
For now at least, most managers agree that there’s a good three to five years of very profitable trading, anything beyond that lies in the realm of clairvoyance.