Don’t roll your own index fund [Crypto indexing part 10]
A golden rule of cryptography is “Don’t roll your own crypto” —unless you are a cryptographer. Likewise, don’t roll your own index fund — unless you are a financial professional. This blog post describes a fraction of the manual work needed to run an index fund.
Written in January, 2019. Published on Medium in Oct, 2019.
Difficult to buy
The Vinter team has registered accounts at over 20 exchanges. To register an account and fulfill the KYC requirements, a user must send copies of gas bills, photos of their passport, and sometimes download a video conferencing app to have a video call with the onboarding team. Waiting times are long — often several days. Patience is a virtue, and the registration process is a real test of patience.
Different exchanges have different user interfaces. This can make order placing confusing when the customer is used to a certain interface and suddenly the order book is visualized differently, or the buy button is on the left instead of on the right. Obviously, this slows down the speed at which trades can be executed and increases the risk of human errors. Different exchanges also have different trading rules on order size, leverage, maker and taker fees, etc. Moreover, the same virtual currency can have different names on different exchanges — Bitcoin can have the ticker BTC or XBT. Differences between exchanges increase the risk of manual errors.
For many investors, registering at a single exchange is insufficient due to asset coverage, technical reliability, liquidity, and pricing. All four reasons are discussed below.
Asset coverage is a problem for an investor who wants to trade the top cryptocurrencies because some might not be listed on your chosen exchange.
Technical reliability and uptime have been problems for many exchanges, especially when many want to trade or open up new accounts, such as during the boom of 2017. During this boom, when many new investors wanted to register to buy, and some old investors wanted to sell, even the largest exchanges like Kraken and Binance experienced severe problems. Kraken was down, so people who wanted to trade could not, while Binance stopped taking on more customers. During times like these, investors who have registered at many exchanges can trade while others are left out.
Liquidity is the third reason to register at several exchanges. When buying large amounts of crypto or buying small-cap cryptocurrencies, the order book might not be deep enough. In these cases, it is beneficial to spread out the trade on several exchanges.
Fess and pricing may matter, too. Sometimes, the fees and prices on one exchange are much more favorable.
Difficult to store
Traditional financial instruments, like stocks and bonds, are stored at a central securities deposit or custodian. When buying these assets, the investor can enjoy his bank's storage solution, giving him peace of mind. Cryptocurrencies, by contrast, are stored by the owner. This is a common source of headache for cryptocurrency investors. Storage is important and complicated.
To quantify the importance of storage is easy because losing the password implies a return of minus 100 percent. To quantify how complicated it is to store digital assets safely, consider that USD 670 million worth of cryptocurrencies were lost in the first quarter of 2018 due to bad storage solutions or theft. When the Mt. Gox was hacked, 850 thousand Bitcoins were stolen. Assuming a BTCUSD price of 6000 this hack was worth USD 5.1 billion.
Apart from protecting against thieves, all cryptocurrency users must be protected against themselves. Even though users are heavily incentivized to store their digital wealth with care, stories of lost coins are plentiful. One common way is to forget the password. Another is to throw away the laptop when the coins were not worth that much, just to realize a year later they threw away thousands of dollars.
History provides a clear conclusion: users are not skilled at storing their own digital wealth. Safely storing digital assets is hard partly because the technology is in its infancy. Anyone who has bought and safely stored cryptocurrencies knows this. Further, the human brain is trained to hide physical objects but not digital information. This fact about human nature makes digital security unintuitive.
Storage complications provide a good reason for investors to stay away from the crypto market. Institutional investors cannot afford to buy an asset when the risk of losing it is so high. The technical knowledge needed to store coins safely takes time to acquire, and investors with deep pockets have a high opportunity cost. Portfolio managers who are asked why they have not bought cryptocurrencies often state volatility as a primary reason, but storage is, in fact, a much larger problem.
Passive investing requires activity
Assume an investor, whom we can call David, is both bullish on the crypto market and believes in a passive investment strategy. What does he have to do to follow this strategy?
David must begin by choosing a suitable index to follow. At its core, an index is a set of rules. Let us decide on an index that contains the 10 largest cryptocurrencies, weighted by their market capitalization. The index is rebalanced monthly to keep up to date with changes in the market.
On the first day, David must take his USD and buy 10 different coins. He wants to safely store the assets himself, so after the purchase, he must move the coins from the exchange to his personal wallets. This act is called moving to cold storage. Setting up a safe storage solution for a single coin is difficult, as described above. Storing 10 different coins increases the difficulty tenfold because many coins have their own wallet, so storing a basket of coins requires multiple software applications (at this time of writing, in January 2019). Every application has its password and preferences. Naturally, David must spend some time to store all cons in safe places.
Increasing and decreasing the portfolio’s assets under management are two important activities. David might want to save a fixed amount every month. Or he might want to let cryptocurrencies have around 5% weight in his total portfolio, which otherwise consists of an equity index. If so, he needs to buy more coins when the value of crypto decreases and sell them when the value of crypto increases (relative to the equity index) in order to keep his 5% weight intact. Regardless of the reason why David wants to increase or decrease the asset under management in his cryptocurrency portfolio, he must repeat the tiresome process of buying at several exchanges and safely storing it in separate wallets. This is difficult and can take hours, even for an experienced user.
A month after his first purchase, David should rebalance his cryptocurrency portfolio. He should rebalance it every month. Monthly rebalancing is needed because he wants to own the current market, not the market how it looked when he made his first purchase. For a passive investor, rebalancing is necessary, and most equity index funds do this automatically (every quarter or so) without any action needed from the investor. In the world of cryptocurrencies, however, rebalancing is a tough manual task.
Rebalancing starts with David transferring the coins from his wallet to the exchange. With several windows open on his computer screens, he will then proceed with executing the trades needed to rebalance his portfolio. As a final step, he sends the coins to cold storage. This is simple in theory but hard in practice with many manual steps. As a simplified example, consider how the rebalancing process would look if the only event that occurred during a month was that the market capitalization of the cryptocurrency ZEC went from place 11 to 10, while the market capitalization of the cryptocurrency ADA went from place 10 to 11. David must first move his coins from the ADA wallet to an exchange that contains both ADA and ZEC. His choice of which exchange to use will vary depending on a combination of factors: prices for ADA and ZEC, the order books for ADA and ZEC, and how familiar David is with an exchange’s interface. When ADA is at the exchange, he can proceed by selling ADA for US dollars, and then buy ZEC with these dollars. Lastly, he will send ZEC to cold storage. If this were the first time ZEC entered the top 10 index, David would probably not know much about this coin or how its wallet software works. To be competent enough and not make a mistake that might cause him to lose the coins, he would have to spend hours reading about ZEC and trying out software applications.
There is a better way
The process described above is a mess! The technical barrier is too high. This is a real hindrance for investors. Even though it is a simplified example, there are many steps that require research, experience, and computer skills. Mistakes are fatal as they can cause digital wealth to be erased. We believe there is a better way forward. That is why we created Vinter.
