Fungible Funds Court Cryptocurrencies

In an almost indistinguishable landscape of funds, some managers are looking to the high-risk, high-reward world of cryptocurrencies for returns. But can cryptocurrencies be stuffed in suits?

Cameron Tucker casually adjusted his thirty-thousand dollar Blancpain watch. The watch was a reward to himself and a reminder of when his hedge fund first cleared US$100 million in assets under management or a “hundred bucks” in the lingo of funds.

Tucker had for all intents and purposes done everything “right.” He’d worked hard in elementary school and played the straight and narrow in high school. Although popular, Tucker was disciplined about skipping parties to concentrate on schoolwork, in particular math and science and when it was time to go to college, opted to do finance at Wharton Business School and for good measure, an MBA at Harvard.

Tucker, who grew up in the small town of Fort Payne in Alabama had none of the trappings of your typical Wharton and Harvard man.

His family, while comfortable, was not by any measure wealthy and so Tucker was determined to make a difference, not just for himself, but for his progeny, recalling the Jordan Belfort (Wolf of Wall Street) quote,

“I’ve been a poor man, and I’ve been a rich man. And I choose rich every fucking time.”

Which is why Tucker chose to be as close to the money as possible, moving from investment banking to starting up his own hedge fund.

But when the quant crowd came onto the financial scene, they upended the power-lunch crowd that was used to receiving “proprietary information” for their trading edge.

Almost overnight, the software was trumping tenacity and Tucker and his ilk were becoming increasingly marginalized.

And while the 80s and 90s were the eras of Tucker and the power suit, after the Great Financial Crisis of 2008, coders in hoodies soon overtook bankers in suits in the battle for Wall Street dominance, with low-cost, low-fee and arguably “simple” investing holding court.

It was around this time that Tucker was introduced to cryptocurrencies.

Despite Tucker’s best efforts to beat the market, the very best and brightest on Wall Street were having to contend with the same issues — that improved access to data was whittling down opportunities to profit and democratizing the markets in ways never before thought possible.

Yet by the early 2010s, when Tucker started to realize that Bitcoin, a brand new cryptocurrency had the potential to become an all-new asset class, he reinvented himself to take advantage of the unsophisticated market, betting that he could rely on his Wall Street chops to stuff Bitcoin into a suit, the same way that coders in hoodies dragged Tucker and his ilk out of them.

It’s All About the Money

But cryptocurrency hedge funds would face no end of challenges setting up shop in the decade since the Bitcoin whitepaper was written.

Many of the “institutional-grade” services for which the fund management industry rely on simply didn’t exist then and are only just now starting to come up — custodians, fund administrators, auditors, lawyers — all of the stuff necessary to service the fund industry just simply hadn’t yet developed the right tools to adequately service the nascent digital asset at the time and soon after the Bitcoin whitepaper was written.

But a decade is a long time and since then, cryptocurrencies have entered popular consciousness, with fund management service providers looking to expand their offerings to cater for increased interest in the sector.

Once derided as nothing more than a scam at dinner parties among the elite, it seems these days that the elite has dipped their toes into this alleged “scam”, bringing with them all of the trappings and baggage of the traditional fund management industry.

So it was only a matter of time before some of the titans of the asset management industry started throwing their hats into the ring.

Sauce for the Goose, Gravy for the Gander

Billionaire trader Alan Howard has long flirted with cryptocurrencies, even setting up Elwood Asset Management to manage his personal stash of digital currencies.

But a recent announcement that Elwood Asset Management would be planning to launch a US$1 billion venture that would put money into a range of cryptocurrency hedge funds will fundamentally change the landscape.

Given the relatively small market cap of cryptocurrencies as compared with other asset classes, cryptocurrencies top US$280 billion on a good day — compared with US$8 trillion worth of derivatives traded in a single day — cryptocurrency hedge funds were always going to be smallish.

Yet the commitment by Alan Howard’s Elwood Asset Management represents some serious cash into cryptocurrencies — US$1 billion is the market cap for some of the smaller cryptocurrencies.

Speaking to the Financial Times, Bin Ren, CEO of Elwood Asset Management said that the firm is working on a platform that would design portfolios of cryptocurrency hedge funds for institutional investors that would pick funds with higher quality operations, that would help avoid a sector filled with hazards.

Cryptocurrencies as a whole have seen a big upswing this year, following last year’s bust. According to data group HFR, cryptocurrency-focused hedge funds are up almost 60% on average to the end of July, helped in large part by a hefty 173% rise in Bitcoin over the same period. Litecoin, Ethereum, and other top-tier cryptocurrencies rose more modestly, but in percentage terms have chalked solid gains as well.

But depending on when one participated in cryptocurrency hedge funds, individual client returns can differ greatly.

And while early adopters such as Tucker, would have marked staggering 2,700% rises in 2017, the precipitous fall of as much as 80% in 2017 would more likely than not have hit the bulk of investors, who only entered the industry towards the end of 2017, when Bitcoin was on a wild, speculation-fueled ascent.

So it’s no wonder then that the approximately 200 to 300 cryptocurrency hedge funds (based on those funds reporting) are still viewed warily by some investors as a risky corner of the asset management industry.

Sorry Not Sorry

And it’s not just the volatility of an essentially unconstrained asset that poses challenges to both cryptocurrency hedge funds and their investors — there are myriad other risks to contend with as well.

According to Ren,

“Losing traditional assets in the real world is hard. In the digital world, it’s very easy to lose assets — put in the wrong address for a Bitcoin transfer and it’s gone forever.”

But losing your Bitcoin assumes that the hedge fund only trades a long-only strategy, what about those funds which actively trade Bitcoin against other cryptocurrencies?

Because cryptocurrency trading is done off a variety of regulated and unregulated cryptocurrency exchanges, many of these digital assets are held in accounts managed and secured by the exchange itself — custodians may custodize long-only cryptocurrency assets, but they are (as yet) unable to afford traders with trading lines on the exchange itself.

Which means that active traders have had to come up with a variety of risk management policies to cope with the peculiarities of trading cryptocurrencies — from holding multiple accounts to spreading risk across a variety of exchanges to requiring multi-sig access to whitelisted cryptocurrency wallet addresses — there are a multitude of measures.

Understandably, cryptocurrency exchanges would much rather traders leave their digital assets for trading on their platforms, because that centralizes much of the functions, power, and resources on their sites.

Old Dog New Tricks

So it’s no wonder then that so many cryptocurrency hedge funds lack many of the traditional features seen in the wider hedge fund industry — such as Cayman-based vehicles and custodians looking after assets.

Because cryptocurrency assets can be so hard to value (price information is garnered from multiple unverified sources), the typical fund administrator’s role in providing reports is also challenging at best and sometimes impossible.

Cryptocurrencies are like no other traditional asset and the industry which supports hedge funds is just coming up to speed in providing the tools that institutional investors have come to expect.

Yet without fully understanding the nature of cryptocurrencies themselves, many service providers may actually be lumping on additional costs to the entire endeavor of managing and profiting from digital assets.

Just because the fund management industry has operated this way for so long doesn’t mean it’s the most efficient way to do things, nor that it should be accepted as the way to operate.

For starters, cryptocurrencies themselves were meant to usher in a more frictionless way to transfer value, to trade and to transact.

For instance, most centralized cryptocurrency exchanges do not have minimum trade sizes and trading fees (typically very low) are fixed percentages. So whether a trade is for 1,000 Bitcoin or 1 Bitcoin, the fees in percentage terms are generally the same.

Whereas in the capital markets, trades need to exceed certain minimum sizes and then there are minimum transaction fees.

So trading strategies that would otherwise be unprofitable using small amounts of resources on the capital markets suddenly become viable and very profitable trading with cryptocurrencies.

While investors prefer to have their reports delivered by independent third party (and preferably reputable) fund administrators, cryptocurrency hedge funds could put their transaction history, along with their client portfolios on the blockchain itself and allow clients to inspect the blockchain to verify their account positions and holdings.

Because the blockchain is pseudonymous, it is entirely possible for a cryptocurrency hedge fund to amalgamate a basket of transactions and place them on a public blockchain, like the Ethereum blockchain, for instance, that would immutably log a client’s portfolio, while still providing clients with the anonymity and privacy they require.

Unfortunately, many of these potential cost-savings are only in the exploratory stage.

As managers from the traditional fund industry start trickling into cryptocurrencies, they are bringing along with them the same cost burdens from that industry, without harnessing the potential cost savings of a decentralized and “trustless” structure.

According to a report released earlier this year by Elwood Asset Management and PwC, cryptocurrency hedge funds charge an average management fee of 1.72% and a performance fee of 23.5%, higher than their counterparts in the traditional fund management space, where HFR reports that fees are an average of 1.41% for management fees and 16.6% for performance fees.

Most cryptocurrency hedge funds also book higher costs — for fund administrators, custodians (if any) and audit and legal fees as well. Because many of the issues with managing and accounting for cryptocurrencies are just being discovered, many service providers are passing on the costs of learning to their fund clients who are then passing the costs on to their fund’s clients.

And Elwood Asset Management’s proposed platform would be adding another layer of costs to access these already expensive funds. While details of the new platform have yet to be finalized, according to the Financial Times, the platform could potentially allow investors to input factors such as the risk they are prepared to take, their expected returns and the liquidity terms desired, while also measuring the potential correlation with a client’s existing asset portfolio.

Given that most cryptocurrency hedge funds have done well this year is no guarantee that they will continue to do so and high fixed fees act like a parachute to returns.

The solution is both a technological as well as an ideological one.

Clients are better served by first understanding the asset class that they are getting into — the days of willful ignorance, in particular when it comes to a brand new asset class, are well behind us — as the rout of cryptocurrencies in 2017 clearly demonstrates.

Cryptocurrency hedge funds are also better served by trying to educate clients as to the nature of the class of asset which they are investing in as well.

With a better understanding and a shared mission, costs for the industry as a whole have a chance of coming down, perhaps well below what costs currently are, for traditional hedge funds.

While we are not likely to see management fees disappear entirely — unless funds are willing to gamble purely on performance (which some already do), efforts ought to be made to leverage the very technology which is being traded on cryptocurrency exchanges by cryptocurrency hedge funds themselves.

Blockchain technology is open-source, freely available and almost infinitely manipulable.

Whether using Ethereum-based smart contracts to log automatic payouts when cryptocurrency hedge funds attain certain targets or using the blockchain itself as a globally-accessible and immutable ledger, the hedge fund industry as a whole has much to gain from harnessing the technology than simply trading with it.

Unlike any other asset class that has come before this, cryptocurrencies and the technology that they represent ought not to be treated as just another asset to be traded.

Rather, cryptocurrencies themselves should actively become essential to the trading environment, whether it’s through the use of decentralized exchanges or logging data on the blockchain for inspection by clients.

And let’s not forget that when Wall Street financier Bernard Madoff swindled billions of dollars, the very same institutional-grade measures were present and in some ways complicit in the con, which clearly shows that service providers are no guarantee of safety.

Which is why Satoshi Nakamoto, the creator of Bitcoin had always envisaged the removal of trusted third parties in the transfer and transaction of value, hedge funds shouldn’t be quick to reintroduce them into the fray.