Sophisticated Crypto Investment: First Principles Matter
Last week, Valmar Capital was privileged to join sFOX for a webinar addressing “The Best Ways To Get Exposure To Crypto As A Sophisticated Investor in 2023.” With the recent announcement of several ETF launches, notably from BlackRock and Fidelity, and the launch of EDX Markets, a crypto exchange owned by some of the biggest TradFi names such as Charles Schwab, Citadel Securities, Fidelity Digital Assets, and Sequoia Capital, the bear market narrative around crypto may slowly be starting to turn, making the conversation as relevant as ever. At Valmar, we believe that sophisticated crypto investment heavily borrows from the tried-and-true discipline and approaches that have been successful in traditional finance, applied and fitted to some of the unique characteristics of crypto (nascency, rapid evolution, increased volatility, elevated risk, etc.). When deciding crypto exposure as an investor, standard first principles matter, and this blog expands on a few themes mentioned in the webinar.
Investment Versus Trading
Long-term investing and active trading are two distinctly different activities. Investing for the long-term entails maintaining a strong belief in the asset class as a whole, formulating a well-researched thesis around a particular asset, and holding that asset through volatile market cycles (unless the fundamental investment thesis changes). Such an approach targets profits achieved over extended time horizons (months or years). A sophisticated approach to this investment style requires a deep understanding of a highly specific characteristic unique to cryptocurrencies, known as tokenomics, as well as a proficient grasp of the underlying technology.
Investing in digital assets can be profitable over the long-term, but as we know, this still-nascent asset class comes with heightened volatility that many investors are not willing to accept. Valmar’s approach is to take advantage of volatility to generate returns through active trading as a complement to longer-term investments. By combining a diverse set of active strategies with more fundamentally driven, longer-term strategies, we can maintain directional exposure while reducing the risk of the overall portfolio.
Active trading may be expressed through a variety of strategies designed to capitalize on unique views and/or inefficiencies in the market. These strategies can be focused on either centralized finance (CeFi) or decentralized finance (DeFi), on fundamental analysis or quantitative methods, on systematic approaches or discretionary decision-making, high frequency or low frequency trading, or some combination of these elements. Many active trading strategies utilize traditional investment frameworks and models to drive investment decisions. Strategies run the gamut of what one might expect on the traditional side of things: long only, long/short, arbitrage (basis, funding, and statistical), trend following, mean reversion, market making, and yield. Such an investment approach focuses on generating profits within shorter time frames, relative to long-term investments. Allocations to active trading strategies typically require a thorough assessment and due diligence on the strategy, risk management practices, team involved, and other due diligence considerations.
Understanding Strategy
An in-depth dive to understanding strategies warrants its own blog post (or even a series), but many fundamental principles remain the same, albeit adapted to crypto markets. At a high level:
What is the historical performance record, AUM, capacity, scalability, drawdowns, and expected compression?
What is the strategy’s direction, style, and alpha source(s)?
What underlying assumptions does the strategy rely on?
How is the strategy expected to perform in different market conditions?
What instruments are being traded? On what venues and how?
How much leverage is used? What types of limits (positions, exposure, leverage, etc.) are in place?
Risk Management
Strategy and risk management are inherently intertwined. A firm understanding of the risk management aspects associated with a strategy is just as crucial as understanding the strategy itself. Valmar will delve further into risk management in future blog posts, as it plays a critical role in both traditional and digital asset investments. Much like the traditional side of things, it comes down to managing both market and operational risk. However, digital assets pose elevated risks that require specific attention.
With respect to market risk, a firm must address the following aspects:
24/7/365 nature of the market, which requires continuous oversight and responsiveness.
Counterparties and counterparty exposures.
Liquidity.
“Black Swan” events.
Regulatory and compliance matters.
With respect to operational risk, a firm must effectively manage:
Trading and execution technology and processes.
Asset custody, to safeguard digital assets from potential threats.
Integrated operational infrastructure, that optimizes efficiency and minimizes operational risks.
Cybersecurity measures and programs, to protect against potential cyber threats and data breaches.
Team
Of course, actively traded strategies, even automated ones, are more than just data, charts, and technology. They are shaped by the collective efforts of team members who build strategies, implement risk management measures, develop technology, and establish a surrounding culture that influences perspective and decision making. Ultimately, any investment team are to be stewards and fiduciaries of investor capital. Investor often employ their own set of metrics to analyze a team, and at the very least a good team should:
Actively listen to investors, and promptly respond to their concerns, inquiries, and feedback.
Possess a track record of trustworthiness and honesty, supported by verifiable reputations that instill confidence.
Maintain a culture that encourages inquisitiveness, integrity, and the pursuit of excellence.
Clearly define roles and responsibilities within the team, ensuring accountability and minimizing potential overlaps or gaps.
Be accessible, communicative, and transparent, providing investors with timely and relevant information.
General Due Diligence Considerations
In any investment process, due diligence must be conducted. When considering an investment into active trading strategies, the due diligence process should closely resemble that of traditional finance.
With respect to the organization, the due diligence process should examine:
Structure of the firm and the fund, understanding their legal and operational frameworks.
Ownership and management structure, including the key individuals responsible for decision-making and oversight.
Composition and expertise of the team, evaluating their qualifications, experience, and track record.
With respect to operations, due diligence should focus on:
Structure of the middle and back-office.
Existence of robust processes and procedures for essential functions such as counterparty management, settlement, reconciliation, governance, IT security, human resources, compliance, and others.
Service providers employed by the firm for various critical functions, such as banking, fund administration, custody, audit, lending, trading and execution, and prime brokerage.
Revenue generation model of the firm and assessing its overall financial health and stability.
Conclusion
Crypto possesses fundamental characteristics marked by its rapid evolution and consolidation, which have implications on opportunity sets, investment approaches, and risk management. As the market continues to evolve and mature, there are numerous viable opportunities for sophisticated investors to achieve exposure to the asset class. An investor may choose to pursue a long-term investment approach, or opt for more active strategies, or a combination of both, when making investment decisions. Should an investor allocate to an active strategy, the application of traditional investment diligence to areas such as strategy, risk management, team, and general organizational matters follows much the same as it does for investments in more traditional asset classes. However, crypto markets have their own unique nuances, and it is essential to have a comprehensive understanding of those nuances to effectively apply and tailor traditional frameworks as necessary.
Both Valmar (on the active investment management side) and sFOX (on the technology and service provider side) strive to create ecosystems that drive the sophistication of this asset class ever forward. We are not reinventing the wheel; we are reapplying it. To watch the sFOX/Valmar webinar, please use the following link: https://www.youtube.com/watch?utm_campaign=%5BCopy%5D+Webinar_June_28_ValmarCapital_Email_Recording&utm_content=sFOX+and+Valmar+Capital&utm_medium=email_action&utm_source=customer.io&v=kiJ7di3uy0I&feature=youtu.be.
As always, please contact us to learn more about markets or Valmar and have a safe and happy July 4th Holiday.