What Actually Is Diversification In Crypto?

Last week we took a hedge fund history trip to explore a bit of industry development and to emphasize the benefits of a multi-strategy investment platform in crypto.  As history has shown us, diversification matters (thanks for underlining the point, Mr. Dalio), but what the hell is diversification in crypto?  From what building blocks do you construct your portfolio?  How do these strategies work, and what risks do they entail?  Fear not, as we are here to break these complexities down for you.

Starting from the top, diversification in crypto can be implemented across various dimensions:

• Trading Experience: having a mix of traditional finance professionals who are applying their expertise to the crypto landscape, alongside managers who have deep-rooted connection to the crypto sphere, a.k.a. “crypto natives”.

• Trading Venue: maintaining exposure to both Centralized Finance (“CeFi”), where all crypto transactions are funneled through centralized exchanges (such as Coinbase, Binance, OKX, and others), and Decentralized Finance (“DeFi”), which pertains to the trading and transfer of financial assets without intermediaries. Diversifying the trading venues also entails distributing your exposure across various CeFi and DeFi platforms.

• Trading Frequency: a combination of low, medium, and high-frequency trading strategies.

• Trading Style: striking some balance between systematic, driven by algorithms, and discretionary approaches, where decisions are judgment driven.

• Alpha Source: a fusion of quantitative, fundamental, and “crypto native” strategies, encompassing both directional and market-neutral approaches.

Among all these factors, understanding the source of alpha (alongside effective risk management) can often pose the most significant challenge. In general, the majority of strategies in crypto are simply adaptations of successful models from traditional finance (quantitative and fundamental). In this category, we would include:

• Long Only

• Long Biased

• Long/Short

• Market Making

• Statistical Arbitrage

• Volatility Harvesting & Volatility Arbitrage

• Momentum & Mean Reversion

However, there are certain strategies that do not fit into any of the above buckets and should be more accurately characterized as “crypto native.” This suggests that these strategies rely on distinct characteristics that are unique to the cryptocurrency asset class. Among the most notable “crypto native” categories that have emerged so far are:

• Buy & Hold

• Basis Arbitrage

• Funding Rate Arbitrage

• GBTC Arbitrage

• DeFi Yield

• MEV

It’s worth looking at each of these “crypto native” strategies in a bit more detail.

Buy & Hold

The foundation of many digital asset funds has been the buy and hold strategy, which persists today in many instances. Buy & Hold strategies often consider token economics (“tokenomics”), which analyzes certain economic properties of the blockchain and other long-term fundamental factors as the basis of investment decisions. These strategies tend to be driven by beta factors and exhibit high return potential along with notable volatility and drawdowns. They often involve discretionary long, long biased, or long/short positions, utilizing fundamentals and thematic investing for asset selection while timing entry and exit points.

These strategies on their own may not entice institutional investors. However, the fundamental analysis can find utility in relative-value and event-driven strategies.

Basis Arbitrage

During the last bull-cycle, generating returns through cash and carry trades was relatively easy - simply go long spot while selling dated futures against it. This strategy worked well when dated futures traded at substantial premiums to spot. At the time, futures easily traded at 20-40% premiums to spot, and traders simply had to wait a few months for the two legs to converge. It’s important to highlight that counterparty risk emerged as a notable concern in this trade, and we know how that can and did work out. 

These days, the spread between spot and futures prices has narrowed, though the trade has not completely dissipated. Valmar has observed that successful execution of this trade often occurs at higher frequencies, capitalizing on shorter-term divergences between spot and derivatives prices. Additionally, as the trading marketplace has seen a reduction in congestion over the past year or so, some of the pressure on this trade has eased for now.

The premise of this trade is the anticipation of convergence between spot and derivative prices. However, the trade always carries the inherent risk of widening spreads due to some technical factors. Counterparty risk with exchanges also adds significant tail risk, prompting the need for robust risk management measures, such as stop losses on trades and fulsome upfront and ongoing diligence of exchange counterparties.

Over time, these strategies on their own have become less attractive to institutional investors due to diminishing rewards and opportunities, coupled with heightened concerns about counterparty risk. 

Funding Rate Arbitrage

This is the perpetual futures version of the basis arbitrage strategy. Unlike the dated futures vs. spot arbitrage, which allows traders to lock in a fixed rate at the time of trade, by going long spot and selling perpetual futures against it, the funding rate arbitrage involves earning funding rate payments when the funding rate is positive.

With perpetual futures, there is no set expiration date that forces convergence. Instead, a mechanism known as the funding rate is used to help perp prices and spot prices converge. If the perpetual futures price is higher than the spot price, then funding is positive, and payments are made from longs to shorts. Conversely, if the perpetual futures price is lower than spot, payments are made from shorts to longs. The wider the deviation from spot prices, the higher the funding rate, which incentivizes longs or shorts to close their positions and bring perp prices back in line with spot.

During the bull market of 2020-2021, funding rates were consistently positive, which made it relatively easy to sit in long spot, short perps funding trades. These days, funding rates are much more muted, and the trade has morphed.

One current variation of this trade is to take advantage of different funding rates across exchanges including DeFi venues. Particularly within the DeFi space, significant disparities in funding rates can arise, presenting prime opportunities for arbitrage.

GBTC Arbitrage

In 2020, a significant number of firms participated in the so-called “GBTC arbitrage trade.” GBTC refers to a closed-end fund managed by Grayscale. GBTC shares were created through private placements, and they were allowed to be freely traded over-the-counter after a 6-month lockup period. Before the Coinbase IPO and the advent of futures-based ETF, options for equity investors to make a bullish bet on BTC besides GBTC were limited, and GBTC emerged as one of the more direct approaches.  The resulting high demand for GBTC in the OTC markets, led GBTC to trade at very steep premiums to spot.

Many funds would create new GBTC shares from BTC in-kind contributions, wait for the 6-months lock-up to elapse, then sell GBTC shares at substantial premiums before buying back BTC. Of course, as more options emerged for expressing a bullish view on BTC and general bullish sentiment vanished, the oversupply of GBTC shares caused it to trade at significant discounts to BTC. 

While the original GBTC arbitrage trade has gone away, opportunities remain. Some have ventured to buy GBTC at a steep discounts, hedging the delta with perps, speculating on an eventual conversion to an ETF and the convergence with spot prices. Others have developed more active strategies, taking advantage of shorter-term correlations.  

The underlying assumption in this trade is that GBTC should trade in line with BTC. However, the risk of persistent dislocations due to imbalances in GBTC supply and demand exists. Additionally, there is clear counterparty risk tied to the hedge leg, along with the necessity to closely monitor collateral for that hedge leg.  Furthermore, the conversion to an ETF is not guaranteed. 

Such strategies, on their own, are not attractive to institutional investors due to the unique set of risk management considerations. 

DeFi Yield

DeFi continues to be an interesting trading opportunity that has evolved tremendously over the past several years.  While in the early days of DeFi it was quite easy to generate returns by providing liquidity to new DeFi protocols and earning incentives, such incentive programs are less prevalent nowadays. DeFi has matured and focus has shifted to “real yield” that is less reliant on token incentives.

Several avenues exist for generating this "real yield," including staking, lending, and providing liquidity for users to trade against. 

Effective execution of such a strategy demands a comprehensive grasp of the working mechanisms of the various protocols as each protocol has its own nuances, edge cases, and potential risks. Furthermore, some protocols interact with others, and they can be "composable," implying that one can be built on top of another, creating downstream exposure that must be factored in. 

DeFi strategies must also account for liquidity, sustainability of the yield, and capacity. A finely tuned approach should avoid becoming an outsized portion of any individual protocol’s activity. It should also actively hedge impermanent loss and prioritize protocols with relatively sticky capital. As compared to CeFi, DeFi presents even more elevated IT security, custodial, and liquidity risks. Because of the elevated risk profile, along with scalability issues, such strategies on their own are not yet attractive to institutional investors.

MEV

MEV strategies are the equivalent of DeFi high frequency trading. They involve monitoring pending blockchain transactions that exist in the mempool and inserting transactions in a specific order to generate returns.  Execution is highly dependent on speed and latency, similar to high-frequency trading, but with some key differences:

• With MEV, the trade is fairly deterministic. If the right to insert a trade is won, it is simple to predict P&L for that trade.

• With blockchains being decentralized, the concept of co-location is inverted.  A strategy should have its node infrastructure with geographical diversity to be nearest to the randomly selected validator that will process the block on the chain.

• Being able to predict and optimize gas fees (the cost of processing a proposed transaction) is critical to the performance of an MEV strategy, a concept that does not exist in traditional HFT.

Conclusion

Suffice it to say, the realm of digital assets offers a broad spectrum of strategies, each carrying its own considerations when contemplating comprehensive diversification. Some strategies align closely with tried-and-true traditional hedge fund approaches, tailored to suit the unique elements of the crypto landscape.  Others have organically emerged and are native to the crypto ecosystem, capitalizing on the uncommon traits of this asset class. 

While this wide array of strategies may seem intricate to those observing from the outside, from Valmar’s multi-manager multi-strategy vantage point, the more diverse the world, the better.

Furthermore, it's crucial to understand that individual strategies, particularly those involving trading and arbitrage, might not inherently shine when standing alone, as often noted above. Nevertheless, their true potential often comes to the fore when integrated into a well-rounded and diversified portfolio.

Finally, we should also emphasize that it is the nature of trading strategies, particularly arbitrage-based ones, to compress and evolve. This process of compression and evolution unfolds at an accelerated pace in crypto compared to traditional finance, due to factors such as the relative newness of the field and its lack of consolidation. Thus, we anticipate all strategies - whether rooted in traditional finance or native to the crypto world - to adapt and expand swiftly in tandem with the growth of the asset class itself.  As these strategies grow, the benefits and importance of a multi-manager approach become ever more clear.

Oh, by the way, Valmar will be joining Coherra (hosted by Dan Lancellotti) on August 23 to peel back the layers of diversification in crypto land. Join us.