Crypto Hedge Funds: Don’t Pay Alpha for Beta

Many crypto hedge funds were launched in the past 2 years because of a significant interest growth in cryptocurrencies. While some of these funds include experienced teams coming from other hedge funds, many of them were actually setup to make a quick profit during the hype.

In this article we will show why most so called crypto hedge funds are not actually hedge funds, but just passive investors in a basket of cryptocurrencies, in a way similar to mutual funds. Despite this, many of them still charge the typical 2/20 management and performance fees typical in the hedge fund world. The first section will introduce crypto hedge funds, while the second one will analyze their aggregate performance by looking at the Eurekahedge Cryptocurrency Hedge Fund Index. The last section concludes with key takeaways.

Crypto hedge funds stats

A crypto hedge fund is a pooled investment vehicle from multiple investors with the purpose of delivering uncorrelated returns with the crypto market by investing in cryptocurrencies. Cryptocurrency hedge funds are actively managed products, with the purpose of generating superior risk-adjusted returns uncorrelated with the direction of the crypto market (alpha). This is in contrast to crypto index funds, which are passively managed product with the aim of delivering just an exposure to the crypto asset class (beta).

Figure 1 shows the number of crypto fund launches, together with the price of Bitcoin. As it can be seen from the figure, there is a high correlation (ρ = 0.70) between the 2 measures. This should be expected, since a higher price of Bitcoin indicates creates greater interest in the crypto space and possibly higher capacity for crypto funds, with consequently greater economic incentives to launch one.

Number of crypto hedge fund launches vs Bitcoin price
Figure 1 Number of crypto hedge fund launches vs Bitcoin price

Figure 2 shows the assets under management (AUM) for crypto hedge funds over time, compared to the price of Bitcoin. It is interesting to note that, despite the bear market of 2018, crypto hedge funds still managed to attract capital. This may be due to a general interest in the crypto space, where investors may want to invest for the long term.

Figure 2 Crypto hedge funds AUM vs Bitcoin price
Figure 2 Crypto hedge funds AUM vs Bitcoin price

Figure 3 shows the distribution of AUM for crypto hedge funds. As it demonstrates, crypto funds are much smaller to traditional hedge funds, with most of them having less than $10 million in AUM, and only 5% surpassing the $100 million mark.

Distribution crypto hedge funds by AUM
Figure 3 Distribution crypto hedge funds by AUM

Figure 4 shows the distribution of crypto hedge funds by city. As it can be seen from it, they are dispersed across the globe, with a prevalence in major financial and tech hubs like San Francisco, New York, London, and Singapore.

Distribution crypto hedge funds by city
Figure 4 Distribution crypto hedge funds by city

Performance attribution crypto hedge funds

We now analyze the performance of the crypto hedge fund industry as a whole to see if they provide uncorrelated returns to the markets (alpha), as they should, or if they just repackage passive cryptocurrency returns (beta). In this analysis we use the Eurekahedge Cryptocurrency Hedge Fund Index to represent the performance of a typical crypto hedge fund, and Bitcoin to represent the cryptocurrency market. The analyzed period goes from June 2013 to April 2019.

Figure 5 shows the performance of crypto hedge funds compared to Bitcoin over time. As it can be seen from it, the 2 series look very similar, posing into doubt the validity of crypto hedge funds as alpha products.

Performance crypto hedge funds vs Bitcoin
Figure 5 Performance crypto hedge funds vs Bitcoin

Table 1 displays the performance stats for crypto hedge funds compared to Bitcoin. As the table shows, the 2 products present very similar characteristics, with both similar returns and volatility.

Performance stats crypto hedge funds vs Bitcoin
Table 1 Performance stats crypto hedge funds vs Bitcoin

Figure 6 shows the relationship between Bitcoin returns and crypto hedge funds, while Table 2 quantifies it with a linear regression analysis. As it can be seen from them, crypto hedge funds are actually beta providers instead of alpha products as they should be. Their beta is actually 0.9, alpha is quite small (0.01) compared to their beta, and correlation with the crypto market 0.98. This is what should be expected by a mutual fund or crypto index fund offering some kind of exposure to the crypto market to its investors. These products are usually cheaper than hedge funds structures, since they do not require expensive resources spent for active management of the fund.

Relationship returns crypto hedge funds vs Bitcoin
Figure 6 Relationship returns crypto hedge funds vs Bitcoin
Performance attribution crypto hedge funds
Table 2 Performance attribution crypto hedge funds

In the next section we analyze the performance a hypothetical systematic long/short crypto investment strategy, a possible crypto hedge fund strategy, and see if it delivers alpha as should be expected, contrary to the previous analyses.

Performance attribution systematic long/short crypto investment strategy

Figure 7 shows the backtested performance net of transaction costs of a hypothetical systematic long-short crypto investment strategy applied to the top 14 cryptocurrencies by traded volume. The strategy is compared to a passive buy-and-hold investment in Bitcoin. As it can be seen from the figure, the strategy would have achieved a better performance compared to Bitcoin, which is also consistent across both bull and bear markets. This is what it should be expected from a hedge fund strategy, in other words delivering uncorrelated positive returns irrespective of market conditions.

Hypothetical performance systematic long/short crypto investment strategy vs Bitcoin
Fgiure 7 Hypothetical performance systematic long/short crypto investment strategy vs Bitcoin

Table 3 shows the performance measures for the hypothetical systematic long/short crypto strategy and compares it to a passive investment in Bitcoin. As the table shows, the systematic long/short would have outperformed a passive Bitcoin investment. On the return side, it would have achieved an annual average return of 224%, almost double both Bitcoin. On the risk side, it would have had slightly more volatility than Bitcoin. As a result of the better return delivered with around the same amount of risk, the strategy would have achieved a much better Sharpe ratio of 1.96, compared to 1.18 for Bitcoin.

Hypothetical performance stats systematic long/short crypto investment strategy vs Bitcoin
Table 3 Hypothetical performance stats systematic long/short crypto investment strategy vs Bitcoin

Table 4 shows the performance attribution stats for the hypothetical systematic long/short crypto strategy compared to Bitcoin. As it can be seen from the results, the strategy would have delivered real positive alpha. In fact, both beta and correlation with respect to Bitcoin returns are almost 0, as it should be expected for an alpha investment product like a hedge fund.

Performance attribution hypothetical systematic long/short crypto investment strategy vs Bitcoin
Table 4 Performance attribution hypothetical systematic long/short crypto investment strategy vs Bitcoin

In conclusion, based on the previous results, a hypothetical systematic long/short crypto investment strategy would have delivered alpha instead of beta and is therefore a good candidate as a proper crypto hedge fund strategy.

Conclusion

Based on the previous analyses, we can derive the following key takeaways:

How to Trade and Hedge Cryptocurrencies and Related Transaction Cost Analysis (TCA)

Cryptocurrencies experienced significant interest during the past 2 years. Many investors and companies became attracted to the market because of the apparently high returns they could get from this new asset class. At the same time, those investors who bought cryptocurrencies in late 2017 sustained a significant loss and drawdown in the bear market of 2018. Among these investors there were ICO companies and crypto miners, who were long cryptocurrencies because of the nature of their capital raising process and operations.

These experiences made people realize the importance of having a proper risk management framework in place to handle the extreme volatility level and risk present in the crypto market. A possible way to reduce price risk for crypto holders is to implement a passive or active crypto hedging program.

In this article, we outline how investors can hedge their crypto exposure and the relative transaction costs. In particular, section 1 discusses various methods of hedging a cryptocurrency exposure. The second section performs a transaction cost analysis (TCA) on the previously introduced methods and estimates transaction costs as a function of traded notional. The third section concludes.

Ways to Trade and Hedge Crypto

Table 1 shows the main methods to trade and hedge crypto holdings, with both advantages and disadvantages.

Methods to trade and hedge cryptocurrencies
Table 1 Methods to trade and hedge cryptocurrencies

In the next subsections we review the characteristics of each method.

Spot trading

Spot trading is the simplest and most common method to trade cryptocurrencies. In order to do this, people need to deposit an amount of fiat on the crypto exchanges where they want to trade and start buying crypto. The main disadvantage is that investors cannot go short, so they cannot profit from bear markets like the one in 2018. Liquidity for spot trading is usually quite high, and it is available on many exchanges all over the world.

Margin trading

Margin trading consists in being able to trade depositing only a certain percentage of traded notional (leverage). Usually with margin trading comes the ability to borrow and short sell cryptocurrencies through loans from other participants on an exchange. In order to do so, the borrower will pay a margin fee to the lender to compensate him for the service. The major benefit of trading of margin is the ability to go short, hence potentially profit from bear markets, even if in these cases margin costs are likely to be higher. Additionally, hedging a crypto exposure is possible and only a fraction of the total hedged amount needs to be deposited on the exchange. Liquidity on exchanges that offer margin trading is usually medium high, so transaction costs are medium-low.

Futures

Futures are a derivative contract that allows investors to participate in the underlying crypto market without holding it. The main benefit of trading futures is the embedded leverage and possibility to go both long and short. Because of it, an investor like an ICO company or a crypto miner can hedge its position just by depositing a fraction of the entire amount. Liquidity for crypto futures is usually medium, and the product is offered only on a few exchanges. In addition, while hedging basis risk, i.e. the difference between the futures price and the underlying spot price before the settlement date, needs to be taken into account.

Swaps

Swaps are derivative contracts that allow two counterparties to exchange payments according to a specified method. Similarly to futures, they allow the investor to go both long and short, and require only a fraction of the traded notional as margin to open a position. In addition, they have very low basis risk, since the counterparties receive payments on a frequent and periodic basis given by the difference between the swap price and the underlying spot. Liquidity is usually very high, allowing big holders of cryptocurrencies to hedge their position with the lowest transaction costs available across all analyzed methods. At the moment, only a handful of exchanges offer trading in crypto swaps, and participants on some of these exchanges can potentially lose all their margin or balance on exchange if liquidated. Furthermore, hedging can be quite complex for a quanto swap (e.g. Ethereum), where the correlation with another instrument needs to be taken into account.

Options

Options gives the buyer the possibility, but not the obligation, to buy (call) or sell (put) the underlying instrument at the given strike price at the maturity date (European style). In other words, crypto holders can buy the required amount of put options to limit their losses if the underlying crypto price goes below a given strike price. This allows investors to participate in upside potential, but limit downside losses. This benefit comes though at the cost of expensive option premia to be paid to the option seller to compensate him for the insurance risk taken. Very few exchanges offer crypto options as of March 2019, liquidity is very low, and transaction costs quite high. This makes option hedging not a viable method to hedge an exposure for large holders of crypto like ICO companies, miners, or other institutional investors.

Crypto Transaction Cost Analysis (TCA)

This section analyzes the transaction costs incurred in trading cryptocurrencies, in particular Bitcoin, used the methods outlined before. We found that liquidity for trading options is very low, in the order of thousands of dollars, so we omit the analysis for options as a consequence. We used exchanges representative of each type of trading method. In particular, we chose Coinbase Pro for spot trading, Bitmex for futures and swaps, and Bitfinex for margin trading. Using order book data as of April 1 2019, we analyze the market impact costs of executing immediately an order ranging from $100K up to $100 million. The costs are expressed in basis points (1 bps = 1 / 100 % = 1 / 10000) and include both spread and market impact. The costs do not include fees charged by the exchange as they are usually dependent on monthly trading volume, but they roughly range from 7.5 bps to 20 bps for traded notional.

Table 2 and Figure 1 show the transaction costs in bps for executing a sell order for various amounts of traded notional.

Transaction costs to sell Bitcoin vs traded notional
Table 2 Transaction costs to sell Bitcoin (bps)
Figure 1 Transaction costs to sell Bitcoin vs traded notional

As it can be seen from them, in order to hedge some crypto holdings by going short an equivalent amount in spot or derivatives, swaps have the minimum transaction costs being the most liquid. At the same time, all other methods incur transaction costs which are exponential in the traded amount.

Table 3 and Figure 2 show the transaction costs for executing a buy order. The same conclusion for the sell order applies in this case, with the linear transaction costs for swaps and exponential for the other three methods.

Transaction costs to buy Bitcoin (bps)
Table 3 Transaction costs to buy Bitcoin (bps)
Transaction costs in bps to buy Bitcoin (log scale) vs traded notional
Figure 2 Transaction costs in bps to buy Bitcoin (log scale) vs traded notional

We now quantify the relationship between traded amount and transaction costs. Figure 3 shows it for spot trading in Bitcoin on Coinbase Pro.

Relationship transaction costs vs traded notional for spot trading
Figure 3 Relationship transaction costs vs traded notional for Bitcoin spot trading

As the figure shows, the relationship is exponential, with a very good approximation (R2 = 0.92). The following relationship holds:

Equation relationship transaction costs vs traded notional for crypto spot trading

Where:

q = traded notional in USD millions

TC(q) = transaction costs as a function of traded notional

Figure 4 shows the relationship between traded notional and transaction costs for swaps. As the figure shows, the relationship is linear in this case (R2 = 0.99), even for large traded amounts. This is due to the high liquidity of the swap contract, being also the most actively traded as of April 2019, with daily traded volume around $1 billion.

Relationship transaction costs vs traded notional for trading swaps
Figure 4 Relationship transaction costs vs traded notional for trading Bitcoin swaps

The estimated relationship between transaction costs and traded notional in the case of swaps is the following:

Equation relationship transaction costs vs traded notional for crypto swap trading

Where:

q = traded notional in USD millions

TC(q) = transaction costs as a function of traded notional

Conclusion

Based on the previous analyses, we can conclude the following:

ICO Treasury Management: Why Should ICO Firms Hedge their Crypto Balances?

Many companies in 2017 and 2018 decided to raise capital through an ICO by issuing tokens in exchange of cryptocurrencies like Bitcoin or Ethereum. We find that, while these firms managed to raise billions of dollars in this period, they didn’t manage their crypto holdings price risk, losing on average around 80% of the entire amount raised with the ICO. As a consequence, existing and new ICO companies should start adopting a proper ICO treasury management and crypto hedging program. This will allow them to minimize the risk of losing the capital raised during the ICO, because of the high volatility present in cryptocurrencies (~100% annualized volatility), and to meet their expenses in fiat.

This research paper is structured as follows. The first section gives an overview of the ICO market, with corresponding raised amounts. The second analyzes the volatility in cryptocurrency prices, Bitcoin and Ethereum in particular as they are the major cryptocurrencies accepted by ICO companies. The third section examines the ICO treasury management practices of a sample of ICO firms, showing their inability in managing their reserves properly. The fourth section concludes with key takeaways.

ICO Market Stats

During the period between September 2015 and March 2019, ICO’s companies raised a total of around $24 billion, with an average of $15.5 million per ICO. Table 1 shows the top 20 ICO’s by amount of capital raised.

Top 20 ICO’s by raised amount
Table 1 Top 20 ICO’s by raised amount

Figure 1 shows the top 20 countries where those ICO’s companies are domiciled. It is interesting to note that despite tighter security laws and scrutiny from the SEC, the United States comes first, followed by Singapore and the UK.

Distribution top 20 ICO countries
Figure 1 Distribution top 20 ICO countries

Figure 2 shows the category distribution of the analyzed ICO’s projects. Platform ICO’s come first, followed by cryptocurrency, business services and investments.

Distribution ICO categories
Figure 2 Distribution ICO categories

Table 2 shows the top 10 platforms used by the ICO projects to issue their tokens. As it shows, Ethereum is the major one with the ERC20 tokens, constituting around 90% of the tokens issued.

Distribution ICO token platform
Table 2 Distribution ICO token platform

Figure 3 shows the distribution of accepted cryptocurrencies from ICO firms for their capital raising process. As it can be seen from it, the most accepted cryptocurrency is Ethereum, constituting around 45% of all analyzed projects, followed by Bitcoin at 22%. As a consequence, in this article we will focus on the price risk of Ethereum balances.

Distribution accepted cryptocurrency ICO’s
Figure 3 Distribution accepted cryptocurrency ICO’s

Analysis Ethereum Price Risk

Figure 4 shows the price of Ethereum from September 2016 until March 2019. As it can be seen from it, cryptocurrencies, in this case Ethereum, are very volatile. The price went in fact from around $12 at the start of the considered period, to a maximum of $1400 in December 2018, and back again to around $140 as of March 2019.

Ethereum price
Figure 4 Ethereum price

Figure 5 shows the rolling 60-day volatility of Ethereum. As it can be seen from it, Ethereum is very volatile, with an average annualized volatility of around 112% for the considered period.

Rolling 60-day volatility Ethereum
Figure 5 Rolling 60-day volatility Ethereum

Figure 6 shows the drawdown for a buy and hold strategy in Ethereum. As it can be seen from it, a buy-and-hold investment in Ethereum experienced significant drawdowns, with a max drawdown of 94% and a mean drawdown of 45%. This means that an ICO company who would have raised capital at the Ethereum price peak in December 2018 and who did not liquidate its position, would have lost almost the entire fiat value of their holdings. This would have probably determined the failure of the project, since it would have not been able to meet its expenses in fiat like USD or EUR.

Drawdown buy-and-hold Ethereum investment
Figure 6 Drawdown buy-and-hold Ethereum investment

Table 3 shows the performance statistics of a buy-and-hold investment in Ethereum during the considered period.

Performance stats buy-and-hold Ethereum investment
Table 3 Performance stats buy-and-hold Ethereum investment

As it can be seen from it, Ethereum potentially provides high returns, with a mean annual return of 151%, but at the same very high risk, In fact, the average annualized volatility is 118%, and a max drawdown of 94%.

The previous data shows the importance for holders of cryptocurrencies like ICO companies to have a proper crypto risk management program in place to avoid losing the majority of their holdings values in fiat terms. An example of treasury management program would be a pure passive hedging program, where crypto holders lock-in their initial value of crypto holdings in fiat term. Another more dynamic approach would be an active hedging program, where they decide at which levels they want to hedge their crypto exposure. A last option would be a systematic crypto hedging program, where an algorithm analyzes the crypto data to determine when a bear market is more likely, and decides automatically on the best periods to hedge. The last two approaches would possibly provide both upside potential, and limit on downside losses.

In the next section we analyze the treasury balances of a group of ICO companies and see if they managed to implement a proper crypto risk and treasury management program.

Analysis ICO Treasury Management

In this section we analyze the treasury management reserves and behavior for a sample of around 50 ICO companies which have raised capital with Ethereum. Figure 7 shows the treasury balances for these companies in amounts of Ethereum. As it can be seen from it, many ICO firms still have a lot of their holdings in crypto, exposing them to a large crypto price risk and potential losses in fiat terms.

ICO treasury reserves in Ethereum
Figure 7 ICO treasury reserves in Ethereum

Figure 8 shows the USD value of crypto holdings for the considered ICO companies. As the figure shows, these firms lost the majority of their value in fiat terms, going from around $2.6 to about $400 million.

ICO treasury reserves value in USD
Figure 8 ICO treasury reserves value in USD

Table 4 shows the amount lost by these ICO companies because of change in Ethereum price, excluding the effect of withdrawals. As it indicates, the average ICO company lost around 73% of the value of their crypto holdings due to a improper treasury management practices. This poses into question the ability of these projects in being able to pay their ongoing and future expenses without raising additional capital.

Stats loss ICO crypto holdings due to crypto price risk
Table 4 Stats loss ICO crypto holdings due to crypto price risk

Figure 9 provides an additional piece of evidence in the lack of proper treasury management practices by ICO companies. As the figure shows, there is an inverse correlation (β = -1068.8) between change in Ethereum price and crypto holdings liquidated from treasury reserves. This is the opposite behavior that should be expected by good risk management practices. They in fact do not sell before Ethereum experiences losses, sitting on unrealized losses and hoping for a possible price increase in the future.

Relationship Ethereum price change vs ICO withdrawals
Figure 9 Relationship Ethereum price change vs ICO withdrawals

Figure 10 further validates the previous conclusion. As it can be seen from it, the analyzed ICO firms do not sell their holdings when the price of Ethereum is high, but instead made most of their withdrawals when the price was at its minimum. A good treasury management practice should do the opposite, i.e. sell only when the price is high.

Relationship Ethereum price vs ICO withdrawals
Figure 10 Relationship Ethereum price vs ICO withdrawals

This data shows that ICO firms are not adopting sound treasury management policies. They should as a consequence consider implementing a crypto hedging program, or delegating the management of their holdings to an investment professional.

Conclusion

The previous results highlight the following key takeaways:

ICO Market Analysis: What Really Drives the ICO Capital Raise Process?

Many companies in 2017 and 2018 decided to raise capital through an Initial Coin Offering (ICO). While the process seemed very promising at the beginning, it also showed its limitations around the end of 2018. In fact, many ICO’s were in fact scams, while other failed to deliver the promises towards their investors. In this research paper we analyze the ICO market from 2015 until present. The first section gives an overview of the ICO market. The second section analyzes more in detail the evolution of the ICO capital raising process over time, while the third section analyzes the main factors driving the ICO capital raise. The fourth section concludes with key takeaways.

ICO Market Stats

For this research we used the info on around 3500 ICO’s completed between September 2015 and March 2019. During this period, ICO’s companies raised a total of around $24 billion, with an average of $15.5 million per ICO. Table 1 shows the top 20 ICO’s by amount of capital raised.

Top 20 ICO’s by raised amount
Table 1 Top 20 ICO’s by raised amount

Figure 1 shows the top 20 countries where those ICO’s companies are domiciled. It is interesting to note that despite tighter security laws and scrutiny from the SEC, the United States comes first, followed by Singapore and the UK.

Distribution top 20 ICO countries
Figure 1 Distribution top 20 ICO countries

Figure 2 shows the category distribution of the analyzed ICO’s projects. Platform ICO’s come first, followed by cryptocurrency, business services and investments.

Distribution ICO categories
Figure 2 Distribution ICO categories

Table 2 shows the type of ICO used. Utility is the great majority at 97%, used mainly initially for regulatory purposes to avoid security laws in many countries. Despite the recent hype in Security Tokens Offerings (STO’s), they only represent about 2% of the total ICO’s so far. We’ll need to see in the coming years if they become the predominant form of ICO type.

Distribution ICO project by type
Table 2 Distribution ICO project by type

Table 3 shows the status of the completed ICO’s. It is interesting to note that, while many proponents of the ICO model claim liquidity as one main benefit of ICO’s, only around 20% of the completed ICO’s are actually listed for trading on an exchange. This shows that the vast majority of participants in ICO’s were not able to exit their position. This is similar to investing in an offering in a private early-stage company, where exit strategies at the beginning are limited.

Distribution ICO project by status
Table 3 Distribution ICO project by status

Figure 3 shows the distribution of number of team members for each ICO project. As it can be seen from it, it is a bimodal distribution, with peaks at 1 person and around 8 people.

Distribution number of team members ICO project
Figure 3 Distribution number of team members ICO project

Figure 4 shows the average number of team members over time. As it can be seen from it, there is a steady uptrend in this number, going from around 5 in 2016 to around 15 as of 2019. This possibly indicates greater professionalism and experience in the recent ICO teams compared to the initial ones, and a maturation of the market and its participants.

Number of team members ICO over time
Figure 4 Number of team members ICO over time

Table 4 shows the top 10 platforms used by the ICO projects to issue their tokens. As it shows, Ethereum is the major one with the ERC20 tokens, constituting around 90% of the tokens issued.

Distribution token platform ICO
Table 4 Distribution token platform ICO

Analysis ICO capital raise over time

This section analyzes the ICO raising process over time from September 2015 to March 2019. Figure 5 shows the number of ICO’s vs the price of Bitcoin during the period analyzed. As it can be seen from it, the number of launched ICO’s is highly correlated to the price of Bitcoin. This makes sense, since it is the price increase in Bitcoin during the considered period that gave rise to the popularity of cryptocurrencies and draw more capital in the ICO market.

Number of ICO’s vs Bitcoin price over time
Figure 5 Number of ICO’s vs Bitcoin price over time

Figure 6 shows the total capital raised for each month compared to the price of Bitcoin. A similar conclusion to what previously discussed applies. In fact, the total amount raised is greatly correlated to the price of Bitcoin.

Monthly raised amount ICO’s vs Bitcoin price
Figure 6 Monthly raised amount ICO’s vs Bitcoin price

Figure 7 shows the average amount raised per ICO each month on a log scale. As the figure shows and contrary to what it could be expected, the amount has been relatively constant around $15 million since August 2017. This indicates that, despite the decreased interest in the ICO market and slowdown in total amount raised and project launched, successful ICO companies can still expect to raise around the same level of capital as before the bear the market of 2018.

Average raised amount ICO over time
Figure 7 Average raised amount ICO over time

Figure 8 shows the average duration to complete an ICO. As it can be seen from it, there is a steady increase in the average time required to successfully launch an ICO, going from around 30 days in 2017 to around 100 days at present times.

Average duration capital raise ICO
Figure 8 Average duration capital raise ICO

In the next section we will analyze more in depth the relationship between the price of Bitcoin and the capital raised through the ICO process.

Factor analysis ICO capital raise vs Bitcoin price

Figure 9 shows the relationship between the Bitcoin price and the number of ICO’s launched each month for the analyzed period. As it can be seen from it, there is an almost perfect log-log relationship between the 2 variables (R2 = 0.92). This means that one of the main factor impacting the number of new launches in the ICO market is the price of Bitcoin.

Relationship Bitcoin price vs number of ICO’s
Figure 9 Relationship Bitcoin price vs number of ICO’s

Figure 10 shows the relationship between the Bitcoin price and the total amount raised each month. Similarly to the number of launches, there is a strong log-log relationship between the 2 variables (R2 = 0.81). This makes sense, since many investors remember the losses they had in the bear market and are not willing to invest in new projects because of that. Also, an increase in price of Bitcoin drives more interest in the market, and more capital to invest as a consequence.

Relationship Bitcoin price vs monthly raised amount ICO’s
Figure 10 Relationship Bitcoin price vs monthly raised amount ICO’s

Conclusion

The previous results highlight the following key takeaways:

Crypto Index Fund: Why You Should Not Invest in It

During the past 2 years many crypto index funds emerged as a result of the increased interest in the crypto market. These products offer to their investors a basket of cryptocurrencies under the promise of higher risk-adjusted returns due to portfolio diversification.

In this research article we show how this is actually far from the truth. We find in fact that cryptocurrencies are highly correlated, offering no portfolio diversification benefit by investing in a basket of them. In particular, we find that the performance of Bitcoin and an equal weighted or notional weighted crypto basket portfolio is essentially the same during the analyzed period. Therefore, investors looking for an actively managed product in the crypto space should look at other options, such as a systematic crypto investment program.

What is a Crypto Index Fund?

A Crypto Index Fund is a product that provides investors an exposure to a basket of cryptocurrencies. The typical methods used to weight the basket constituents are the following:

The main benefits that could potentially be achieved in a basket of cryptocurrencies is portfolio diversification if the constituents are uncorrelated. On the other hand, an investor usually has to pay higher costs compared to a direct investment in cryptocurrencies. These expenses include transaction costs to rebalance periodically and management and sometimes performance fees to the sponsor of the crypto fund index.

In the next section we see if it is worth paying these higher costs analyzing the correlation in the major cryptocurrencies constituents of such portfolios.

Correlation Analysis Cryptocurrencies

Usually proponents of crypto index funds cite portfolio diversification as the main factor in considering an investment in their product. Based on Modern Portfolio Theory, an investor can achieve benefits from portfolio diversification if he invests in a basket of uncorrelated or inversely correlated products.

In this analysis we consider the top 14 cryptocurrencies by traded notional on Bitfinex as of April 13, 2019. The period covered goes from March 2013 to April 2019.

Table 1 shows the top 14 cryptocurrencies by traded notional considered in this analysis.

Top 14 cryptocurrencies by traded notional
Table 1 Top 14 cryptocurrencies by traded notional

Figure 1 shows the average rolling correlation among the considered cryptocurrencies. As it can be seen from it, cryptocurrencies are highly correlated, with an average correlation of 0.7 as of April 2019. This poses in question the potential benefit that can be achieved through portfolio diversification by investing in a basket of cryptocurrencies through a crypto index fund.

Mean rolling correlation top 14 cryptocurrencies
Figure 1 Mean rolling correlation top 14 cryptocurrencies

The next section will analyze if this is true by comparing the performance of one cryptocurrency, Bitcoin, to a crypto basket and see if they are similar.

Performance Crypto Index Fund vs Bitcoin

Figure 2 shows on a log scale the hypothetical performance of 2 crypto index funds, equal weighted and notional weighted, compared to a passive investment in Bitcoin. The figures for the crypto funds are gross of transaction costs and fees charged by the sponsor. The performance of the crypto fund indices will be actually lower after considering them. As the figure shows, the performances of the 3 portfolios are very similar.

Performance crypto index funds vs Bitcoin (log scale)
Figure 2 Performance crypto index funds vs Bitcoin (log scale)

Table 2 shows the performance stats of the 3 portfolios to compare them in a more rigorous way. As the Table show, they all have similar levels of returns, volatility, and Sharpe ratio accordingly.

Performance stats crypto index funds vs Bitcoin
Table 2 Performance stats crypto index funds vs Bitcoin

Table 3 displays the correlation matrix between the 3 portfolios. As we would have expected from our previous correlation analysis on cryptocurrencies, the 3 portfolios are highly correlated (ρ = 0.9), posing in serious doubt the validity of an investment into crypto index funds.

Correlation matrix crypto index funds vs Bitcoin
Table 3 Correlation matrix crypto index funds vs Bitcoin

As we have seen from the previous data, crypto index funds cannot provide any benefit compared to a passive investment in Bitcoin. Therefore, an investor looking for an actively managed product in the crypto space should consider other options. An example is a systematic crypto hedge fund, which could potentially deliver alpha and an uncorrelated performance compared to Bitcoin and other cryptocurrencies in both bull and bear market conditions.

Conclusion

From our analysis we can deduct the following key takeaways:

Crypto Market Cap Evolution and Comparison to Traditional Asset Classes

Executive Summary

This article analyzes the cryptocurrency market capitalization for the top 20 cryptocurrencies. In particular, it shows the composition of market cap by cryptocurrency, how it evolved over time, and how it compares to traditional asset classes like stocks and bonds. The research finds the following:

The article is structured as follows. The first section analyzes the market cap composition for the top 20 cryptocurrencies over time. The second section compares the crypto market cap to traditional asset classes. The final section concludes.

Crypto market cap composition over time

Table 1 shows the top 20 cryptocurrencies by market capitalization considered in this research.

Market cap top 20 cryptocurrencies
Table 1 Market cap top 20 cryptocurrencies

As the figure shows, the current total market cap for all the cryptocurrencies is around $111 billion. Figure 1 shows the distribution of the crypto market cap for the top 20 cryptocurrencies. As it can be seen from it, over 80% of the total market cap is in the top 3 cryptocurrencies, with Bitcoin having 57.63% of the total.

Crypto market cap composition as of Jan 2019
Figure 1 Crypto market cap composition as of Jan 2019

Figure 2 shows the evolution of the crypto market cap in billion of US dollars over time.

Crypto market cap from Apr 2013 to Jan 2019
Figure 2 Crypto market cap from Apr 2013 to Jan 2019 ($ billion)

As it can be seen from it, the cryptocurrency market cap is very volatile, in a similar way to the crypto prices. It went in fact from around $1.5 billion in April 2013 to $111 billion in January 2019, an increase of around 100 times in almost 6 years.

Figure 3 shows the composition of the market cap by cryptocurrency.

Composition crypto market cap from Apr 2013 to Jan 2019
Figure 3 Composition crypto market cap from Apr 2013 to Jan 2019

As the figure shows, Bitcoin lost its dominant market share during the analyzed period, going from around 95% of the total market cap in April 2013 to around 57.63% in January 2019. Cryptocurrencies that have been quite successful are Ethereum, used in ICO through ERC-20 tokens, and Ripple. Both in fact have managed to achieve around 12 percentage points in market share during the analyzed period.

The next section puts the crypto market cap into perspective by comparing it to traditional asset classes.

Crypto market cap compared to traditional asset classes

Figure 4 shows the market cap of Bitcoin and cryptocurrencies compared to traditional asset classes.

Crypto market cap compared to traditional asset classes
Figure 4 Crypto market cap compared to traditional asset classes

As the figure shows, despite their tremendous growth in the past 6 years, cryptocurrencies and Bitcoin still have a very small market cap compared to traditional asset classes. In particular, their market cap is still lower than Amazon, currently the largest publicly listed company by market cap in the US stock market.

This data shows that crypto is an emerging technology that has the potential to become a new asset class, but it still has a relatively small market cap.

Conclusion

Crypto is a new technological innovation that has experienced tremendous growth in the past 6 years in terms of market capitalization. Nonetheless, it is still quite small compared to traditional asset classes like equity and bonds. We will probably need another 5 to 10 years before considering crypto a relevant asset class in terms of market capitalization.

Highlights from the Equities Leaders Summit 2018

On December 7, 2018 Bluesky Capital was invited at the Equities Leaders Summit at the Trump National Doral Miami to discuss the adoption of cryptocurrencies as a new tradable asset class from equity investors. The following key takeaways emerged:

•     There are still too many risks for institutional investors to enter in the crypto space, including regulatory, reputational, custody, and counterparty risks.

•     Cryptocurrencies as an uncorrelated asset class provide benefits to equity or other investors in terms of portfolio diversification

•     Crypto is a highly volatile asset class, creating opportunities for hedge funds that employ trend-following / CTA strategies

•     The benefits offered by the blockchain technology and cryptocurrencies imply their mass adoption in the next 10 to 20 years

•     High fragmentation and scarce liquidity on exchanges create profitable opportunities for hedge funds that use market making and statistical arbitrage strategies by providing liquidity across crypto exchanges

Key Takeaways from the Conference

Below are the key takeaways from the conference.

1.     Why have some institutions moved into the crypto space and why are others, like banks, asset managers and hedged funds still reluctant?

Cryptocurrencies have 4 main risks still too high for institutional investors:

Some hedge funds, especially more nimble ones that manage investments from HNWI’s and family offices, have already decided to assume and possible mitigate those risks with appropriate measures and take advantage of the opportunities created by the volatility present by cryptocurrencies. We anticipate that more institutions will enter the cryptocurrency market in the next 3 to 5 years, when there will be more stability and development in the space and a reduction in the previous risks as a consequence.

2.     How would crypto exposure impact an equity trader’s portfolio?

Historically cryptocurrencies have been uncorrelated to equities and fixed income. This means that equity or other investors who allocate to crypto as a new asset class can obtain portfolio diversification benefits by achieving lower risk for the same level of expected return or higher expected return for the same level of risk.

3.     Do the volatility advantages outweigh the risks?

Cryptocurrencies are highly volatile, with an average annualized volatility of Bitcoin around 100%. This presents high risks, but at the same time big opportunities for professional investors who adopt CTA / trend-following strategies which generally perform very well in these market environments. The crypto space is highly similar to the futures market in the 80’s or 90’s, which was very volatile and almost no institution wanted to invest, while nowadays is one of the most actively traded and liquid market across all asset classes.

4.     Is there enough growth potential and opportunity in this space to suggest that mainstream cryptocurrency trading is inevitable?

We believe that there has already been too much investment by big institutions and corporations in the blockchain technology and there are many benefits in adopting cryptocurrencies in terms of speed of payment processing to let it go away. The industry is still very new, in a certain way very comparable early stage of the Internet era in the 90’s, where a new technology was brought but people still had to figure out the real potential and new applications of the technology. We believe that complete adoption of blockchain and cryptocurrencies is an inevitable long-term process, which similarly to Internet will probably take between 10 to 20 years to complete.

5.     What’s the current state of liquidity on cryptocurrency exchanges?

The crypto market is currently highly fragmented, where one cryptocurrency trades on at least a dozen exchanges, and characterized by a lack of institutional liquidity. These creates profitable opportunities for hedge funds and proprietary trading companies who employ market-making and statistical arbitrage strategies that can collect spreads by providing liquidity on multiple exchanges. At the same time, only a few companies have so far entered the market because of the expertise needed and the substantial investment in technology to operate such activities. We believe that more liquidity providers need to enter the market in order for institutions to consider trading cryptocurrencies without having a meaningful market impact and substantial transaction costs as a consequence.

Highlights from the Art Decentralized Conference during Miami Art Week 2018

On December 6, 2018 Bluesky Capital was invited at the Art Decentralized conference during the Art week in Miami to discuss the application of blockchain technology, in particular tokenization, to the art industry. The following key takeaways emerged:

•     Tokenization has the potential to attract lots of interest in the art industry as an investment in a new asset class in terms of portfolio diversification

•     A regulatory framework needs to be developed to define what a token represent on a legal standpoint and provide more investment confidence for accredited and institutional investors

•     Art owners will be able to liquidate portions of existing collections through tokenization

•     Accredited investors will be able to invest in art funds who invest in tokenized art and achieve exposure to art as an uncorrelated asset class compared to equity and fixed income

Key Takeaways from the Conference

Below are the key takeaways from the conference.

1.     What are the mechanics of tokenizing something like a piece of art?

Tokenizing a piece of art consists in creating a dividing the ownership of a piece of art in multiple pieces through the issuance of a token linked to that piece, which is then purchased by multiple investors. This process is equivalent to an equity investment in a company, where multiple investors buy different shares in a company.

2.     What are the benefits of tokenization for art?

This technology has several benefits and opens up new opportunities in the art space, among which:

3.     Does the blockchain technology guarantee the authenticity of a piece of art?

The technology itself does not guarantee the authenticity of a piece of art itself, which is a work that still needs human experts at the beginning. The blockchain technology in fact only allows the storage of the information regarding a piece of art, such as its provenance, author, etc., on multiple databases (ledger). If the initial information stored in the blockchain technology is misleading or counterfeited, all the subsequent records stored on multiple computers will be as well. This is a process analogous to garbage-in garbage-out (GIGO). On the other hand, once an initial expert has validated that a piece of art is actually authentic and has stored that information in a ledger, it is very difficult to tamper that information.

4.     What are the legal aspects of tokenization for works of art?

Tokenization is a new technology, so regulation still needs to keep up with it. Most likely tokenizing a piece of art and selling it to multiple people as an investment configures in a similar way to an equity share in a company, so it will probably fall under security laws and be regulated by the SEC.

5.     How can investors buy tokenized art now?

Since selling tokenized pieces of art is similar to an offering of securities, in the United States they are usually conducted as a private offering to accredited investors under the exemption of Rule D. Another possibility is to invest in an art fund, which pools money from multiple investors with the purpose of getting an exposure to art as an asset class of to generate a return above a specified benchmark in the sector.

6.     Can retail investors buy tokenized art?

For now it is difficult for retail investors to participate in tokenized pieces of art mainly because of a lack of regulation in the sector and absence of art exchange where tokens can be freely traded. It is possible that in the future, when both regulation and technology will develop for this sector, retail investors will be able to own a fraction of an expensive piece of art like a multi-million dollar Picasso painting by freely trading them on exchanges or investing in an art mutual fund.

7.     What do the artists say?

Currently artists are happy about the technology since it provides an alternative way to monetize their works of art and potentially sell their works directly to consumers, bypassing galleries, art dealers, and auction houses. It is important to underline that the greatest reward will be probably taken by famous artists who sell pieces worth millions of dollars, since the process of tokenizing and monetizing a piece of art as a form of investment makes sense only for expensive works.

8.     Will institutional investors invest in art as an asset class?

We believe that the great potential offered by tokenization to create liquidity in an illiquid asset class, the low correlation of art as an asset class compared to equity and fixed income, and the low returns delivered by traditional asset classes will potentially attract substantial interest from institutional investors in art as an asset class in an optics of portfolio diversification.

Credit to Light Node Media for organizing the conference.