Wall Street vets vie to be BlackRock of crypto

Fund launch uses fundamental analysis to identify value propositions in high-risk industry


Much like the 19th-century prospectors who flocked to California in search of gold, today’s pioneers are likely to be bitcoin devotees seeking their fortune in finance’s new frontier. But, like the Wild West, cryptocurrencies have proven to be a risky, volatile arena, ready to trap the unwitting investor.

Criticism of the crypto industry as lawless and, even, as a haven for money launderers and criminals has not deterred mainstream companies from preparing new ventures. Last October, Boston-based Fidelity Investments launched an institutional platform for cryptocurrencies, providing custody services, a cryptocurrency trading platform and – since digital currencies never sleep – round the clock institutional advising services.

Regulators, too, are making exploratory moves in this area. The UK’s Financial Conduct Authority has hosted a series of “sandboxes” for fintech firms. Of the 28 projects involved in its most recent cohort, 12 were related to the technology that underpins cryptocurrencies: blockchain and distributed ledger technology.

Start-ups are plentiful in the industry, and one notable newcomer is a crypto hedge fund with a lofty goal: to become the BlackRock of the digital securities world. Its founders – Rayne Steinberg and Jeff Dorman – hope to achieve this by harnessing the traditional virtues of institutional investment to help tame the unpredictability of cryptocurrencies.

“What differentiates us is that many of the funds in the crypto space came at this from a bottom-up scenario, meaning they owned bitcoin, they made a lot of money in bitcoin. And then they said, ‘Now I can start a fund’. But they were never fiduciaries for other people’s capital before,” says Dorman, who previously worked the trading desks of Lehman Brothers, Merrill Lynch and Citadel.

“We’re doing the opposite. We believe that an actively managed portfolio of cryptocurrencies with strong risk management overlay can really outperform traditional markets.”

Named Arca Funds, the company’s business plan is to build and manage digital currency products that use crypto and blockchain technology. The fund has been investing partner money since August 2018 and hopes to raise $100 million by the middle of this year.

Arca’s primary strategy is to invest in any of the 2,000-plus exchange-traded digital tokens that show potential to grow their user base, though it concentrates mainly on the 100 most liquid. In an industry where the attrition rate is high – industry estimates put the number of failed cryptocurrencies at around 1,000 so far – the fund is looking for assets that will survive before they thrive.

To assess the prospects of a token, the fund conducts fundamental analysis of the team behind the asset, economic incentives that might drive future adoption and the product’s usability.

There are some derivatives markets between futures and options that are popping up which are very liquid but they really only work on bitcoin

Jeff Dorman, Arca Funds

An example of a well-structured token would be Binance Coin, Dorman says – a token issued by the Binance cryptocurrency exchange, currently the world’s largest. The token functions mainly as a means of paying transaction fees on the exchange: as Binance trading volumes increase, so does demand for Binance Coin. To ensure a stable value for the currency when demand falls, the administrator periodically repurchases tokens and “burns” then, removing them from circulation.

“Most of the industry is following very technical analysis, doing very quantitative trading strategies where the underlying asset doesn’t matter that much; they are really just trading trends and momentum,” Dorman says. “We’re coming at it more from a traditional deep-dive fundamental evaluation standpoint, where we are actually analysing these protocols, technologies and companies.”

The difference, of course, is there’s no Graham and Dodd book in crypto; no industry bible that explains exactly how to value assets. This, Dorman says, is perhaps the biggest challenge for institutionally minded crypto traders, in that there’s no standard for traditional portfolio and risk management calculations like Metcalfe’s law, NVT ratio, the equation of exchange, and discounted cashflows.

To manage the day-to-day volatility of digital currencies, the fund is borrowing tried-and-tested risk management procedures from the institutional world – ensuring that no more than 20% of the overall risk is sat at any one exchange, avoiding illiquid assets, employing the same counterparty risk management methods used in traditional asset classes, an active approach to position sizing, and of course, crash protection.

“That’s a little harder in the space because the tools don’t exist yet,” Dorman says. “The market is not very liquid and it’s also very expensive to short. There are some derivatives markets between futures and options that are popping up which are very liquid but they really only work on bitcoin. So we’re trying to introduce other methods to reduce overall volatility and to protect against the big 20%, 30% or 40% crashes. But that’s still a work in progress.”

Hedging strategies are rudimentary. The dominance of instruments referencing bitcoin limits the manager’s ability to hedge other tokens, Dorman says.

“When we do hedge, we are using the tools that are available, and there just aren’t as many tools as we’d like. For example, we often hedge long-risk using bitcoin options. The problem is, we like bitcoin and believe over time it will outperform many of the other tokens in the marketplace. So using bitcoin as a hedge to protect against other assets is imperfect because it’s not representative of the overall market and it has its own unique characteristics. There is no liquid market hedge like SPY for equities or JNK for high yield bonds that makes hedging more precise.”

Crypto and blockchain are going to be disruptive in some way, shape, or form

Jeff Dorman, Arca Funds

The coolness of regulators towards cryptocurrencies might put some off building a business in the area. The Securities and Exchange Commission has expressed reservations about the use of blockchain as an alternative to traditional custody and warned investors to be vigilant when considering investments in initial coin offerings.

Despite the grey areas, Arca is aiming to release innovative product types to appeal to new investor segments. The firm has a registration statement pending with the SEC for a fund investing in US Treasuries that will issue shares as digital securities on the blockchain – an industry first.

“Our goal is to be like the BlackRock or WisdomTree of crypto where we have a suite of products, and investors of all levels will find some product that works for them,” Dorman says. The analogy is apt since co-founder Rayne Steinberg was one of the architects of WisdomTree Investments.

With the same optimism that fuelled the forty-niners, Dorman is unwavering in his belief that crypto is the next frontier for the intrepid investor.

“Most of the people in traditional finance that come over to crypto recognise that there’s something here. We don’t know how long it’s going to take. We don’t necessarily know exactly the form it’s going to take. But we know that crypto and blockchain are going to be disruptive in some way, shape, or form to what has existed for ever in financial services.”

Editing by Alex Krohn

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