The demand for market-neutral strategies:
In the course of the last year, I’ve met with 100s of family offices, RIAs, and accredited investors. While our fundraising continues to be successful, one of the most common objections and themes we heard from potential investors was a desire for Market Neutral strategies due to the perception that these strategies are of lower risk. Even some of our largest LPs offered us seed cheques if we would take the market-neutral tactics we occasionally use in our primary fund and spin up a 2nd solely market-neutral fund due to this belief. However, our analysis shows that at the present time, market-neutral funds are far riskier than is commonly believed.
Let’s start with one group of investors, Family offices.
Family offices are generally considered to be risk-averse. Their clients typically have significant wealth and are more concerned with preserving and growing their assets than pursuing high-risk, high-reward investment strategies as they look to protect and grow capital over generations. In theory, a strategy that would reap consistent, if not exponential, returns regardless of the market cycle would be perfect. The private credit market & real estate investment are generally highly represented across portfolios because they serve this demand exceptionally well.
So why wouldn’t market neutral serve as well in digital assets as in other areas? In short: counter-party risk.
Market-neutral strategies aim to minimize the impact of market movements on the performance of a portfolio. Most of these strategies leverage slight price differences in assets, markets, or time (convergence strategies) to take many small gains very quickly and are generally algorithmically traded to perform in this manner. For this type of trading to occur, these funds must have their assets nearly fully deployed on exchanges. In markets with mature and well-regulated exchanges, this is generally accepted. In fact, in most mature commodity markets, it is not necessary to custody assets to trade. However, in the emerging digital assets market, to trade cryptocurrency, it must be held on the exchange, which opens traders to counter-party risk. This is an existential risk to both funds and investors who choose to pursue the market-neutral path at the present time.
Counterparties' effects on Market Neutral Strategies in digital assets
2022 was a turbulent year in digital assets. Many top managers have been calling the bear market since Q4 of last year. This aligned with the historical three-year bull, a one-year bear cycle we have previously seen in the digital asset market. As Warren Buffet says, “When the tide goes out, you can see who is not wearing shorts.” Unfortunately, that tide has gone out, and now we see more than we ever cared to. We’ve seen prominent institutional players across the landscape fall, including some of the largest crypto hedge funds, such as 3AC & Alameda, and multiple exchanges, such as FTX, BlockFi, and Celsius. This culminated with the fall of FTX, the west’s largest exchange.
The scale of these failures demonstrates that there is no safe haven from counterparty risk. Even the largest and most-trusted providers are not immune from risk.
Let’s look at how just one of these failures affected Market-Neutral strategies.
Across funds, Galaxy Digital’s Vision track reports performance on the average market-neutral hedge fund performance was 3.98% through Oct 2022, with 20.58 as the best performance. Last year at the height of a bull market, average performance was 37.04% with a high of 137%.
As we’ve already covered, most market-neutral strategies must be fully deployed on centralized exchanges to get the speed of trading and liquidity their algorithms need. Due to this, we’ve seen fund after fund announces their losses due to assets locked into FTX. One report indicated that one-third of funds with FTX exposure lost a 30% of their assets and many over 50%. Some examples of exposure included Galaxy digital’s indication that it had 77M on the exchange, Coin shares 30.3M, Galois 45M, and Crypto Fund Research estimated Pantera had about 100M. **
It is not my intention to criticize their choice of counterparties. A responsible fund in this space should diversify across multiple exchanges (that pass their DD) with institutional access for their trading. DD on exchanges is limited, with very few exchanges, like Kraken, offering full proof of reserves via Merkle Tree. We are still learning the extent of the shenanigans FTX was pulling, but even a good-faith counterparty exposes you to risk.
What are Counterparty Risks:
Security risks: Cryptocurrency exchanges are potentially vulnerable to security breaches, which can result in the theft or loss of the assets held on the exchange. Breeches can come from nation-states, outside hackers, or bad actors internally.
Operational risks: Cryptocurrency exchanges may experience technical issues, such as outages or system failures, which can prevent users from accessing their funds. These issues may also result in the hedge fund's inability to trade or a total loss of assets.
Regulatory risks: The regulation of cryptocurrencies is still evolving worldwide, with different municipalities moving at their own pace. The domicile an exchange operates out of could interfere with operations, freeze assets, or even nationalize and exchange.
Unbacked / Leveraged Accounts: A centralized exchange could hold fractional reserves of the assets they represent. This means the digital assets on the exchange may not exist. In the case of a run on the exchange, the assets you believe you are holding there could evaporate or get locked up for years in a bankruptcy filing and, if ever, only returned fractionally.
Biased towards Long biased:
I often refer to counter-party risk as the second biggest threat in digital assets, which always leads to the question, “What is the first?”. The most significant risk is that most projects are going to zero. This industry is rife with intentional fraud, but even avoiding them, many well-intentioned projects are not going to make it.
So why enter such a new and volatile market? For many, it was because of a core belief that blockchain technology is an infrastructure on which technology innovation will grow in the coming decades. Blockchain technology, infrastructure companies, and solution providers who get this right will be at the core of the next technological revolution, in the same way, TCP/IP, the web browser, and the personal computer was at the center of the last. With a deep understanding of technology, an obsession with its thematic evolutions, and a thorough analysis of both on-chain data and traditional technical analysis, the right teams can place directional bets on the technologies themselves.
In a market still developing and with emerging technology, our experience shows that long-term capital growth is generated by focusing on fundamental value. For an asset class with the potential for exponential growth, preservation of capital during downturns is more important than trying to capture every basis point.
How long-biased strategies minimize counter-party risk:
Today, BTC can be moved from cold storage behind a technical custody provider like Fireblocks onto a trading platform in under 10 minutes. In a faster blockchain, such as AVAX, the time is closer to 60 seconds. Value investors typically hold assets based on their convictions. However, the above-mentioned times are still fast enough to live by the adage “strong convictions loosely held.” As such, they do not require deploying assets from one's own custody outside of a trade, significantly mitigating (but not eliminating) counterparty risk.
The volatility in digital assets and the inefficiencies of the digital asset market makes it seem ideal for market-neutral strategies. However, at this time, our analysis shows that the risk exposure, primarily from counterparties, far outweighs the reward potential of this sort of play. These strategies will make more sense as the market matures with regulated exchanges, improved custody solutions, and/or post-trade settlement. In the meantime, we feel directional investment with a team of cautious and thorough technologists may position you to share in what may be our generation's greatest wealth-creation event.