In the crypto industry, five years is considered a significant timeframe. With 24/7 trading hours, one crypto year can feel like five normal years. Over the past five years, many players have come and gone, leading to survivorship bias in crypto asset management. Despite the risks involved, it is indeed possible to invest and manage a crypto fund for five years.
Jeff Dorman, a CoinDesk columnist and chief investment officer at Arca, brings his 20 years of trading and asset management experience to share the key insights gained from managing a crypto portfolio over the last five years.
Adjusting Assumptions and Risk Models
It’s no secret that investing in this market is challenging. The frequent ups and downs create a misleading sense of liquidity and unreliable expectations for returns. Risk models, loss provisions, and sizing parameters are all based on historical data and correlations, which change rapidly. This is why most funds in this space focus on early-stage ventures, where real-time market issues are less relevant. However, for those of us managing liquid funds, it’s a constant process of adjusting assumptions and risk models.
Prioritizing Interpretation over Speed
Escape the misconception that constant trading is essential in the world of crypto. Overtrading on every minor price movement is costly in any asset class. While extended trading hours in crypto may tempt individuals to be more active, the fragmented global investing landscape actually provides ample time to react to news and information. Bots and algorithms may react instantly, but their knee-jerk responses are often incorrect. Furthermore, with a significant portion of the world asleep at any given time, it takes days for the true market reaction to unfold. Thus, having a correct understanding of information outweighs the need for quick reactions.
In this context, meticulous documentation is of paramount importance.
However, the 24/7 nature of the cryptocurrency market does pose unique challenges absent in traditional markets. In traditional finance, even the worst day or week eventually ends, allowing individuals time to reset and carefully consider decisions while markets are closed, unburdened by price fluctuations. But in the crypto market, these natural resets are rare.
Consider the Terra/Luna events as a stark example. The complete collapse of a $30 billion ecosystem unfolded within three days, with continuous trading and new information emerging throughout. Decisions made during this period, in hindsight, would have been different if more time for thoughtful consideration was available. We have since learned to implement better risk management during similar situations in the future.
In hospitals, mistakes often occur not due to overwork or fatigue of doctors, but rather inadequate handoffs to the next doctor, resulting in incomplete information. Similarly, managing crypto assets necessitates seamless knowledge handoffs and meticulous documentation.
Striking a Balance Between Short-Term and Long-Term
Unlock the secrets of market dynamics in debt and equity markets versus the world of digital assets. While quiet periods in traditional markets often lead to gradual price increases and buying interest, the opposite holds true for crypto. Slower periods in the crypto sphere can reduce asset momentum, leading to more frequent negative price movements. With minimal costs for shorting and the absence of cash flow distributions, hedging and making long exposure decisions become challenging.
Hence, active management emerges as the pathway to success, outperforming passive indexes. Rules-based passive strategies struggle to adapt to market innovations and fail to capitalize on alpha generation opportunities amidst volatility. While this might change in the future as the market matures, it remains the current reality.
Crafting a formidable team is paramount for achieving triumph, yet it poses its own set of challenges. With an impressive 25-year track record across seven renowned financial firms, Jeff brings invaluable expertise spanning various departments such as banking, trading, research, sales, and business development. His extensive experience includes reviewing countless resumes and conducting numerous interviews. If a traditional Wall Street firm sought a suitable candidate, they could effortlessly find one that precisely meets their requirements.
Employing Individuals with a Strong Passion for the Industry
Uncover the essential attributes and qualifications sought after in a research analyst within the dynamic crypto industry. Who possesses the ideal skill set for excelling as a Trade Ops expert? Which candidate proves most adept at handling investor relations? These questions continue to challenge the crypto landscape. In the early days of their fund, they had to make do with whoever was available, attracting individuals seeking employment without much consideration. The compensation was underwhelming, the working hours seemed never-ending, and the future appeared uncertain. Those who ventured into this industry in 2018 carried a genuine passion for the triumph of blockchain and were willing to acquire any necessary skills to thrive in their roles. The majority of those who joined prior to 2020 still actively contribute, continuously adapting their responsibilities in real-time.
However, by 2021, they had the chance to handpick candidates from major banks, brokerages, and hedge funds, even if they lacked direct crypto experience but anticipated substantial financial opportunities. Resumes flooded in, yet many of these new hires fell short of expectations. As they venture into 2023, they once again find themselves relying on individuals who possess unwavering passion and are willing to go above and beyond to secure a place in this industry.
Everyone wears multiple hats
Embrace a hands-on approach that drives success in this dynamic industry. As a research analyst, your role entails evaluating application functionality, challenging conventional financial modeling, and fostering valuable connections with industry experts at conferences. Traders, on the other hand, navigate the intricate landscape of US macroeconomics, Asian currency markets, and crypto-specific on-chain wallet activities, leveraging correlations and trends to make informed decisions. Back-office professionals must continually test new service providers to comply with evolving regulations, embrace best practices, and meet the demands of limited partners, all while navigating the ever-present risks of bankruptcies, closures, and hacking attempts.
A common thread that unites these roles is the need for a willingness to explore uncharted territory. In the world of equity analysis, ten analysts given the same inputs would likely arrive at the same answer, employing standardized modeling techniques. However, in the realm of crypto analysis and trading, ten professionals presented with the same inputs would likely offer ten distinct answers, utilizing diverse analysis methods. This diversity brings forth a fresh perspective and has the potential to unlock higher alpha, but it also poses the challenge of establishing a consistent formula for success.
The Importance of the Trade Operations Department
In the realm of credit and equity funds, the back office often went unnoticed during Jeff’s tenure. Populated mainly by ambitious young professionals yearning to transition into a “real” trading position, their responsibilities primarily revolved around mundane tasks such as ensuring prompt trade settlements, maintaining accurate brokerage statements, and overseeing fund administrators.
Compliance teams were a necessary presence, but their role was limited to rule enforcement and seeking guidance when uncertainty arose, resulting in a rather cautious approach of “do not proceed.”
However, in the captivating world of crypto, we find ourselves fortunate. Trade operations take center stage, recognized as the utmost priority. These skilled professionals handle assets day in and day out, acutely aware that even the slightest error can lead to substantial financial losses. Their reliability and ability to establish robust redundancies are critical in ensuring seamless continuity. Transitioning into a Trade Ops role is more enticing than transitioning out, as those who specialize in it acquire invaluable expertise in blockchain.
Compliance holds an equally crucial role in the crypto industry. Unlike the traditional finance landscape (TradFi), employees may not possess an inherent understanding of the rules due to their diverse backgrounds. Continuous education and diligent monitoring become indispensable. Compliance officers cannot merely rely on reading the rules and assuming compliance, as limited clear-cut guidelines exist. Striving to act as both fiduciaries and law-abiding entities demands substantial effort.
Improvement in the Sell-Side
In the realm of traditional finance, the sell-side occupies a pivotal role, encompassing underwriting transactions, generating financing ideas, offering capital markets advice, facilitating trading, and providing invaluable research and market insights. However, the cryptocurrency industry paints a different picture, with a fragmented sell-side lacking essential services, consequently limiting investment opportunities. While written research from OTC trading shops has seen improvements, exchange-based trading lacks the natural avenues between investors, resulting in a scarcity of market information sources. The absence of a comprehensive investment bank offering underwriting and advisory services for token launches remains a pressing concern.
The crypto industry yearns for the well-known tools of Wall Street, as their absence poses challenges for token issuers and yields subpar investment prospects. While certain services like custody solutions and OTC trading are making strides in improvement, the retreat of fund administrators and auditors following FTX has left a void. The crypto services provided by Bloomberg have failed to keep pace with the industry’s growth, while innovative newcomers such as Nansen, Messari, Glassnode, and Dune Analytics have emerged. These trailblazers have revolutionized the landscape, enabling the operation of a crypto fund without reliance on a Bloomberg Terminal.
Hence, the lack of sell-side tools continues to hinder the management of funds. Nonetheless, as the sell-side sector undergoes enhancements, one can anticipate a surge in the number and diversity of funds, paving the way for a brighter future.
The Investor Base is Becoming More Knowledgeable
When the fund was established five years ago, the managers knew that educating potential investors would be a slow process. They continued to learn about the industry and educate investors as they invested. However, it was unrealistic to expect non-industry professionals to keep up with the rapid pace. Investors were more interested in how the fund invested rather than what it invested in, and trust played a role.
Now, investors have become more knowledgeable about the asset class and ask insightful questions. In some cases, they know more than the fund managers because they have exposure to different areas of the industry. However, erroneous information spreads easily through the media, causing surprise on certain topics that the managers might consider irrelevant.
As investors become more familiar with digital assets, they want more control over their investments. This has led to the launch of specialized funds like DeFi-focused and NFT funds to meet demand. Some managers, like Arca, offer “Funds of 1” that provide professional management while allowing investors to personalize their investments.
In 2018, it was recommended to rely on professional investors. However, retail investors are now encouraged to research and invest due to the availability of information and user-friendly interfaces. Nonetheless, having professional fund managers is crucial to generating alpha in an environment of information asymmetry. Managers can take advantage of the 24/7 news cycle, market volatility, and regulatory uncertainty.
Running a fund in this new and innovative space has been highly rewarding, and we are excited for the next five years. Fund managers will navigate between adopting Wall Street best practices and capitalizing on crypto-specific opportunities like yield farming and airdrops.
The key to success in the digital assets space is having faith in the future. We believe we are at the forefront of building a new financial system that can revolutionize society. Although we anticipate challenges and resistance from incumbents benefiting from the current system, as long as we keep progressing, advocating for necessary changes, and adapting when necessary, this industry will thrive.