A New Frontier for Digital Asset Investing

Dear Investors,

As we enter the last quarter of 2022, we are living in truly remarkable times. Through the end of the third quarter, the Bloomberg US Aggregate Bond Index was down 14.6%, with all segments of the bond market posting negative returns. This is the worst year of performance in the 45-year history of the index. Meanwhile, the S&P 500 has fallen 24.7%, on track for its worst year since 2008. As of mid-October, the generic “60/40” portfolio has had its worst year-to-date stretch in a century. To further challenge the conventional picture, consider that bitcoin is now less volatile than the S&P 500 and Nasdaq for the first time since 2020.¹

Amid this disruption, a recent report by PwC revealed that more than one-third of traditional hedge funds are now investing in cryptocurrencies, highlighting the growing acceptance of digital assets for alpha-generating trading strategies.²

This is a dramatic turnaround. When I began my personal journey into cryptocurrencies in 2013, bitcoin was the only readily tradable asset, and it was primarily seen in a limited role as a censorship-resistant store of value. Even in 2017, after I participated in my first ICO and formally began to research crypto investments at Corbin Capital, the world of opportunities was constrained: Investors were mostly focused on venture investments and a few awkwardly constructed hedge fund vehicles that sought more or less similar exposures. 

Five years later, the picture has changed. The space is full of companies like Paradigm, one of the largest liquidity networks with 600+ institutional clients trading over $10 billion per month, and Anchorage Digital, which had just launched in 2017 and is now a federally chartered digital bank. As investors embrace enterprise-ready technology and financial services thanks to the flow of venture funding over the last decade, I believe they are also slowly recognizing that actively managed crypto strategies, enabled by such rapid development, now provide a novel vector that can push into uncharted corners of the efficient frontier.

In short: To access alpha in this asset class, institutional allocators have to fundamentally reset their assumptions. 

Consider these new economic paradigms emerging around digital assets: 

• Digital assets are altering the technical fabric of global trading markets and their underlying structures, producing liquid opportunities at a scale and pace that was once thought impossible. 

• Economic and social institutions are adopting blockchain technology built on top of crypto assets—venture-like assets with public market liquidity—thus accelerating the need for a flexible investment approach that is faithful to crypto’s underlying technological utilities and value-capture framework. 

• As new internet cooperatives that blur the traditional line between investors and operators come online (and on-chain), the investment vehicles that seek to capture them are changing apace. 

• Regulators are now beginning to recognize the widespread potential and inevitability of digital assets. 

We believe that alpha-generating opportunities in digital assets over the next decade are going to look unlike anything we have seen before … and that the inflection point is approaching ever more rapidly.

There are now more than 800 crypto-focused hedge funds. Many have demonstrated that attractive risk-adjusted returns can be captured by the pursuit of alternative strategies with rigorous due diligence. For that reason, it is more worthwhile than ever to consider the role an uncorrelated multi-strategy crypto allocation can play during a time when traditional portfolio theory is failing. 

We are now ready to inaugurate the quest for an efficient frontier that is 100% crypto-native. When we examine the crypto space, we see these alpha engines: 

• Event-driven trading: During October—a month when crypto markets were relatively flat—Huobi’s utility token HT increased by over 100% after the founder agreed to sell his controlling stake. During the same month, BNB token performance was largely unaffected despite the $100 million hack of the Binance Smart Chain. 

• Credit strategies: For the first time ever, MakerDAO voted to invest $500 million of their collateral pool into U.S. Treasuries and corporate bonds. Riding the growing wave of permissioned lending, Maple Finance onboarded a new solution to provide secured debt financing to bitcoin mining and infrastructure companies, bringing real world assets on-chain while leveraging aspects of securitization technology. These are unique moments that demonstrate the two-way flow of decentralized finance into traditional finance and vice-versa.

• Arbitrage strategies: In September, the CME Group continued its expansion into crypto options trading with the launch of Ether contracts, joining the derivatives market frenzy alongside FTX, Deribit, dYdX, and many others. Meanwhile, FTX partnered with Paradigm to permit “one-click futures spreads trading” to bring further sophistication to trading technologies. The market continues to mature, achieving greater price efficiency and liquidity despite a market structure that is fragmented among traditional, centralized crypto-native, and decentralized exchanges. In this environment, those trading opportunities can be captured across a widening range of digital assets.

These examples are by no means exhaustive. Earning uncorrelated alpha correctly requires deep technical expertise—for instance, the ability to leverage private order routing to evade malicious trading activities, or to deploy smart order algorithms that can leverage on-chain data to improve execution price. Knowing how to navigate the signal-to-noise ratio of idiosyncratic events requires specialized knowledge of narratives and a deep presence in the crypto community. 

In pursuit of that goal, Bitwise’s core mission is to provide the education and research that help institutional investors understand and access these strategies. To that end, I am pleased to be joined by Vin Molino, an industry leader in operational due diligence from Northern Trust and Mercer, and Denyven Peng, a highly experienced risk specialist hailing from Millennium Management and BlackRock. We are excited by the caliber of the institutional team leading this effort. We’re committed to elevating the standards for operations and risk management alongside our deeply respected and admired crypto research team, helmed by the peerless leadership of Matt Hougan and David Lawant. 

Inspired by the novel ways that decentralized crypto networks mobilize and empower human capital, we envision a bold partnership model for our clients: one that honors these powerful catalysts to empower like-minded LPs as trusted partners for years to come. 

Thank you for trusting us as your guide in navigating and capturing these evolving opportunities.

Jeffrey Park, CFA

Portfolio Manager, Head of Alpha Strategies

(1) https://blog.kaiko.com/bitcoin-volatility-matches-nasdaq-533da6266777

(2) https://www.pwc.com/gx/en/financial-services/pdf/4th-annual-global-crypto-hedge-fund-report-june-2022.pdf