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Table of Contents – Introduction to Portfolio Diversification Using Crypto Assets

1.     Introduction

2.     Why do I need to diversify my investment portfolio?

3.     Where to start my diversification?

3.1.    Zerocap Bitcoin Trust (ZBT)

3.2.   Zerocap Collateralised Lending

3.3.   BTC/ETH 70/30

3.4.   Bitcoin Smart Beta

3.5.   Zerocap DeFi Index

3.6.    Smarter ways to play the market – Structured Products

4.     Conclusion

5.     Sources

1. Introduction

As a sophisticated investor, you must have begun to wonder about cryptocurrency as a potential portfolio allocation avenue. According to S&P Global Ratings analysts, Cryptocurrency is increasingly being considered by the U.S states and local governments as an investment, a payment mechanism, and a job generator. The Bitcoin Whitepaper written by Satoshi Nakamoto [1] back in 2008 following the aftermath of the GFC gave the official birth of Bitcoin and introduced the technology of Blockchain [2] and Cryptography [3] into a financial instrument. Already in Asia and other emerging market economies, Cryptocurrency payments through Stablecoins [4] (more on them below) have been used for cross border remittance, banking Letters of Credit cost reduction, and other bureaucratic red tape cutting purposes. But only until recently are we able to integrate the decades of Traditional Finance (TradFi) expertise into the innovative world of Cryptocurrency investment.

2. Why do I need to diversify my investment portfolio?

Savvy Investors are beginning to diversify their portfolio allocation away from stocks, bonds, property, and even commodities, because there is a limit to how much politicians are able to kick the can down the road before it becomes too heavy!  Thirty years ago, the Japanese authorities began strategising unconventional monetary policy in terms of ZIRP[5] (Zero Interest Rate Policy).  It failed to revive a continual stagnated economy with little to no consumer inflation visible. The Bank of Japan (BoJ), with the help of the Ministry of Finance, then decided to employ additional forms of unconventional stimulus, including Quantitative and Qualitative Monetary Easing[6] (QQE) and Yield Curve Control[7] (buying debt issued by the government with printed money, to stop the market from worrying about government debt level).  Perhaps due to a particular set of demographic situations or simply incorrect methods of economic management, these tools have also failed to ignite the growth engine of the Japanese economy. But it has provided a precedent for other central banks of the developed world to follow. It formed an escape route when the politicians have lost control of the economy, such as following the GFC[8] in 2008. 

What follows is almost a constant continuation of money supply growth to fund fiscal deficits, generating no employment income growth and kicking the debt problem down the road to be “handled” by the next generation.  Central Bankers initially thought the unlimited supply of money printing would generate an economic multiplier effect and ignite real GDP growth through income and employment. The actual result ended up elevating the profitability of banks’ balance sheets by providing them with ultra-low interest rate funding, with little to no benefit to the real macroeconomic variables. As a corporate citizen that looks after shareholder interest, it seeks the most profitable avenue for return. The money went into financial assets and lifted stocks, property, and even bonds to record price levels. But how long will this last, and what happens when the “music” stops? According to the Federal Reserve Bank of St. Louis, in the U.S., the velocity of money[9], which helps generate the “multiplier” effect of central bank’s money printing, has dropped from 2.15 just before the year 2000 to 1.43 in 2019. That means the marginal impact on stimulating the economy diminishes for every extra dollar the central banks are printing.  Not far into the distant future, money printing will not save us from a recession. That is when it’ll be too late to diversify your portfolio away from the TradFi investment world. Fiat currencies will depreciate in value against real assets due to the increased supply above demand (more details in 3.1), the bond market will be impacted due to inflationary pressure from a depreciating base fiat currency, the real rate of return drops below zero due to central banks falling behind the curve, stock markets will be impacted from spikes in the discount rate as the bond market sells off, and the present value of future returns are no longer calculated on zero rate, commodity market will be impacted as the economy falls into stagflation.  

What’s the answer? Smart investors such as Ray Dalio, who founded the world’s largest hedge fund, Bridgewater Associates, said he had put a “certain amount of money” in cryptocurrency assets, amongst other hedge assets.

3. Where to start diversification of my investment portfolio using crypto assets?

At the time of writing, there are over 10,000 cryptocurrency coins, tokens, and various forms of investable assets in the crypto space. To make institutional portfolio diversification a more smooth and scalable process, Zerocap has employed a team of traditional investment experts to construct the following products for you.

3.1.     Zerocap Bitcoin Trust (ZBT)

 In economics 101, we learned that the price must always come down if you increase the supply of something greater than the demand. With most central banks in the developed world unconditionally creating an unlimited money supply, the value of your investment in fiat currency holding (such as USD, JPY, AUD and GBP) cannot hold its value infinitely. This is where Bitcoin becomes interesting as a starting point for diversification.

The modern world of cryptocurrency began with the creation of Bitcoin. It is also the asset with the largest market capitalisation within the asset class (around 41% of the entire market cap at the time of writing). Bitcoin (BTC) is immutable, non-sovereign, and has a fixed, finite supply (21M). The biggest contrast between the structure of BTC versus modern fiat currency such as the USD is the theory behind the Stock to Flow ratio. In common terms, it means that due to the limitation of ultimate supply and the cost involved with generating each marginal coin, the annual predicting increment of BTCs has very little impact on the price of the currency.

Though it has become relatively easy to buy and sell BTC by opening accounts at various exchanges or Over-The-Counter (OTC) providers, experienced investors know too well that unregulated platforms present counterparty risk that keeps them up at night. The Zerocap Bitcoin Trust (ZBT) fund was constructed to ease such concern. The fund is created in an Australian Unit Trust structure, with an institutional custodian platform and insured by Lloyd’s of London. 

3.2.     Zerocap Collateralised Lending

To maximise the yield return of a portfolio without the worry of market price volatility, Zerocap constructed the Stablecoin Collateralised Lending offering. Stablecoins are a type of cryptocurrency pegged to a common fiat currency such as the USD and backed by a balance sheet of money market instruments to maintain its stability. Currently, Zerocap Collateralised Lending has an option to invest into either Tether (USDT), created in 2014, which is the first stablecoin to be invented with a USD 68 billion market cap, and USD Coin (USDC), the second largest stablecoin with USD 29 billion market cap. Not only can we provide this product in the base currency of USD, but we can customise individual portfolio needs by employing FX hedging strategies to neutralise Foreign Exchange risk. The construction of the lending process includes institutional borrower due diligence, counterparty credit analysis, and FX hedging through a Cross-Currency Swap embedded into the final offering. For the investor, it is as simple as earning a high yield (5% – 10% p.a.) return with very limited  price FX, and counterparty risk. 

3.3.     Zerocap BTC/ETH 70/30 Efficient Frontier

While Bitcoin (BTC) is the limited supply, store of value, Ethereum or Ether (ETH) is the cryptocurrency behind the building blocks of almost all the current financial networks in the crypto space. In simple terms, Ethereum is the tool used to create contracts on the blockchain, and ETH is the currency employed for those transactions, a coin to pay for protocol fees and transfer value. Due to the popularity of Ethereum in the development and construction of the Decentralised Finance (DeFi), ETH has become the second-largest cryptocurrency.

With a growing number of traditional asset managers entering the cryptocurrency space, Zerocap in 2021 began employing portfolio analysis with Sharpe Ratio optimisation and covariance correlation techniques to seek the best portfolio return for each given volatility level. In addition, the Zerocap Investment Committee meets regularly to dissect a number of updated macroeconomic, market research, crypto-specific on-chain data, and news event updates to construct the best ratio allocation to each cryptocurrency asset for different types of investors. The creation of the BTC/ETH 70/30 product is a prime example of this process, which reassesses the BTC and ETH ratio in the portfolio continuously.

3.4.     Zerocap Smart Beta Bitcoin Fund

One of the prime concerns of Cryptocurrency investing is the level of volatility. At the time of writing, options markets are implying 100% annualised volatility for BTC, and even higher for other cryptocurrencies. In answering such concerns, Zerocap’s team of experts integrated the traditional finance toolkit to create the Bitcoin Smart Beta Fund.  Smart Beta allows clients to participate in this asset class whilst avoiding large swings in price volatility through a process of dynamic rebalancing between spot BTC and USDC.

3.5.     Zerocap DeFi Index

The most simple generalisation of Decentralised Finance (DeFi) is the creation of the banking system on the blockchain, effectively removing intermediaries.  Investors can deposit (lend) money, and borrowers are able to borrow money while the token owners of the platforms are the owners of these decentralised banks, with voting rights to how the banks should operate and develop. When you begin owning the tokens, you’re a minority shareholder and you get to participate in the AGM and benefit from the appreciation of “bank shares”. As you accumulate the tokens, you get to have a bigger say on how this “bank” is run and potential future developments. Of course, once you have a classical banking system, you have the investment bank and asset management, private banking, treasury services and so on. 

The Zerocap DeFi Index offers exposure to ten assets across six key verticals that cover the largest services in the ecosystem through the most prominent protocols. The Zerocap DeFi Index was constructed by the Zerocap Investment Committee (IC) to employ extensive market research in selecting the initial ten assets that meet our due diligence criteria, including the free-flow market capitalisation measurement guidelines. The main difference between the Zerocap DeFi Index fund and other popular market funds is that the free-flow market cap criteria are only one piece of our selection and rebalancing process. Unlike various existing market funds that rebalance their allocation purely on the free-flow market cap of current DeFi assets, the Zerocap DeFi Index Fund employs a Relative Weighting Allocation Method throughout the duration of the fund management process. In addition, the Zerocap IC reviews each portfolio mix every quarter and analyses the current market event, updated research, and future forecast to determine if rebalancing the portfolio will benefit investors.

3.6.     Smarter ways to play the market – Structured Products

In addition to the above products mentioned, Zerocap is currently in the process of constructing bespoke structure offerings such as 

i. Yield Enhancement Entry/Exit Notes (YEEN) 

Entry Note: While having a long term positive perspective on cryptocurrency as an asset for appreciation, YEEN allows investors to capture market swings to the downside while elevating the yield return of their portfolio allocation. A fixed percentage interest rate is paid in US dollars within the structure period. One or more pre-agreed levels of accumulation in either BTC, ETH, or other coins below the current market price is set at the beginning of a structured product contract. On the fixing/maturity date of the agreement, if market pricing is at or below the predetermined level, the client accumulates the agreed amount of BTC/ETH/altcoins at the specified level. In addition, clients also earned the enhanced agreed percentage of return to be paid in the BTC/ETH/altcoins accumulated. On the other hand, if by the fixing/maturity date of the contract, BTC/ETH/altcoins prices are above the predetermined level, the client receives the principal USD notional plus the enhanced agreed yield return in interest. 

Exit Note: In a similar structure as the Entry Note, the Exit note caters for investors who already have the BTC/ETH/Altcoins in their portfolio and would enjoy an enhanced yield return on their holdings in return for a profit-taking strategy if the market rallies. A predetermined level is then set above the current market price for the duration of the structured product contract. At the fixing/maturity date of the agreement, if the price is at or above this level, the client would sell the holding at this predetermined price and receive an additional yield paid in the BTC/ETH/Altcoin. If it is below the predetermined level, the client gets the agreed interest payment in US dollars and keeps the investment holding. 

ii. Principal Protected Notes (PPN) 

A strategy that provides upside to the price of the investors’ BTC/ETH/Altcoin holding with principal protection if the asset price falls below entry-level. At a predetermined entry level of the structured product note, the client enjoys the initial 50% of the upside benefit of any price appreciation that is determined by the fixing/maturity date of the contract. This level of benefit is capped in order to provide the investor with downside protection of the investment holding. If the asset price falls below the predetermined entry level, the investor will be guaranteed to receive 100% of the entry price for the relevant holding notional. 

4. Conclusion

Now that a gateway to the world of cryptocurrency products to diversify the investment portfolio is open, investors are rushing to participate in this new asset class. Even though there is an abundance of opportunities in the marketplace, having a credible partner with extensive knowledge of the crypto world yet still understanding and taking experience from traditional finance is vital to the success of your investment. In addition to the product mentioned above, Zerocap is also in the process of constructing other innovative products in the context of a Multi-Strategy fund for our clients. Contents of the Multi-Strategy fund will include on-chain data analysis, which is performed using blockchain big data. Zerocap performs the data gathering, cleaning, historical backtesting, and technical analysis to create investment strategies. Depending on your level of Cryptocurrency investment knowledge, level of investment criteria and level of portfolio diversification needs, Zerocap is able to construct a portfolio mix of products to optimise the investment outcome for you. It’s an exciting time in the crypto asset space, and with the help of Zerocap, you can stay ahead of the curve and understand your risk profile as it changes.

About Zerocap

Zerocap provides digital asset investment and custodial services to forward-thinking investors and institutions globally. Our investment team and Wealth Platform offer frictionless access to digital assets with industry-leading security. To learn more, contact the team at [email protected] or visit our website www.zerocap.com

5. Sources

[1] Nerurkar, P, Patel, D, Busnel, Y, Ludinard, R, Kumari, S & Khan, MK 2021, ‘Dissecting bitcoin blockchain: Empirical analysis of bitcoin network (2009–2020)’, Journal of network and computer applications, vol. 177, p. 102940.

[2] Shrivastava, Ga 2020, Cryptocurrencies and Blockchain Technology Applications, Place of publication not identified : John Wiley & Sons US.

[3] Al-Kahtani, N 2019, ‘Technology demonstration: How cryptography, blockchain and distributed ledger technologies can transform B2B/G2B electronic payments in healthcare?’, Computer methods and programs in biomedicine, vol. 171, pp. 1-1.

Sun, Wa 2019, Security tokens and stablecoins quick start guide : learn how to build sto and stablecoin decentralized applications, Birmingham

Mumbai : Packt Publishing.

[5] Ullah, W, Matsuda, Y & Tsukuda, Y 2014, ‘Dynamics of the term structure of interest rates and monetary policy: is monetary policy effective during zero interest rate policy?’, Journal of applied statistics, vol. 41, no. 3, pp. 546-572.

[6] Koeda, J 2019, ‘Macroeconomic effects of quantitative and qualitative monetary easing measures’, Journal of the Japanese and international economies, vol. 52, pp. 121-141.

[7] Kinugawa, M 2019, ‘The unconventional monetary policy of the Bank of Japan during the period 2013–2018: comments and views on Shirai’, International Journal of Economic Policy Studies, vol. 13, no. 2, pp. 347-358.

[8] Hall, VB & McDermott, CJ 2020, ‘The business cycle and monetary policy: what changed after the GFC?’, New Zealand economic papers, vol. 54, no. 3, pp. 312-326.

[9] Leao, P 2005, ‘Why does the velocity of money move pro-cyclically?’, International review of applied economics, vol. 19, no. 1, pp. 119-135.

Schnabel, JA 2009, ‘Dual Currency Deposits’, The journal of structured finance, vol. 15, no. 3, pp. 32-36.

[11] The unique feature of bitcoin and other cryptocurrencies compared to traditional assets is the lack of a centralized exchange. Spot markets for digital currencies are fragmented due to their largely unregulated nature where the same asset, such as bitcoin, is simultaneously traded at multiple cryptoexchanges around the clock and around the world. By virtue of that, bitcoin and other cryptocurrencies represent a unique case to empirically assess the presence of arbitrage and to study the forces that may affect its existence or influence its limits.

Shynkevich, A 2021, ‘Bitcoin arbitrage’, Finance research letters, vol. 40, p. 101698. Makarov, I & Schoar, A 2020, ‘Trading and arbitrage in cryptocurrency markets’, Journal of financial economics, vol. 135, no. 2, pp. 293-319.

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