Zerocap’s Senior Trader and PhD finance researcher William Fong discusses incorporating traditional investment tools into cryptocurrency assets.
Ever since Satoshi Nakamoto wrote and published the Bitcoin whitepaper as a response to the institutional failings that led to the Global Financial Crisis (GFC), the world of finance was destined for a revolution through cryptocurrency assets. I’ve been working in the traditional finance (TradFi) world since the 1990s and have learned many lessons from one crisis to another. My learning began during the Asian financial crisis of 1997/98, on the front-line battle end of one of Asia’s largest commercial banks, observing first-hand how market panic could create extreme volatility for asset prices. But it wasn’t until I was given a major responsibility to manage a high-risk portfolio of investments during the GFC of 2007/08 that I found myself falling into an abyss of stress over the market’s version of liquidity constraints and loss of trust. Over a decade later, as the COVID-19 pandemic took hold, the emergence of institutional level cryptocurrency adoption was taking place, and with it – a gradual migration of expertise from the old world of TradFi into the new realm of crypto. The tools of the trade which tradfi practitioners have developed, innovated, and refined over the decades are now being deployed in the brand-new arena of cryptocurrency markets.
There are now over 10,000 different versions of cryptocurrencies available for buying and selling, in addition to centralised and decentralised “exchange” traded futures and options contracts, ETFs, ETPs, unit trusts, and most innovative of all, Decentralised Finance (DeFi). For a tradfi professional faced with current central banks’ Zero Interest Rate Policy (ZIRP), and their support for asset price inflation, crossing over into the world of cryptocurrency investing was never going to require a second thought.
Cryptocurrency as an asset class
The entire market cap of the crypto space is roughly around USD 2 trillion at writing. Of course, relative to the combined onshore and offshore USD bond market, which is estimated to be close to USD100 trillion, cryptocurrency as an asset class is still relatively minuscule in comparison. Bitcoin (BTC) is by far the most traded cryptocurrency in the spectrum with roughly 42% of the entire cryptocurrency market cap., with Ethereum (ETH) closing in second place with approximately 18%. This is followed by a long list of up-and-coming currencies with less than USD100 billion market cap. However, due to decades of an ultra-low interest rate environment created by global central banks and political followers of the Modern Money (Monetary) Theory (MMT), investors have longed for an alternative asset class to hedge against when, and not if the music stops in the tradfi bubble. The growth in the cryptocurrency market in recent years has been nothing but extraordinary; according to Chainanalysis Index (2021), worldwide Crypto adoption has jumped over 880% since the same time last year. As mainstream global too-big-to-fail institutions enter the cryptocurrency space, portfolio allocation into this newfound asset class has become too-big-to-ignore.
How to avoid volatility?
One of the main frustrations of portfolio investment allocation in the tradfi world during 2021 is the lack of volatility. Since the market rebounded during the March 2020 pandemic selloff, there has been little to no opportunity to enter the risky asset market at a reasonable valuation. The ZIRP Environment in most of the developed world, together with some negative interest rate domains (Japan and Europe), has facilitated the entire multiplier effect into asset price inflation across the globe. While the supply of fiat money has become so abundant in economies like the U.S. and Australia; stocks, bonds, commodities, and real estate investing have become a form of an inflation anticipation hedging tool. But as stock markets reach record levels and property values are pushed beyond fundamental values, who really wants to buy into the top of the cycle?
As more and more tradfi investors look to allocate at least part of their portfolio into the cryptocurrency assets arena, implied and actual volatility has made participation somewhat difficult. At the time of writing, both BTC and ETH’s implied volatility measures around 100% p.a. In addition, actual historical swings in some new innovative products such as DeFi (detail below) could reach multiples of this standard deviation. However, with the integration of a traditional investment toolkit and the knowledge of market timing experiences, some leading market innovators like Zerocap have been able to offer their clients the ability to participate in this asset class while avoiding the full swing effects of its volatility through a process of volatility balancing and dynamic delta management.
How about some stable yield returns?
The Zero Interest Rate Environment created by decades of balance sheet expansion and failures of politicians to rein in fiscal deficit spending have forced investors in the tradfi world to dive down the credit quality curve to achieve respective returns. This type of yield-seeking portfolio management has led to the GFC and the European crisis, and potentially many more in the future. Smart investors are now allocating part of their portfolio into the world of collateralised stablecoin placements. Asset structuring teams in market-leading firms can customise money-market-like products in the client’s base currency while delivering enhanced yield returns (5-7% p.a.) without foreign exchange risk or asset price fluctuation. As the migration of tradfi hedging tools into the cryptocurrency market intensifies, I can see a stream of structured products tailored to the individual investor will emerge.
As for the risk-seeking investor
If one prefers to seek a more volatile product mix in return for higher capital appreciation, a portfolio of DeFi assets could be just what you need. The Decentralised Finance space is changing rapidly, and new innovative protocols are launching every day. In order to steer through this uncharted but exciting world, one needs to partner themselves with investment firms of proven experience and deep knowledge that are able to assess the credit quality and viability of a project to benefit from its full potential. The combination of knowledge, experience and prudent tradfi due diligence is now helping to avoid unnecessary capital losses.
Another extremely hot offering from the innovation of the crypto space is Staking. The Proof of stake (PoS) concept is the next version of Proof of Work (PoW). The ability to participate in validating the blockchain and in the actual creation of newly mined cryptocurrency assets presents a high-yield return opportunity. However, the quality of the partnering firm to manage and provide custody of the allocated asset is a crucial consideration and should be part of your due diligence process in order to build peace of mind.
Derivative trading with the ability to capture deviations in forward yield curves through the process of both gamma and vega risk management tools are now the prime example of tradfi/cryptocurrency integration. Employing data analysis and portfolio construction using historical on-chain and derivative information will bring more sophistication into the realm of cryptocurrency investment.
Conclusion: cryptocurrency assets and traditional investment tools
In recent years, cryptocurrency as an asset class has gradually matured. Now investors across all walks of the risk spectrum can no longer ignore the potential opportunity offered by this alternative investment. What started as a currency market based on blockchain technology has now become a marketplace full of innovative derivative structures. To put a perspective on this evolution, over 60% of daily BTC trading volume is now in futures contracts (Delphi Digital 2021). The ability for leading institutions to integrate their tradfi experience and innovative approach into the crypto space and provide bespoke investment products to investors has completely changed the attractiveness of portfolio allocation. I am certain this is only the beginning; more and more tradfi expertise will find its way into this revolutionary asset class.
About the author
William Fong is a Senior Trader at Zerocap. His career spans more than 25 years having held senior positions at leading financial services organisations including Citi, Deutsche Bank, Ernst & Young and Westpac. Will is an avid researcher, currently pursuing a PhD on global capital markets linkage with fiscal stimulus and MMT strategy at Melbourne’s Swinburne University of Technology.
Zerocap is a crypto asset investment platform for private clients, family offices and institutional investors. We provide unique investment products and custody to forward-thinking investors and institutions globally.
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1 Satoshi Nakamoto is the name used by the presumed pseudonymous person or persons who developed bitcoin, authored the bitcoin white paper, and created and deployed bitcoin’s original reference implementation. As part of the implementation, Nakamoto also devised the first blockchain database, leading the way to all cryptocurrency assets.
4 MMT followers believe there is no limit to the quantity of money that can be created by a central bank. That they believe as long as the money supply is created for the benefit of fiscal stimulus for the good of its people and printing is done is its sovereign currency, there is little to no downside effect as a result.
5 Decentralized finance is a blockchain-based form of finance that does not rely on central financial intermediaries such as brokerages, exchanges, or banks to offer traditional financial instruments, and instead utilizes smart contracts on blockchains, the most common being Ethereum. (Wikipedia 2021).
6 The Proof of Stake (PoS) concept states that a person can mine or validate block transactions according to how many coins they hold. This means that the more coins owned by a miner, the more mining power they have (Investopedia 2021).
7 Proof of work is a form of cryptographic zero-knowledge proof in which one party proves to others that a certain amount of a specific computational effort has been expended. Verifiers can subsequently confirm this expenditure with minimal effort on their part (Wikipedia 2021).