A Primer on Digital Asset Strategies
The case for alpha-generating digital asset strategies for institutional investors.
Nov 17, 2023The narrative surrounding digital assets has come a long way since the early days of the digital asset market. Wall Street has started to see beyond the speculative nature of this new asset class and is recognizing it as a part of the global financial markets.
Institutional interest has grown significantly in recent years as digital assets become more mainstream. Research indicates that institutional investors are increasingly adding digital asset allocations to their portfolios.
In this article, we break down the elements that are boosting institutional interest in digital assets and make the case for digital asset strategies to be part of institutional investors' portfolios.
A Brief Overview of Digital Assets
Digital assets are an asset class that exists purely in digital form, encompassing cryptocurrencies such as Bitcoin (BTC) and Ether (ETH), non-fungible tokens (NFTs), security tokens, and other blockchain-based assets.
Unlike traditional assets, such as stocks, bonds, or commodities, digital assets - also often referred to as cryptoassets - typically operate on decentralized blockchain networks that provide transparency and security.
One of the most compelling aspects of digital assets for institutional investors is their potential for alpha generation. These assets often exhibit low correlations with traditional financial markets, providing diversification benefits and the opportunity for potentially outsized returns in a well-structured portfolio.
However, the market for digital assets is relatively new and can be highly volatile, requiring sophisticated risk management strategies and a deep understanding of the underlying technology and market dynamics.
Digital Assets: A New Avenue for Alpha Generation
Now, let’s look at why digital assets are suitable for investors looking to generate above-average returns.
Characteristics of Digital Assets
Once you get past their speculative nature, the value proposition of digital assets is remarkable. Several characteristics give digital assets an edge over traditional asset classes.
Decentralization
Decentralization is a key distinction between digital and traditional asset classes. It creates a new and unique financial system where transactions are conducted peer-to-peer (P2P) without the need for intermediaries. This reduces costs, making transactions more affordable for investors. Additionally, investors have greater control over their assets.
In contrast, traditional asset classes require investors to go through intermediaries, resulting in higher fees. The centralized nature of traditional finance also limits investors in exercising control over these assets.
Transparency
In “TradFi” (traditional finance), investors are unable to see all the trade details of their brokerage accounts because the process is centralized. On the other hand, the transaction details of digital asset trades are publicly recorded (in the case of public blockchains) and can be viewed and audited by anyone.
Speed
While securities trades can take days to settle, digital asset trades settle almost instantly or within an hour. This enhanced speed is crucial in a world constantly seeking to increase efficiency.
24/7 Trading
Blockchains operate 24/7, 365 days a year, with no breaks during holidays or business hours. As a result, investors can trade digital assets at any time.
On the contrary, traditional financial asset trading typically occurs five days a week from 9 am to 5 pm. Holidays also pause operations, further minimizing efficiency and accessibility.
Zero Risk of On-Chain Rehypothecation
Rehypothecation, while beneficial for brokers, banks, and other financial institutions in accessing short-term working capital, can have devastating consequences during a time when the economy is fragile, as was the case in 2008.
Fortunately, on-chain transactions prevent multiple investors from using the same digital assets as collateral in the DeFi markets, making it impossible to rehypothecate.
In addition to the characteristics mentioned above, digital assets are grabbing the attention of institutional investors due to technological advancements, declining price volatility, and rising market growth.
The Tech is Evolving, the Market is Maturing
The most impactful technological advancements in blockchain that have taken place since 2017 are layer-2 scaling solutions, cross-chain infrastructure, and the introduction of more sustainable DeFi yields through real-world assets (RWAs). These innovations have enhanced efficiency, speed, and adoption.
Furthermore, the digital asset market has grown significantly since 2017 from a market capitalization of approximately \$0.5 trillion to more than \$1.6 trillion at the time of writing. At its height in 2021, the total digital asset market reached nearly \$3.0 trillion.
Historical Market Cap of All Digital Assets
Source: CoinMarketCap as of December 18, 2023.
The market has also grown in terms of the availability of digital-asset-based products. Today, investors can buy futures, options, ETFs, and mutual funds that provide exposure to the asset class.
Interestingly, the price volatility of Bitcoin has eased, according to a Glassnode report released in early August 2023, which revealed that Bitcoin’s annualized 30-day volatility was relatively low at 17%. That same month, Bloomberg also reported that the asset’s 90-day volatility was at its lowest since 2016.
As indicated in the chart below, Bitcoin’s average five-day volatility has been lower than the S&P 500, Nasdaq, DXY, and gold eight times between January 2019 and August 2023.
Average 5-day volatility (BTC vs NDQ, SP500, DXY and Gold)
Source: K33 Research, “Ahead of the Curve,” as of August 1, 2023.
Historical Performance Analysis
While digital assets are generally regarded as risky financial instruments, they are also known for their mind-blowing bull runs, particularly when it comes to Bitcoin and Ethereum.
Bitcoin has displayed tremendous growth in value over the years and has become an expensive asset for anyone wishing to obtain a whole coin, meaning one entire Bitcoin. Its price has risen from \$65.53, recorded on July 5, 2013, to a high of \$44,084.30 this month, a 67,173.46% surge in ten years.
The second-ranking digital asset by market capitalization, Ethereum, has also registered an impressive performance, climbing from the low price of \$0.40 to $2,311.04 in eight years, a 577,660.00% increase. Percentage increases at this level are unheard of in traditional finance.
The following table compares the performance of these two digital assets versus three primary traditional investment vehicles:
Sources: CoinMarketCap, S&P, Google Finance, DailyFX
Alpha-Generating Strategies in Digital Assets
Now, let’s look at several alpha-generating strategies investors are applying in the digital asset markets.
Diversification with Digital Assets
Digital assets can help reduce portfolio risk as they are not closely correlated with traditional assets. The following table shows that the correlation between BTC and various traditional asset classes has remained consistently low (below 1) since 2009.
BTC Monthly Correlations as of November 30, 2023
Source: Lazy Portfolio ETF
Furthermore, studies have shown that adding digital assets to a traditional portfolio leads to higher relative returns in risk-adjusted and absolute terms. [1]
Active Management Strategies
DeFi offers various opportunities for fund managers to grow their clients’ portfolios with digital assets through various income-generating strategies.
One such opportunity is staking, which rewards investors for locking their digital currencies in a smart contract for a specified period of time and participating in blockchain consensus. Staking also provides investors with additional avenues for earning by using liquid staking tokens (LSTs) to generate higher yields through liquidity provision or arbitrage trading. LSTs are pegged to the value of staked tokens and are issued when investors lock their digital assets in a smart contract.
In addition to staking, investors can earn returns by lending their digital assets to borrowers or providing liquidity on a DeFi protocol. Moreover, trading strategies like arbitrage can be profitable for investors.
Identifying profit-making opportunities, particularly in complex algorithmic trading strategies like arbitrage, scalping, and mean reversion, requires studying on-chain analytics. Advanced computerized systems are typically used to automate and speed up the execution of algorithmic trading strategies.
Long-term Holding and Market Timing
Although the digital asset market has evolved considerably over the last five years, accurately predicting all the factors that can influence price fluctuations remains difficult. Therefore, attempting to determine the “right” time to enter or exit the market with a simple long or short position is very challenging.
For this reason, the buy-and-hold strategy has become popular among many investors, especially when it comes to Bitcoin. Market-neutral strategies, employed by Samara Alpha Management, are designed to generate alpha regardless of the overall market direction, are also a viable alternative for institutional investors.
Institutional Investment in Digital Assets
We can attribute institutional investment in digital assets to several reasons. Let’s take a look at a few here.
Growing Demand
The growing demand from clients who wish to tap into high-performing assets has prompted institutions to provide digital-asset-based investment products.
During the 2021 digital asset bull market, Morgan Stanley, Bank of America, and JPMorgan introduced various cryptocurrency-based products to meet client demand.
Furthermore, major financial institutions such as BlackRock, VanEck, Invesco, Fidelity, and WisdomTree are seeking to create more demand for digital assets with spot bitcoin ETFs. These spot bitcoin ETF applications, along with seven others, are still awaiting approval from the SEC. Once approved, experts predict that Bitcoin will become mainstream as it will be more accessible to traditional investors.
Regulatory Environment and Compliance
The lack of regulatory clarity in the digital asset space is an ongoing concern for some institutional investors. This problem persists in the US as regulators continue cracking down on digital asset companies, while international regulations are progressing.
In 2023, the EU released and approved its Markets in Crypto-Assets (MiCA) regulations. The regulatory framework will introduce homogeneous compliance rules across all EU markets and provide clear guidelines for token issuers and digital asset service providers once it takes effect in 2024.
Moreover, global financial oversight bodies like the FSB and IOSCO have released standards for regulating digital assets. Member countries of these institutions may soon begin implementing the published recommendations.
While some headway is being made on the regulatory front, it is clear that making the digital asset sector fully compliant will not be easy. The industry has introduced new financial assets and innovations that cannot be regulated through a “copy and paste” approach. For instance, imposing TradFi compliance rules within DeFi diminishes the goal of decentralization and stifles innovation. Regulators have their work cut out for them as they aim to provide consumer protection without impairing innovation.
Nonetheless, regulators must classify digital assets appropriately before guidelines can be fully implemented. While some have called on the Howey test, using 20th-century methods to categorize 21st-century innovations may not be the way to go and lawmakers may need to look to novel compliance rules for this new financial asset class.
Infrastructure and Security Considerations
With the rise of reliable digital asset custodians and insurance providers, the barriers of infrastructure and security no longer hinder institutional investors from entering the market.
Prominent Wall Street institutions such as BNY Mellon, Deutsche Bank, Standard Chartered, and HSBC now offer digital asset custody services. These services are crucial for institutional investors who want to protect their clients’ assets.
In addition to custody, asset insurance is vital to institutions as it covers their clients from loss in the case of cyber theft. The digital asset insurance policies available today protect investors against losses incurred through cyber theft, smart contract failure, mining equipment failure, and theft conducted by dishonest custodians.
Regulated digital asset exchanges have also emerged, enabling professional and institutional investors to trade in a secure, compliant environment.
The Case for Alpha-Generating Digital Asset Strategies for Institutional Investors
Investing in digital assets for alpha generation is starting to make more sense to institutional investors who recognize the potential of this new asset class. The potential outsized returns, combined with diversification opportunities, make a strong case for digital asset strategies.
Moreover, it’s now clear that, given enough time, challenges such as price volatility, inadequate regulations, and scalability can be solved. This means that the barriers that once seemed monumental and insurmountable have become less intimidating.
As these obstacles become smaller and technological advancements increase, digital assets could start playing a more important role for institutional investors outside of yield generation and diversification, as they explore investment in tokenized stocks, bonds, and other securities, or tokenize their own assets to access capital and attract new investors.
In all scenarios, the future is poised to be rewarding for institutions that adopt digital assets.
[1] Source: Carrano and Duong, “Crypto's Role in Portfolio Diversification.” May 31, 2023.
