Investing Post “Crypto Apocalypse”
Samara Alpha has an advantageous perspective as both a digital asset allocator and a fund manager. This dual role better positions us to reflect on investing holistically, assessing risks and market opportunities, while addressing implications of market dislocations for investors.
Jun 5, 2023The FTX fallout and ensuing crypto meltdown of 2022 has left many investors feeling uneasy about the sustainability of digital assets. Most recently, the SEC’s lawsuit against Binance and Coinbase has further fueled investors’ apprehensions.
Following Bitcoin’s resurgence, having seen a 70% YTD increase last month, native crypto investors experienced a renewed sense of confidence as they recovered losses or amplified gains. Notwithstanding, many institutional investors remain cautious about expanding their exposure to digital assets, with trepidations surrounding regulatory uncertainty and the long-term stability of the market.
Like with any asset class, a comprehensive understanding of the market and the implications of market dislocations is crucial for successful investing. At Samara Alpha, we recognize that the digital asset market has undergone significant changes since the 2022 meltdown, with stable alpha-generating opportunities emerging among market-neutral strategies.
Crypto Investing in a Post-FTX World
What are the implications for digital asset strategies following the FTX fallout and the 2022 crypto meltdown? In the aftermath of these events, market-neutral funds are actually generating higher returns now than in 2022 prior to the bankruptcies. Samara Alpha’s select universe of market-neutral digital asset funds is a prime example, having outperformed FY2022 returns by 10% despite ramping up counterparty risk management.
Following the meltdown, many over-levered players had pushed spreads tighter and squeezed out alpha. As soon as these non-economic players went bankrupt or left the space in 2022, the conservative funds that were not chasing yield are finding great success providing liquidity to and extracting returns from a more rational market.
A great example is one type of arbitrage that involves buying and selling the same coin on different venues simultaneously. This strategy suffered as a result of Binance and FTX processing the majority of volume in the ecosystem. As these exchanges shut down or downsized due to regulatory pressure, liquidity began migrating to more venues across the globe with more price discrepancies for funds to arbitrage.
With many over-leveraged players pushed out of the market, savvy investors were left with an abundance of such alpha-generating opportunities.
Digital Asset Sources of Return
As allocators, it is important to consider the tried-and-true methodologies that have been generating wealth for generations of sophisticated investors. At Samara Alpha, we invest in strategies that have existed in the traditional space for decades, but due to inefficiencies within the digital asset space, are able to generate greater returns over a shorter time horizon. For instance, traditional assets are closed for trading for large parts of the day, while crypto trades 24/7 globally. Systematic strategies that can also trade 24/7, algorithmically executed with human oversight rather than directly traded by people, can reap the rewards.
The following are select examples of how we at Samara Alpha extract value from market-neutral strategies that take advantage of such inefficiencies:
Market-Making:
Conventional players such as Citadel and Jump have been extracting alpha by providing liquidity to the equity and bond markets. Experienced traders have left these shops to apply their honed techniques to crypto order books and flow data to generate significant returns. Since bid-offer spreads in digital assets are larger than conventional markets and there are more decentralized venues available to trade digital assets, significant profits can be had with less leverage. However, these strategies have lower capacity than traditional assets, resulting in an opportunity befitting investors with allocation sizes in the millions rather than the billions.
Basis Trading:
Futures contracts were initially launched on BTC in the form of perpetual “futures” contracts (“perps”) in 2016 on the BitMEX exchange. The CME Group launched these futures in Q4 of 2017. Since then, the chains on which futures are offered as well as the exchanges offering perps have proliferated. Both futures and perps trade at different prices than the underlying assets, allowing for a variety of market-neutral, relative-value strategies for systematic funds to exploit. Although basis trading is done in most commodity/futures conventional markets, the potential spreads in crypto are higher with greater profit available at lower levels of leverage.
Volatility Trading:
Options on BTC, ETH, and other liquid tokens are another source of returns for arbitrageurs. Traders with knowledge of gamma trading, covered option strategies, and index arbitrage in traditional markets who also become experts in the operational and counterparty issues in digital assets are rewarded with a rich source of alpha. The cards are stacked in their favor as most crypto-native option users are purely speculating with limited depth of knowledge.
Statistical Arbitrage:
There are many related assets in the digital asset space making up distinct cohorts with short-term relative movements to each other, yet move together, in general, with various leads and lags. This is not dissimilar to sector equities in traditional equity markets. Examples include Bitcoin vs. altcoins, and various Layer1 ecosystems such as Ethereum+project tokens and Solana+project tokens. Using very short-term price patterns and flow data, statistical arbitrage models lifted from traditional markets make comparable returns in crypto but with a lot less leverage.
Portfolio Construction and Due Diligence
Identifying managers who can generate consistent alpha can be challenging in any environment, particularly in this evolving market. As any professional investor knows, conducting proper due diligence is essential in constructing a portfolio designed to generate consistent risk-adjusted returns. Due diligence is even more crucial for allocators who want to extract value from digital asset investing.
At its core, operational due diligence for cryptocurrencies is widely the same as for traditional managers: evaluate business infrastructure as well as control and operational procedures. How one determines managers’ experience, commitment to the success of the product, their motivation, and incentives to outperform is unchanged across asset classes.
Where it differs is the evaluation of specific characteristics of digital asset trading, especially given the regulatory uncertainty surrounding this space. Successful digital asset managers apply knowledge of traditional asset management regulations, risk/return metrics, and qualitative analysis to determine which managers meet appropriate parameters to generate results.
At Samara Alpha, as experts in traditional asset management, we know what the rules are; as experts in digital asset management, we adopt the rules to this evolving asset class.
Extracting Value from a Nascent Asset Class
Contrary to popular belief, the post-crypto-meltdown environment has not deterred potential outperformance of digital asset funds. In fact, market-neutral funds are generating higher returns. These strategies are extracting value from inefficiencies in this nascent asset class. Expert investors are able to conduct thorough due diligence to identify digital asset managers who have a proven ability to consistently generate alpha in this challenging and evolving market.
Strategically assessing risks and market opportunities while addressing implications of market dislocations are the keys to generating value for investors post-crypto meltdown.
