WHY THIS MATTERS IN BRIEF
Services and industries are increasingly becoming decentralised, and the financial services industry is no exception.
A little while ago I discussed how one hedge fund, Aidyia, is now fully autonomous, a decentralised autonomous organisation run by an AI without humans, and how another, Numerai, is tapping the power for the crowd and trying to use blockchain and cryptocurrencies to “open source” Wall Street, but now the volatile nature of the cryptocurrency market is helping entrepreneurs re-invent hedge funds in another way, by decentralising them.
The volatile nature of the cryptocurrency market might seem daunting for individual investors, and while some believe Bitcoin to be the next global currency, others still remain understandably wary. For example, in a recent interview the judges on the popular ABC show Shark Tank in the US, Kevin O’Leary and Robert Herjavec, sat down to share their thoughts on Bitcoin investments. When asked about investing in cryptocurrency, O’Leary mentioned that he is a fan of digital money, but has some reservations.
“When you can pay your taxes in Bitcoin, it will become a global currency, and that’s why I own it,” said O’Leary.
Herjavec, however, was less enthusiastic about Bitcoin, stating, “I think Bitcoin is the current-day tulip trade bubble and people like Kevin that have invested will lose their shirt.”
While individual investors share differing opinions on the cryptocurrency market the market’s volatility is a dream come true for hedge funds.
Data from fintech research house Autonomous NEXT recently showed that the number of hedge funds focused on trading cryptocurrencies more than doubled between October 2017 and February of this year to 226, and the firm also showed that assets under management hit between $3.5 and $5 billion.
It’s interesting too to note that this surge in funds come at a highly volatile time for the cryptocurrency market. For instance, Bitcoin hit its record high of close to $20,000 in December and then lost 70% of its value one month later in January, slipping below $6,000.
“ High volatility is an enemy to individual investors, but a friend to hedge funds,” said Dr. Changhe Qiao, co-founder of the decentralized hedge fund, another trend that I’ll discuss in a minute, Alpha Protocol, which at the time of writing had ironically, as is the volatile nature of the markets, imploded and shut down.
Qiao has years of experience trading cryptocurrencies and views the high volatility of the crypto markets as an opportunity not just for hedge funds, but also for the development of so called “decentralized hedge funds.”
The rise of “crypto hedge funds” really took off last year, when crypto enthusiasts started recognizing that a massive amount of money could be made in the market if they played their cards right. Laura Shin published an article in January of last year, which reported on 15 new crypto hedge funds seeking big returns from the booming cryptocurrency market.
While the development of crypto hedge funds isn’t a new concept anymore, investors and strategists are finding even more value in what they term “decentralized trading protocols,” which will essentially help both parties gain the most profits from the volatile cryptocurrency market.
“While many traditional hedge funds are anxiously waiting for large exchanges to create opportunities to bet against cryptocurrencies, a new class of hedge funds are emerging, which are entirely decentralized. Decentralized hedge funds, like Alpha Protocol, apply blockchain technology to connect crypto investors with quant strategists, solving nearly all the issues that occur with traditional hedge funds,” Dr. Qiao explained.
Many of today’s “traditional crypto” hedge funds focused on trading cryptocurrencies take a number of different individual approaches to ensure profits.
“I trade almost exclusively OTC (Over The Counter) to minimize risk,” said Arianna Simpson, founder and managing director of the crypto hedge fund Autonomous Partners.
Meanwhile other crypto hedge funds believe that patience is the real key to long-term value.
“Patience equals profit when it comes to realizing long-term value in the crypto space. Most realized gains thus far are speculative and only a shadow of what’s to come when blockchain technology and its market matures,” said Jehan Chu, co-founder of the crypto hedge fund, Kenetic Capital.
Decentralized hedge funds, however, take a different approach that is based on resource sharing and community profits, which are made possible thanks to the use of blockchain technology.
“A decentralized hedge fund is a crowd sourced hedge fund, where the fund allocation is selected by the crowd, not a hedge fund manager. Blockchain technology provides trust in a trustless environment and ensures that everyone can participate in the consensus,” said Michael Yuan, Chief Scientist at CyberMiles Foundation. “Just look at Bitcoin. No one on the network trusts each other, but they all trust the protocol. As a result, they also trust the account balances on the blockchain.”
It’s no secret, to many at least, that the cryptocurrency market was originally intended to be fully decentralized hence its reliance on blockchain, so similarly many believe that it makes sense for the financial models that make up this market to be decentralized as well. And that’s what blockchain enables.
In the case of the decentralized hedge fund created by Alpha Protocol, blockchain technology can help organize a large number of strategists together. The investors in the community could cast votes for the strategists using a native token called “ALP”. Then based on the voting results, each strategist could use certain amounts of cryptocurrency from an asset pool. The profits generated are split between the strategists and the asset pool – which eventually rewards investors.
Unlike traditional crypto hedge funds that are typically managed by fund managers within one single enclosed entity, decentralized hedge funds offer an open platform allowing many more crypto investors and strategists to participate.
“A simple way of reducing risk in quantitative trading is through diversification,” said Dr. Qiao. “The effective control of risk relies on the abundance of excelled strategies and a rich digital currency pool.”
The mission of the decentralized hedge fund created by Alpha Protocol was, when it was alive and kicking atleast, to “create a community of crypto investors and quant strategists.” The alpha protocol is designed to inspire the quant strategists to contribute low-risk strategies and tools in the crypto market to gain excess returns, providing crypto investors with a low risk crypto fund.
Another reason for the rise of decentralized hedge funds has to do with the huge volatility of the crypto market, which provides many fleeting shorting opportunities.
Lou Kerner, a partner at Flight VC who invests in the cryptocurrency, mentioned in a Financial Post article, “Some see the Bitcoin market as one of the greatest shorting opportunities ever.”
However, while investors can earn large profits by shorting cryptocurrencies, many are being scared away by the risks. Short sellers essentially borrow a security, betting that the price will fall so they can pocket the difference when the holding is returned. While this can result in great profits, borrowing cryptocurrency can be difficult for individual investors.
“I wouldn’t short anything in this market. While it’s certainly less exuberant than it was at the end of 2017, the market is still quite irrational – there are companies with multi billion dollar market caps that don’t even have functioning networks. There’s no way of knowing how long that irrationality will last, and things may get much more irrational before they correct, so there’s real danger associated with shorting. In the case of Bitcoin in particular, I wouldn’t short it because I think there’s still major upside potential,” Simpson said.
While shorting cryptocurrencies pose more of a risk for individual investors, decentralized hedge funds aim to make it easier to short, not to be confused with less risky though, because of matching capabilities.
Ultimately, the benefit behind a decentralized hedge fund is that it creates an aggregated community of investors and strategists. There is also a pool of cryptocurrencies that strategists can quickly borrow from when needed. For quant strategists, when the short signal triggers, the ability to borrow cryptocurrencies, along with the amount, is crucial, and when shorting opportunities are ripe, strategists will be able to better take advantage at that time.