The “Crypto” Investment Opportunity for Family Offices, High Net Worth and Institutional Investors – A Multi-Strategy Liquid Approach
Michael Schwartz, CEO & Co-CIO, Arena Digital Capital Management, LLC
November 2022
We are in the early days of a major technological renaissance driven by the development of distributed computing and blockchain technologies. Blockchain is a potentially transformative technology and the rails on which a new digital economy is being built. It has numerous commercial and financial use cases across massive addressable markets and the potential to disrupt many legacy industries. It promises a more cost-effective, decentralized, transparent and democratized way for people and businesses to engage with one another.
Financial and human capital has flowed into the digital asset and blockchain sector. Many consider it an asset class unto itself, and it is an important area for investment in a well-diversified portfolio. This paper describes the “crypto” investment opportunity and a multi-strategy liquid approach for family office, high net worth and institutional investors to use a portion of portfolio risk capital to gain diversified, curated and actively managed exposure to a potentially asymmetric investment opportunity.
Background
Basic blockchain technology had been around for some time before Satoshi Nakamoto in 2008 solved what is known as the double spending problem (a digital asset being copied and used or spent in more than one transaction) that had heretofore limited the commercial applicability of blockchains. This resulted in the creation of Bitcoin, a “trustless” peer to peer payment system and store of value reliant on cryptographic proof and game theory. Importantly, Bitcoin demonstrated how blockchain technology could be used to permit the secure transfer of value across the Internet without reliance on centralized intermediaries. Blockchains could now be used to track and securely send anything of value – money, stocks, bonds, intellectual property, software licenses, votes in an election – without the need for a centralized 3rd party.
The use cases for such technology are numerous and expansive and extend well beyond a new form of money or store of value. There are any number of industries and sectors that can benefit from the efficiencies created by removing middlemen and intermediaries from the chain of commerce.
For example, the financial services industry and its infrastructure are ripe for disruption. The current financial infrastructure is centralized (making it difficult to move accounts), limited in access (there are 1.7 billion unbanked around the world, though 1 billion of those have mobile phones and 480 million have Internet access), inefficient and costly (cross border flows and settlement are difficult and it is more costly to move money by Western Union than 150 years ago; $650 billion of annual global remittances average a cost of 6%), lacks interoperability (based on proprietary applications) and lacks transparency. 1
Decentralized Finance (“DeFi”) replaces traditional financial intermediaries with software and smart contracts (programs on a blockchain that run when certain predetermined conditions are met). It promises a wider reach (anyone with a network connection), faster speed (no intermediary and near instantaneous settlement), lower costs (removes middlemen and built on nearly free transfers) and self-execution (smart contracts functioning without human interaction).
Similarly, blockchain technology can innovate and improve upon communication and information networks, art and other intellectual property rights, music distribution systems and gaming and alternative reality platforms.
Over time blockchains will mature and find product-market fits. Utility value will increase. Blockchains are likely to play a role as a store of value, in decentralized computer applications, in utility tokens permitting participation in specific networks and in other property, equity and ownership uses. Still, we are early in that process and can look to the growth of the Internet for a comparison to the potential growth of blockchain and digital assets. We think this is a useful chart to demonstrate that potential: 2
1 Source: 2022 a16z State of Crypto Report
2 Source: Real Vision Finance per
https://dailyhodl.com/2022/05/04/crypto-winter-unlikely-as-astonishing-user-growth-dwarfs-internet-adopti on-rate-macro-guru-raoul-pal/
To extend the analogy to the development of the Internet further, the blockchain sector is currently building the infrastructure (Layer 1 blockchains) on top of which decentralized applications will be built (Layer 2 and Layer 3 applications). We are at a similar stage in the development of the Internet when companies such as Cisco, Sun Microsystems, Intel and Microsoft were developing connectivity, digitized access to information and access to electronic forms of communication. Ultimately, applications like electronic commerce and social media platforms (e.g., Amazon, Paypal, Facebook,Twitter) were built on top of that initial infrastructure to permit a networked economy, digitized business processes, ecommerce, and digitized business and social interactions. Similarly, we expect decentralized applications to be built on top of the blockchain infrastructure and ultimately offer enhanced and more efficient commercial engagement and value propositions for both creators/merchants and consumers, without rent-seeking intermediaries.
Multi-Strategy Liquid Approach to Asymmetric Investment Opportunity – Liquid Venture Capital Investing and Liquid Trading Strategies
Accordingly, we think that there is a very attractive opportunity to invest in the digital asset and blockchain sector. Investors can access two distinct categories of investment opportunity – investment opportunities driven by the underlying technological innovation and investment opportunities driven by the structural inefficiencies embedded in nascent and emerging markets – in order to gain diversified exposure to the sector.
Importantly, the publicly traded token-based structure of the digital asset markets allows investors to invest in digital asset companies and protocols from the early stage of their existence without having to lock up capital for 10+ years in illiquid traditional private investment vehicles.
We also note that there is potentially asymmetric upside in such an investment given that we are in the early innings of the development and implementation of the technology and use cases. The digital asset markets – with a current market capitalization of around $1T – are a fraction of the various markets ripe for disruption. For example, the Global Digital Payments market (e.g., Visa, Mastercard, Amex, Paypal, Square) is a $5T market, Gold has a $12T market size, Global M2 Money Supply is $100T and Global Bonds and Global Equities are each more than $120T markets.
Moreover, the three main use cases for digital assets developed to date – Bitcoin (as a store of value / digital gold / secured digital financial asset), Ethereum (as the largest platform on which smart contract protocols are being built) and Stablecoins (as money markets to access the digital asset ecosystem) – comprise $731B of the overall market capitalization. This leaves investment opportunities in only $269B of liquid venture projects with significant upside should they have commercial success in any of the numerous markets ripe for disruption.
We think that a multi-strategy liquid fund of funds provides investors with a single, simplified investment vehicle offering diversified, curated and actively managed access to a spectrum of blockchain investment strategies.
Liquid Venture Capital – Fundamental-Driven Hedge Funds
Fundamental-driven hedge funds are research-driven and thematic investors focused on the developing use cases for digital asset technologies. They invest in the public liquid tokens and economics of early stage companies and protocols seeking to innovate and disrupt.
They are ostensibly investing in “Series A” to “Series E” companies. For example, these managers can invest in a Series A stage company, participate in the growth to a Series C level and be able to trade the asset if the valuation gets ahead of itself or buy more if the valuation has yet to catch up or the risk profile has improved. It is arguably more capital efficient than typical closed-end vehicles as managers can exit positions that do not become core and recycle that capital into more “shots on goal”. Investors can access such funds without having to lock up capital for 10+ years as in traditional venture capital vehicles that do not readily provide transparency into the value of underlying investments.
We note, though, while liquid and while transparent, the returns will likely take the normal distribution of returns at the venture stage. Some protocols will work; others will fail.
Liquid Trading Strategies – Market Inefficiency-Driven Hedge Funds
We generally believe that “someone has to be able to trade an 80 vol asset like Bitcoin and make money with limited directional risk”.
The digital asset markets are at an early stage of development. The market structure is developing in real time. Investors face fragmented liquidity across exchanges, counterparty management challenges and custody constraints. Speculative retail capital has outpaced institutional flows, creating wider trading spreads and arbitrage opportunities. New market structures, like DeFi, are being built from the ground up, creating new types of investment opportunities for first-movers, crypto-native investors and others willing to provide liquidity to new markets and networks.
All of these factors have led to heightened volatilities in digital assets. These factors have also created arbitrage opportunities that are quite similar to those present in earlier stages of development of traditional financial markets. However, these opportunities are complicated by the operational challenges of trading new digital asset markets and require crypto-facile investors.
A multi-strategy fund of funds approach to investing includes a significant allocation to managers who port arbitrage and trading strategies from traditional financial markets to the nascent and inefficient digital asset markets. These trading strategies include market making and liquidity provisioning, arbitrage (basis and curve arbitrage, statistical arbitrage, funding rate arbitrage and currency pair arbitrage), algorithmic and systematic trading, and yield farming.
Exposure to these managers allows a fund of funds to blend its risk profile such that part of the portfolio can protect capital in bear markets, earn returns based on market dynamics, but have pro-cyclical elements that historically have also captured significant upside during bull markets.
Fund of Funds Value Proposition
There are more than 600 digital asset hedge funds. Technological, regulatory and operational factors are rapidly changing. Of the 20 top tokens by market capitalization in 2017, 14 were no longer in the top 20 in 2022, and a majority of the top 20 in 2022 did not exist in 2017. We think that active management is necessary to invest at this early stage in a rapidly changing sector.
A fund of funds provides a single, simplified vehicle to gain diversified actively managed liquid exposure to the sector. The fund of funds manager is able to cull the universe of hedge funds and focus on experienced managers with identifiable domain expertise and an ability to invest and manage capital. In addition to extensive investment due diligence, the fund of funds provides deep operational due diligence into the ability of, and related security in, managing capital in new markets with new operational challenges around such factors as custody, trading systems, counterparty risk and compliance matters. The rigorous diligence process is complemented by ongoing engagement with portfolio funds and potential new investments.
Fund of funds are often criticized for adding a layer of fees on top of those of underlying managers. However, we think that the diversification, manager curation, asset allocation, and access to a portfolio of managers provides significant value for family office, high net worth and institutional investors in a sector that is difficult to access in such a manner. Moreover, the potential returns from such an asymmetric investment opportunity remain quite significant on a net after-fee basis even accounting for the fund of funds structure.
Conclusion
In sum, we believe that there is an exciting opportunity for family offices, high net worth and institutional investors to invest in both a potentially disruptive technology and emerging markets with structural and tradable inefficiencies. The current bear market in the sector is in prices of assets and not innovation; ebullience and leverage has been flushed from the system but human and financial capital continues to innovate at high speed. We do not think there has been any impairment of the technology’s long term transformative potential and believe there is a terrific asymmetric investment opportunity for a portion of a portfolio’s risk capital.
Moreover, we think the drawdown from more than $3T in total digital asset market capitalization in November 2021 to approximately $1T currently presents an attractive opportunity to allocate to the sector.3
3 We also note that despite the current bear market, there are regularly reported positive developments involving the continuing engagement of brand name financial firms and businesses in the digital assets and blockchain sector. In the third quarter of 2022 alone, these include:
BlackRock announcing both a partnership with Coinbase to facilitate institutional investors managing and trading Bitcoin on the BlackRock platform and plans to create a private BlackRock spot Bitcoin trust as a vehicle to trade Bitcoin; BlackRock noted that both are indicative of growing institutional interest in the asset class
Fidelity working on an expansion of its Bitcoin trading capabilities to its retail brokerage platform of more than 34 million individual accounts
The launch of a new digital asset exchange, EDX Markets, backed by Charles Schwab, Fidelity Digital Assets, Paradigm, Sequoia Capital, Citadel Securities and Virtu Financial
Mastercard partnering with Binance to allow Binance customers to use digital holdings for payments in over 90 million stores worldwide within the Mastercard merchant network
KKR tokenizing a portion of one of its health care private equity funds and making interests available on the Avalanche blockchain
Starbucks revealing a Web3 and NFT loyalty program that combines with existing rewards and loyalty programs “allowing its customers to both earn and purchase digital assets that unlock exclusive experiences and rewards”
BNP Paribas announcing a partnership with Fireblocks and Metaco to provide a wide range of solutions and services linked to digital assets
Barclays purchasing a stake in crypto custodian Copper
Ernst & Young deploying a blockchain-based carbon monitoring solution built on Ethereum to track carbon footprints
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