After a tumultuous year in the digital asset sector, portfolio managers are looking ahead and preparing for the next growth cycle. Nuant’s Chief Revenue Officer, Stuart Peterson recently participated in a Blockworks webinar on critical technology, systems and processes digital asset funds and asset managers need to consider when planning for the next crypto bull market. The discussion focused on how investing in these areas can help funds better manage costs, provide teams with optimal tools and systems, and ultimately win and retain business when preparing for the next growth cycle.
Stuart was joined by Matt Hougan, Chief Investment Officer at Bitwise, and Michael Hall, Chief Investment Officer at Nickel Digital Asset Management, who also had some very interesting insights to share in the webinar. The session is summarized below, or alternatively you can click here to watch the recording.
Learning from past cycles
Graham Perry, who was moderating on behalf of Blockworks, opened the discussion by asking the panel what parallels can be drawn between the current state of the digital assets market and previous market events, such as the dotcom crash and the 2008 financial crisis.
Stuart recalled parallels with previous market events, outlining how these periods cause investors to zoom out from short-term returns and more superficial market metrics toward more profound questions about how firms are set up and governed. He believes that the digital asset industry is now at a similar crossroads and needs to ensure that it takes the opportunity to put in place the infrastructure for the next phase of growth.
Matt concurred and pointed out that the 2018 crypto crash also has similar echoes of seismic events in 2003 and 2018. He highlighted that even just over the last five years, the cryptocurrency sector has matured substantially in terms of the availability of services such as custody and analytics.
Michael contributed his view that companies should learn from these past cycles by developing only software and solutions that leverage or complement their core competencies and provide a competitive advantage.
Matt elaborated on this point by highlighting that firms must establish a balance between the tools and systems they need to develop in-house versus recognizing the right moment to leverage third parties and outsourced providers as they become available in a maturing sector.
Leveraging technology to manage costs
Graham asked the panel how technology, systems, and processes can help funds better manage costs and provide teams with what they need to prepare for the next market cycle.
Matt explained that Bitwise needed to create its own Bitcoin price index, as during its earliest days, no such index existed. Today, however, there are many pricing providers, so it makes no sense for Bitwise to continue maintaining an internal price index as maintaining it consumes valuable resources that can be reallocated to more productive activities.
Stuart added that the choice of whether to develop a solution in-house or rely on third parties can make a big difference to a fund’s bottom line. He recalled the shift to digitalization in traditional markets when some trading firms employed as many developers as traders. By shifting these activities to expert third parties, funds can proactively improve their bottom line by reducing costs. Furthermore, it allows individuals like the fund manager to focus on his/her core responsibilities rather than developing solutions to emerging market problems.
He further elaborated on how a fund’s technological challenges can change over time depending on how the market advances. For instance, order and execution management used to be a significant gap in the digital asset sector, leading firms to develop their own solutions. However, now that the OEMS infrastructure is in place, portfolio management has emerged as a gap, with portfolio managers frequently using legacy tools like Excel to track the performance of their positions. This creates significant risk and consumes substantial resources.
Michael agreed and explained that integration is one of the sector's biggest challenges, as different firms and systems handle different parts of the trade and fund management processes. The panel briefly discussed the merits of catch-all providers like Bloomberg in traditional finance and concluded that while some integration is desirable, it should not come hand-in-hand with centralized monopolies.
Reshaping compliance in the fallout of FTX
Referencing the increasing focus on compliance and due diligence following the FTX collapse, Graham asked Michael and Matt what investors are currently asking for when it comes to fund selection.
Michael explained that funds have to start out with the intention of targeting institutions. He described how Nickel Digital engaged a Big Four auditing firm to demonstrate the fund’s assets and applied for approval from the UK Financial Services Authority. Regulated custodians are now a requirement for any fund starting out. In general, these are the types of assurances that institutional investors are seeking.
Matt concurred and added that investors are also interested to know how much exposure a fund has had to previous market events such as FTX. He also detailed how institutions are using a variety of methods and engaging internal and external specialists in an attempt to make sense of digital asset investing and the various funds available, along with the due diligence process.
Responding to a query from Stuart, Michael explained the complexities of risk management for funds when dealing with exchanges and outlined the various strategies for ensuring that off-exchange settlement happens whenever possible and, where not possible, appropriate risk management needs to be applied. Matt added that many funds haven’t always been prudent, and such practices are unlikely to be tolerated in the future.
Managing risk in DeFi
Graham asked the panel how they approach risk management when it comes to DeFi. Michael explained that this is one of the areas where infrastructure hasn’t caught up with demand, and so his fund invariably ends up requiring the services of a Solidity developer to write a smart contract that can handle the risk management element. The question then becomes: does the firm attempt to leverage these solutions by packaging them and selling them as a service to others who need them?
Stuart agreed that the industry is seeing an increasing interest in DeFi, but the infrastructure around decentralized finance for institutions is still very immature. He gave the example of liquidity pools, where there is institutional interest but a lack of tools or services that enable effective research regarding potential risk and return – for example, modelling impermanent loss.
Graham asked a final question to the panel: what advice would the fund managers give to a new fund today regarding how they store and analyze their data?
Matt stated that there would be no sense in working on proprietary systems, and funds should leverage the third-party solutions available. There may be some requirements for in-house solutions in areas such as DeFi, but new fund managers would do well to take advantage of third-party providers and focus on their core business. Michael advises managers to always question the returns on a given activity and focus only on activities that generate returns wherever possible.
The end segment of the session focused on audience questions. One questioner asked the panel for their insights into potential areas of opportunity in 2023. Michael pointed out some areas of interest, including liquid staking derivatives and Layer-2 protocols, but explained that some sectors, such as gaming or NFTs, are very niche and require specific expertise to quantify risks and opportunities.
Matt offered the perspective that each of the three historic bull cycles in digital assets has been dominated by a particular development – first the ability to trade Bitcoin, then the launch of Ethereum, with the most recent bull cycle attributed to the rise of DeFi. Matt believes that the next cycle will be driven by the scalability offered by Layer-2 protocols and applications requiring that scalability and cost efficiency, such as micropayments and social media.
The last question focused on how funds can ensure compliance with upcoming regulations. Stuart outlined how the process will be comparable to the way regulatory audits are carried out in traditional finance and added that funds will need to set up the necessary systems and datasets to demonstrate compliance.
Regtech solutions are already emerging, and more robust systems and tools to support the new regulatory environment in digital assets can be expected in the coming years. Institutions have been asking for reports such as transaction cost analysis that demonstrate compliance with regulations such as MiFID 2. Frameworks such as the European Markets in Crypto Assets Regulation will likely formalize this practice.
Matt and Michael both underscored that compliance already has a substantial focus for funds, which are heavily recruiting compliance professionals to ensure they can meet their obligations. Both agreed that focus and spending on compliance will only increase over the coming year as new regulations roll out.