The digital asset sector presents unique challenges to investment managers – in particular, the problem of accessing reliable, comprehensive data, and the tools to make sense of it. In a recent Blockworks webinar, summarized below, our Chief Revenue Officer Stuart Peterson joined Bequant’s Head of Research Martha Reyes and Coinbase Institutional Head of Asset Allocators Anthony Bassili to dig into how portfolio managers, professional investors and analysts alike can combine on-chain and market data to gain a deeper, more comprehensive understanding of cryptocurrencies. Macauley Peterson was moderating for Blockworks.
Macauley kicked things off by raising Coinbase’s recent survey of digital asset allocators, and asking what the surveyed managers had had to say about their decision making in the current market. Anthony said that crypto was expected to deliver alpha for hedge funds, but the outlook was better over three years than 12 months. The respondents, he said, had mentioned barriers including the lack of clarity over regulation as well as over asset allocation (with confusion over whether to consider crypto an alternative asset class, an emerging technology stock, a commodity, or something else). Problems surrounding due diligence and risk management were another concern, as was the issue of asset fragmentation.
Stuart picked up on this with reference to Nuant’s own survey, in which managers complained of an urgent need to see their portfolios in a single place. Having assets spread over a number of exchanges, wallets and custodial solutions makes it a real struggle to manage risk, compared with traditional assets. Managing multiple platforms is a necessary part of crypto market participation, because of the challenges of achieving best execution and managing counterparty risk. That means managers have to deal with a plethora of connections, integrating various market data providers in order to maintain a view of their portfolio valuations, exposures, derivative positions and more. Doing all this on a spreadsheet entails major operational and data management risks.
Recalling the 2003 landscape after the dotcom crash, Stuart pointed out that asset managers started to care less about top returns than about good portfolio management infrastructure. That is being repeated now.
Martha confirmed client concerns about fragmentation. On the upside, this fragmented market allows for arbitrage of inefficiencies, but liquidity is now more concentrated. She pointed out that especially smaller hedge funds or family offices were not resourced to track data in real time, and that the dramatic, high-speed collapse of FTX showed the importance of good portfolio management. Bequant expects the current crisis to accelerate the development of solutions, as a result.
The second challenge raised was the reliance on exchange-provided data. While traditional asset managers look first at fundamentals, Stuart argued, in crypto, there is no direct equivalent. Instead, managers look first at on-chain data, to drive decisions, and then market data, to confirm them. Managers need to become adept at using multiple different systems and custom analytics. This overload can result in analysis paralysis, showing a pressing need for tools to curate data and generate actionable insights.
Martha confirmed that portfolio managers experienced this paralysis, especially as they questioned the reliability of their data. The crypto market has evolved out of high-frequency trading, with data coming from centralized exchanges; at this point, DeFi is becoming more important and with that increase in volume of DeX activity, on-chain data is more important.
Anthony agreed, saying that although centralized data sources were cheap, easy and organized, they might not reflect all activity. Fund managers have to use multiple liquidity sources and combine data from multiple sources. This presents a major engineering challenge, with a highly skilled team needed to harvest and process the relevant data. This is one way in which crypto portfolio management demands completely different skills from traditional finance.
All the panelists agreed that the task of sourcing and using clean, reliable, trustworthy data was an urgent challenge. Given the costs and complexity of data sourcing, there is a market need for a comprehensive data provision solution that can support good decision making. This is especially true in light of the major market events we have seen in 2022 – Martha reported that Bequant clients were seeking preventative tools, in terms of analytics that could provide early alert signals to flag big liquidity events.
Asked about the uncertain reliability of on-chain data, Stuart explained that Nuant used a range of techniques including multiple data sources, and community validation. Anthony agreed that community involvement was important, and that building ecosystem integrity was in everybody’s interest – building a layer of trust is more art than science, he said.
Turning to the question of market outlook, Martha reported that her clients had been cautious throughout the year, given the difficult macro picture, and that they expected further deleveraging. The steepening yield curve suggests a recession ahead, which could be bad news for crypto given that until now, it has been strongly correlated with equities. Managers are pursuing individual strategies, but not taking big directional bets.
Stuart raised the point that this kind of pause in the market was actually good for tech companies such as Nuant, providing an opportunity for companies to take stock and consider how to improve their automation and research to achieve a better growth position for the next cycle. Investors are looking harder at due diligence, but also hoping for more regulation.
Martha agreed with these concerns about security and regulation, as investors wait for MiCA to provide greater clarity. New rules were likely to be somewhat onerous, she said, but positive for the market. She pointed out that the crypto sector can be like emerging markets, in that it attracts flighty money that is ready for a quick exit, but that the goal is to attract pension funds and other long-term investors. Regulation will help.
After the FTX debacle, said Anthony, some investors would steer clear of crypto until there was more clarity. Fund managers should be paying attention to the regulatory dialog, being sure to implement their trading strategy in a way that is likely to be compliant with the upcoming rules. That does entail an element of risk and uncertainty, adding to the already high complexity of bifurcated liquidity and market volatility.
With all this complexity, the need for better decision support tools is even stronger. Stuart said that portfolio managers were more aware now of the need for deep and timely analytics, as well as for standardized sector classification to improve risk management and portfolio balancing, especially for compliance.
Martha argued that as the industry developed, there would not be just one formula or one set of analytics. She expects increasing attention to be paid to underlying project health, tokenomics, and especially governance. Just as in traditional markets, after a crisis, people will dig through the rubble and see what needs to be improved for the next growth cycle.
A question from the audience addressed caution around tokenization. All the panelists agreed that it would take time to build out this market. Stuart said that the development of tokenization from private banks as a means of raising capital and generating liquidity in a single step would open the floodgates. Martha agreed, giving multiple examples of current projects in development from banks as well as government entities experimenting with ways to improve settlements, avoid fraud and more. Anthony added that blockchain at scale was really only a couple of years old, and compared tokenization to ETFs, which took many years to develop into their current status as liquidity vehicles.
Finally, the panel touched on the rise of decentralized exchanges. In the short to medium term, Stuart said, we expect DeFi to benefit strongly from investors looking for greater transparency in the wake of the FTX crash. Anthony and Martha both agreed that DeFi would be attractive as a more risk-aware form of liquidity provision.