Trends Watch: Digital Assets

EisnerAmper’s Trends Watch is a weekly entry to our Alternative Investments Intelligence blog, featuring the views and insights of executives from alternative investment firms. If you’re interested in being featured, please contact Elana Margulies-Snyderman.  

This week, Elana talks with Tom Costello, Chief Investment Officer, Bedrock Digital Asset Management. 

What is your outlook for investing in digital assets?

There is still a lot of debate about the best use cases of crypto, but we think that question is misplaced.  If you compare the properties of Bitcoin to the most liquid and largest currency in the world (the USD), of course it’s going to come up short on multiple dimensions.  But compare a stable coin like Tether (USDT) or USDC to the Venezuelan Bolivar or the Sudanese Pound and you’re going to come to a totally different set of conclusions.  To many who don’t have the benefit of access to the U.S. or European banking systems, crypto can look like a lifesaver.  It’s a way for ordinary people to overcome the misplaced vanity of top-down autocrats who believe they know best, but maybe don’t.

But we aren’t really ‘crypto true believers;’ we’re financial professionals and have no real agenda.  To us, whatever else crypto may be, it certainly is an investable asset, so we treat it that way.  The halving and the Fed ending quantitative tightening (QT) in early 2024 will cause the long beta guys to return to profit which will attract a wider audience, and then we’re all off to the races again this year.

Where do you see the greatest opportunities and why?

In crypto the vast majority of hedge funds are first time managers, and they are either long only, or focused on strategies where technological sophistication can provide an advantage like arbitrage or high frequency trading.  The latter tend to be high performing strategies, but as they get crowded out, they become extremely limited in capacity.  What we’re striving for is to deliver the kind of high-performance strategy that makes the most of the inefficiency of the crypto markets but does so in a way that isn’t as capacity constrained.  

Right now, we’re running a ‘low volatility’ accrual strategy returning a Sharpe ratio of 7, and have at least 1.5 billion in capacity.  Strategies like that are common among the top tier of traditional finance hedge funds, but a first-time manager who previously only worked in tech or venture capital is unlikely to see it.  Opportunities like this exist all across the crypto ecosphere.  When the largest hedge funds are ready to commit to crypto in earnest, this kind of strategy will become commonplace, but by then we will have already been running similar strategies for years.  

What are the greatest challenges you face and why? 

We conceived of our low volatility strategy in May of 2022 but because the culture of the crypto industry is based on a venture capital mindset, it took us 20 months to find a broker who was willing and capable of trading it with us.  The industry simply wasn’t interested in a strategy that wasn’t a technology-focused high frequency or arbitrage strategy.  As far as they were concerned, that’s all that trading ever is.  

Getting past that has been a real challenge.  And in fairness to the brokers in the space, when 90% of ‘hedge funds’ you deal with are former tech guys who have never heard of quantitative risk management, it can be very difficult to recognize when you’re speaking to someone who see’s things differently.  Even now I spend about one-third of my time trying to explain to people in the industry that there is no such thing as risk-less trading, and the only issue is whether you’re being paid enough for the risk that you’re taking.  I’ll get a middle manager at a broker with trad-finance experience who will agree that I’m saying something obvious.  But when it comes time for them to get their organization on board with that idea, it's next to impossible. The Dunning Kruger effect is incredibly common in trading, and the ego-driven types of people who tend to succeed in venture capital are common sufferers from it.  From our perspective we have a lot of crypto brokers who want to be Robin Hood, but none that want to be Goldman Sachs. That makes life very difficult when you’re trying to raise the sophistication level.

The other big problem for us is the lack of any U.S. regulatory framework. That’s caused many of the markets big players to avoid any client that has a U.S. citizen associated with it.  We’re a BVI entity and an SEC-registered institution but our partners are U.S. citizens so many won’t even take our calls.  Anywhere else in traditional finance, the general approach is that the people who run institutions are treated as professionals and should be expected to know better.  I can certainly understand that U.S. retail investors could use some regulatory protection, but surely institutions can be exempted.  

We absolutely comply with every U.S. AML and KYC law.  We would never consider anything else. All the risks that seem unique and indiscoverable to the crypto world are known quantities to us and we can demonstrate that.  If there is some threshold the regulators would like us to meet, we’re happy to do so.  But in our view, regulation by enforcement at this point is really harming U.S. interests.

What keeps you up at night?

We call it the ‘reinvention’ problem.  The ’titans of crypto’ set out to recreate a capital market that was more ‘fair’ and egalitarian than the established markets, where they perceived the biggest players as having some unfair advantage.  That isn’t actually the case, but from a pedestrian ‘retail' perspective it can seem that way.  The upshot is that when they ‘reinvented things’ they thought they were making things better, but what they were really doing was engineering instabilities into the system.  

The Terra/Luna collapse is a good example.  That was an algorithmic stable coin that had a capital structure which had obvious financial engineering flaws, but crypto tends to believe that newer is always better so the industry just charged ahead with it.  When it blew apart it was completely predictable, but it still took something like one-third of the crypto industry with it into insolvency.  

What we look for is mistakes of others, so many of these reinvention errors look to us like opportunities.  But in many cases the volatility of crypto makes that a very, very expensive position to take.  It’s akin to seeing that a market crash is coming (which is usually obvious) but knowing precisely when involves answering a different set of questions.

There are dozens of reinventions out there that are waiting to explode.  So many that it’s impossible to avoid them all.  So, we manage our beta and gamma exposure carefully, do what we can to manage our counterparty risk, and hope that our counterparties are doing the same.  But quantitative risk management skill is spread very thin in the crypto world, and it’s often overruled by ‘political’ priorities of the venture world.  So, whether we’re working with people who have access to it or not is largely beyond our control.  

The views and opinions expressed above are of the interviewee only, and do not/are not intended to reflect the views of EisnerAmper.