Striking ‘digital gold’: Hedge Funds and the lure of Cryptocurrencies

Investment Technology

Striking ‘digital gold’: Hedge Funds and the lure of Cryptocurrencies

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Co-authored by Michael Cummins and Tim Wong, Portfolio Management leads at FINBOURNE Technology

Amid a booming hedge fund industry, the hunt is on for emerging opportunities and right there in the thick of it is the industry’s latest gold mine; cryptocurrencies. At nearly USD 3 trillion, one per cent of global assets and with over 300 exchanges, digital assets, such as cryptocurrencies are enjoying their hey-day as the new ‘digital gold’. The hedge fund industry is no stranger to the asset class, as it makes its way into the mainstream, at a rapid rate.

According to 2021 year-end data from Hedge Fund Research (cited in HedgeWeek), digital assets managers have ‘outflanked all other hedge fund strategies’. While the Global Crypto Hedge Fund Report 2021 published by PwC, Elwood Asset Management and the Alternative Investment Management Association, found 1 in 5 traditional hedge fund managers actively invest in digital assets, amounting to 3% of their total AUM. With 85% of those hedge funds intending to deploy more capital into the asset class in the next 12 months.

The attraction isn’t limited to emerging or niche managers either. Household names including Brevan Howard Asset Management are also entering the fray, having launched BH Digital in spring last year, with the sole remit of managing cryptocurrency and digital assets. Other Crypto fans include the founder of Tudor Investment Corp, Paul Tudor-Jones and the former Fortress Investment Group manager, Michael Novogratz . Even industry stalwarts; Ray Dalio and Anthony Scaramucci are not immune to its allure.

You can see why too. With thousands of transactions happening 24/7, 365 days a year, cryptocurrencies are a very different beast to traditional asset classes, with an attractively low correlation, making it a prime portfolio diversifier for active managers. It also offers the perfect combination of volatility (and in the case of Bitcoin and Ethereum) liquidity, which hedge funds can thrive on. None, more so than systematics and high frequency trading firms. Sitting at the opposite end of the HODL (Hold On for Dear Life) spectrum, these funds are not looking to buy and hold in the face of severe market swings. They are here to capitalise from them.

In light of this, exchanges such as Coinbase and Binance are offering more options to institutional investors, making it easier for systematic hedge funds to buy and sell currencies directly. This offers a far more liquid, flexible and faster way in and out of the asset class, than fixed-term contracts, like Bitcoin futures, which can only be traded during exchange open hours.

Like most things in life, though, there are no free lunches here and while cryptocurrencies offer a highly lucrative market opportunity, it is not without its challenges. To successfully manage this volatile asset class, systematic hedge funds must first deal with a two-fold challenge:

  1. Scale: With no market open or close, funds will need to achieve an operational infrastructure that can handle the herculean daily volumes – without being handicapped by vendor downtime – across global crypto exchanges.
  2. Diversification: Funds will also need to leverage a Portfolio Management System (PMS) that delivers automated and rich functionality, to successfully support the increasing depth and breadth of diversified asset classes and strategies, in play.

In a buoyant market, while it’s entirely possible and tempting to throw people at the problem, even with the right expertise, it is difficult to see how systematic hedge funds can reap the alpha potential of this asset class, without first unlocking the data at the root of their infrastructure to overcome barriers to scale and diversification.

Scale + diversification = alpha potential

Achieving scale can alleviate a number of challenges, from operational risk and cost pressures, to missed opportunities, but this is only one half of the equation. With cryptocurrencies, both scale and diversification, are necessary, to achieve alpha potential. This nirvana state is what many hedge funds are aiming for, particularly in the advent of emerging digital assets, like NFTs.

In the past, funds have opted to add more people in to the mix, with the simplistic notion that more bodies (to run Excel spreadsheets) = more scale. Or, they’ve bought in best of breed systems to automate the growth in trading volumes and attempt to deliver timely reporting. Over time and with a lack of investment, this has created its own obstacles; from data breaks downstream, human error and workarounds that try but fail to overcome a fundamental lack of reproducibility or trading clarity.

With hedge fund growth moving faster than ever, the limited scope of time in which these short-term hacks are serving funds, is getting increasingly shorter. As they outgrow the confines of such workarounds, many funds are being led back to square one, or worse still facing innumerable barriers to growth.

As funds scramble to reap cryptocurrency returns, the spotlight is firmly back on alpha generation and cost optimisation. With many funds beginning to recognise that hosting technology environments and being responsible for their upkeep is neither their purpose, nor of any real benefit. We agree and believe cloud-native SaaS technologies can deliver a new and interoperable approach to the operational efficiency needed by hedge funds, to reap the full potential of digital assets.

By combining data management and PMS capabilities in one platform, hedge funds can access core investment data, such as real-time positions and cash in a single data store, while also producing shadow NAVs, reconciling positions and calculating firmwide risk analytics to support their portfolios. This provides greater control of investment data and achieves value in a faster time to market. At the same time, this foundational technology can future-proof funds to continually support scale and diversification, including the onboarding of new funds and strategies, without incurring costly expenses. Not convinced? Here’s how…

Fund-wide view of the world

Given cryptocurrencies are far more volatile than traditional asset classes, there is a heightened need to stay on top of portfolios. Obtaining a multi-asset view, alongside publicly traded equities and bonds is essential, but a common challenge many systematic hedge funds face today.

Here, SaaS technology that can stay on top of an ‘always on’ market without any downtime is vital. It can also augment visibility of trade flows, where a fund does not have true clarity of their real-time trading activity, positions and available cash. Leveraging a SaaS platform, funds can overcome limited oversight, using open APIs to integrate with multiple existing OMS/OEMS and achieve a real-time view of positions, cash, P&L and exposure.

The timely data can also be used to run valuable NAV and GAV insights, shadow accounting and financial statement reports too – giving fund managers not only the confidence but also the tools to drive performance and efficiency in investment operations. What’s more, while the asset class is enjoying a brief interlude from regulation, having readily available and reproducible data in the back pocket now, will serve hedge funds well for when the regulatory tide inevitably turns. In fact, in the US the SEC is already turning its attention to both hedge funds and cryptocurrencies.

Similarly, achieving a granular view of trade flows enables funds to quickly and easily see what they own and how much it’s worth at any given point in time, potentially avoiding substantial trading losses. This enhanced support benefits the fund across trade capture and allocation, as well as post-trade compliance workflows. For example, the same open APIs can plug into execution algorithms, to generate orders at a high volume and frequency, while also processing incoming trade data, such as order fills.

Tackling the data crunch

One of the unique features of cryptocurrencies, and perhaps its attraction to hedge funds is that the asset class is continuously traded; 24/7, 365 days a year. With no daily open or close, systematic hedge funds are in their element, with numerous arbitrage opportunities available across exchanges. That said, one of the most consistent questions we get when we speak to funds is ‘How can I derive more value from the data I own, to produce alpha’ or ‘How can I quickly exploit new data sets’. The questions all point to the need for operational agility, to capitalise on the data available and speedily respond to the market opportunity.

The first step to facilitating this, is being able to crunch vast swathes of data, from pricing libraries to real-time news. Using open API’s, systematic hedge funds can plug into multiple data sets, applications and existing systems, to quickly create an interoperable landscape that can pull in and draw out high volumes of disparate data sources – from day one.

The second step is being able to convert these external data sets into a usable format to inform decision making and deliver meaningful portfolio positions. Here, a SaaS platform that delivers an extensible data model, excels at translating large volumes of typically complex data; including non-traditional assets like cryptocurrencies.

These disparate sources and deviating formats of multi-asset data are effectively consolidated into one data store and can feed into mission critical workflows. What is super important for hedge funds to know, is that a data store with no built-in financial sense cannot deliver any value or insight into the data it holds.

Much like a filing cabinet with no folders or tabs to assign papers to. A platform with innate financial sense, however, can recognise and organise data into the corresponding fields, codes and formats the fund uses, making it easier to glean value from the data and support alpha generation. Using a secure cloud infrastructure, this timely and trusted data can also be made accessible and permissible across the organisation, and even extended into the external ecosystem, to investors and regulators.

Back testing, the bitemporal way

One of the nuances of cryptocurrency markets is that correlations tend to be highly complex, making them better suited to quantitative funds, rather than traditional discretionary funds. Being on the back foot, these funds will need both human expertise and cutting-edge technology to be able to gauge where the opportunities lie.

Back-testing forms a pivotal process, by which funds can see how well a given trading strategy is performing, and how it would have done, using historical data, had it been implemented differently. In the same vein, modelling, this time looking at future trading strategies, is also key to testing out vital insights from data. A bitemporal Investment Book of Record (IBOR) that warehouses all historical events and transactions, vastly improves these what-if analyses and simulated portfolios, to deliver insights that can more precisely inform future decision-making.

By delivering an immutable event register – a ledger of all changes or events – which have happened to a portfolio and related entities, native bitemporality enables the user to reproduce data as it was, at any point in the past. This ultimately eliminates the need to keep multiple copies of data within data warehouses and data lakes, or in multiple, customised Excel sheets. The fund can effectively move away from static end of day or end of period reporting, to dynamic and fully reproducible data at the click of a button.

Where this feature shines is in enabling hedge funds to extend a SaaS platform, with their own logic. For example, funds can re-run portfolios against a particular risk-weighting, across two timelines i.e. pre- and post-risk weighting. These deep insights into trading patterns, deliver an improved risk profile, reduce exposure, and can positively impact future cryptocurrency transactions.

The one commonality cryptocurrencies have with other asset classes is that they are not immune to bubble risk. The ability to manage exposure, as well as reproduce data along timelines for back-testing and modelling, is not only critical but will also minimise losses and the need for sell-offs in order to cover margins. More than anything, addressing scale and diversification through a SaaS PMS that addresses data at the core, provides both rich capabilities and trusted data that will serve systematic hedge funds, as they enter cryptocurrencies and other emerging opportunities, both now and well into the future.

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