Crypto Risk Management Part II – Illiquidity

Liquidity is a classic double-edged sword. As traditional securities markets provide less alpha, investors have focused on capturing the so-called illiquidity premium. Private debt, private equity, real estate, infrastructure and venture capital generally promise outsized and/or uncorrelated returns in exchange for some loss in liquidity, often formally and for the long term. Investing for the long term, pension funds have increased their allocation to illiquids from 7% to 26% over the last twenty years.

Yet illiquidity is an investment risk that needs to be considered by all managers who do not have permanent or locked-in capital.

Many crypto opportunities have more in common with private illiquid markets, venture/angel investing or small cap stocks than the deep US large cap securities markets. Since the “DeFi summer” of 2020, many protocols have launched with a private locked-in sale, and/or have otherwise low liquidity in the secondary market.

The challenge for Hartmann Digital Assets is that, as a hedge fund, we need to provide for redemptions and therefore need to actively engage with illiquidity risk in our search for alpha.

Crypto VC

In crypto, illiquidity risk comes in many forms. With crypto venture (VC) investing, there are usually hard liquidity constraints, such as explicit lock-ins and vesting periods.

Crypto VC differs from TradFi VC in that timelines to “public” funding in the form of liquid marketable token issuance are short, and therefore VC funding is limited to seed, pre-product, and occasionally a series A. Further funding to scale a functioning platform with established revenue and volume metrics is rarely needed. This makes crypto VC smaller and arguably riskier (earlier-stage on average) than in TradFi. Yet the reward potential in crypto VC can be very compelling.

A very recent controversy surrounding the VC funding of Sushiswap provides us with some idea of how some VCs, at least, price illiquidity. In exchange for some lock in (e.g. 2 years), a consortium of investors were demanding a discount from the current market price of 20%-30%. In the warrant alternative that was favored as of this writing by Sushi’s @OmakaseBar, the discount could be even greater.

Rewards can be much higher than a 20% discount, especially if the VCs invest before there is any liquidity at all, or, oftentimes, before there is a working product. Anchor Protocol’s (ANC) VC investors purchased 100 million tokens at $0.10 in March of this year with the promise of more off-market issuance. Getting involved only a few weeks before launch at the cost of little more than a six-month lock-in and one-year vesting has provided investors with a 18x gain as of writing, even after a 70% correction since April. A $10 million investment has become $180 million.

Anchor Protocol (ANC) daily price. Source: Coingecko.

The margin for error is definitely skewed in favor of illiquid strategies in such cases.

Another reason for a liquid fund to venture into the illiquid space is the need to maximize the opportunity set. Many of the fastest-growing traditional companies have been choosing to stay private for longer. Without a roaring bull market, it’s likely that crypto protocols will follow suit. OpenSea provides a very recent example of a crypto marketplace choosing VC funding, even though the platform is valued at the multi-unicorn level of $1.5 billion.

When a profitable venture investment appears, our alpha focus require we consider it, even in our liquid fund at times. Hartmann Ventures (HV) was a strategic investor in Deversifi (DVF) in May. Even with the correction, valuations have improved from our entry at $40 million to $200 million, a 5x return in two months. Like ANC, DVF has fallen since launch, but an attractive entry price mitigates some market risk.

Though Hartmann Capital cannot afford to ignore the venture space, we do need to manage illiquidity risk when we invest with our liquid product, Hartmann Digital Assets Fund (HDAF).

Lack of Market Depth

Like in small-cap stocks with little analyst coverage and few if any market makers, small projects in crypto may have very limited market depth. Buying or selling an illiquid token may involve high slippage, reducing investment returns. At the limit, it may be impossible to exit at any price. Yet small caps, at least in the stock market, offer the potential for higher returns. Like in VC funding, tokens with thin markets require a trade-off between liquidity and potential return.

Small caps, yet to be listed on major venues, can offer tremendous opportunities. Hartmann Capital acquired Enzyme (MLN) tokens before it was traded on most major centralized exchanges like Coinbase and Binance and before it was whitelisted with decentralized exchanges Sushiswap or Bancor. The only (rather thin) liquidity was on Kraken. Slippage not only forced us to accumulate over days, but also eventually forced the price up (just take a look at June 10th 2020). Wider listings and DEX liquidity incentives improved market depth, giving us even more conviction on this activist position.

Lack of market depth can also provide fertile grounds for manipulation. Many smaller-cap and newly launched tokens are only available on automated market makers, and liquidity can be skewed, in either direction. In a pump scenario, it is easy to buy the token but near impossible for non-LPs to sell.

I was running for the door
I had to find the passage back to the place I was before
“Relax,” said the night man
“We are programmed to receive
You can check-out any time you like
But you can never leave!”

Like the Eagle’s Hotel California, and many traditional private assets, it’s easy to get in but hard to leave.

Lack of market depth also contributes to rise in correlation. In the Global Financial Crisis, funds and shadow banks holding unsellable structured products such as subprime RMBS were selling their best and most liquid stocks and bonds to shore up capital or repay short-term funding. As such, serious corrections in illiquids tend to be contagious.

Limited Flexibility

Portfolio construction is a key component of risk/return optimization. In VC markets or simply thin markets it’s often very difficult or costly to right-size a position that has either improving or deteriorating fundamentals or technical.

Crypto markets are changing rapidly. As an example, there has been a wholesale rotation from DeFI into Metaverse recently.

Hartmann Capital operates primarily in liquid token markets. In general, we aim to hold positions that can be liquidated in minutes with minimal slippage. This allows us to rapidly take advantage of changing market sentiment. This suits our investors. While sometimes it makes sense to invest in illiquids, we optimize liquidity by aiming to invest no more than 10% of AUM into our VC deal side pockets and aim to keep lock ups at 2 years or less.

On last thought on illiquidity risk: Illiquidity and leverage don’t mix. Thin markets can become manipulated markets. Manipulation makes it easier to “run for the stops”, forcing leveraged players to liquidate at the worst possible time, and the shorts to cover profitability. By avoiding leverage in illiquids, Hartmann Capital can avoid being sold out of high-conviction though illiquid positions.

Diversification

Diversification is often touted as a solution to not only minimize idiosyncratic risk, but also for “free beta”. If assets are truly not 100% positively correlated, modern portfolio theory tells us that we should diversify widely in order to maximize the expected reward given risk.

Though the science is mostly flawed, diversification does help Hartmann Capital manage liquidity as well.

We size our lower liquidity tokens appropriately. Generally, deeply liquid tokens make up 5-10% of our portfolio, whereas less liquid ones may make up 2-4%. The main exception are activist investments which may make up as much as 10%.

Fortunately, illiquidity limits are generally not a hurdle. Launches are generally not capital intensive. The team needs to be paid, but they are often content with “equity” in the form of tokens. With expenses low, VC ticket sizes are commensurately small. Our limitation is therefore a positive. Keeping allocations to illiquids low and therefore smaller suits the protocols as much as it suits us.

Limiting exposure to illiquids also gives us more opportunities, especially in corrections. Illiquid tokens that fall in sympathy with the wider market yet further due to thin markets are primed for dollar cost averaging. With BTC down 50%, are tokens such as Rune, Handshake or RGT worth a 80%+ discount from their all-time highs?

Illiquidity therefore can be a feature rather than a bug, in two ways. Firstly, lock-ins focus the mind. Do we want to be in a certain token over the long term? Secondly, illiquid tokens suffer more liquidity vacuums on the downside, allowing better dollar-cost averaging or initial entry points.

On the other hand, a VC investment may be a bad idea and it might be better to play the “public” token or await a momentum play after launch, even if the price potential is dampened by the higher post-launch entry point.

Final Thoughts

While Hartmann Capital is actively exploring a variety of digital asset products for its clients, Hartmann Digital Assets Fund (HDAF) focuses on liquid hedge fund strategies. We aim to deploy capital primarily in mid to large cap assets with deep liquidity, while following careful concentration rules to avoid illiquidity traps that many digital asset allocators may fall victim to. To still benefit from the opportunities small caps can provide, we take a more active approach on the less liquid symbols as explored in our activist investing strategy.

Content