The Institutionalization of Crypto Funds

Data – Analytics – Execution – Margining/Lending/Borrowing – Custody

First there was Bitcoin, with very little trade and no investor interest. Then in mid-2010, after many days of advertising, Laszlo Hanyecz convinced someone to take 10,000 BTC for two pizzas. The same year, Mt Gox introduced some liquidity and Silk Road in 2011 provided a use case: Now one could buy BTC, sell BTC or buy drugs with BTC.

At its height in mid 2013, Mt Gox was trading 70% of global BTC volume, or 150,000 BTC per day. While that’s billions at today’s prices, the daily dollar volume at the time was around $15 million. A few months’ later, a good part of Mt Gox customers’ Bitcoins disappeared.

“Mt Gox, where is our money?”

There weren’t any institutions. Buying Bitcoin was certainly possible, though sometimes very risky. Yet meetings in alleyways were probably more secure and certainly more private than the early exchanges.  The student that filled Hanyecz’s pizza order might have been the first aribtrageur, as the pizzas were worth less than the market value of the BTC. But the trade was hardly scalable: The basis was about 8 dollars.

Times have changed. Those same 150,000 BTC are now worth 470 times as much. And volumes have skyrocketed, by any measure.

Source: CoinMarketCap.

BTC no longer dominates crypto asset trading, and many of the newest coins have fundamental value as they are entitled to fees from real businesses. The MKR governance token for decentralized bank MakerDAO accrues value through buybacks. Staking decentralized exchange tokens SUSHI or CRV entitles the holder to a percentage of trading fees. Even Ethereum is now an income producing asset, staked in an eth2 node.

Source: 6th ICO/STO Report, pwc (2020).

As market activity in crypto picked up in 2017, culminating in the ICO boom and bust of 2018, the tools to trade and manage a portfolio of crypto assets were still all but non-existent. Margin trading and leverage in general was not possible in any size. Borrowing BTC and shorting – to hedge against losses in market crashes or to speculate on market direction – was difficult.

This was the state of affairs when Hartmann Capital began trading as a hedge fund.

It was like trading with two hands tied behind our backs. Infrastructure was, if not medieval, around 200 years behind TradFi. Institutionalized margining and shorting in commodities futures arrived in the middle of the 19th century.

Cambridge economist and UK representative at Bretton Woods, John Maynard Keyes was an active short seller and options trader beginning just before WWI. By 1929, 40% of all stock purchases on the New York Stock Exchange were margined.

DeFi met some of the needs of traders and portfolio managers. MakerDAO offered leverage on ETH while also creating a new US$-pegged stablecoin, DAI. Compound and then Aave also allowed traders to leverage, as well as to borrow to go short. Decentralized exchanges such as Uniswap overcame the custody concerns relating to Mt Gox and other hacks, tech failures and rug pulls.

Source: The Defiant.

DeFi has exploded since. DEX volumes have exceeded the expectations of almost everyone:

Source: Dune Analytics.

By 2020, exchanges had mostly improved in UX and in security. These now larger and more liquid markets attracted new funds to crypto. The basic decentralized ecosystem and disparate exchanges serving different clientele, often in different geographies, provided arbitrage and trading opportunities.

Many of those taking advantage of this new-found liquidity and bullishness were simply very large crypto natives, or whales. Narrowly held firms like Alameda, CMS Holdings and 3 Arrows Capital also prospered, sometimes with a tech advantage but often executing the same trades available to any sophisticated investor.

New and unsophisticated retail, on the other hand, began to coalesce around buying BTC and other cryptocurrencies or even the best-marketed altcoins on an exchange or repackaged into funds. Yet some retail and small institutions were drawn to more active solutions, such as ours at Hartmann Capital. Managers like us demanded more customized solutions. And we got them. Institutional custody, lending, execution and intelligence services now help us identify alpha, optimally execute our strategies and safeguard our clients’ funds.

The informational edge

Alpha in crypto is sourced in a wide variety of ways. It could be as simple as a community call on Discord, or a frank talk with founders, colleagues or competitors. Data is also key, as is how it’s used. Bloomberg in combination with several data services drive TradFi hedge funds, but the pseudonymous and transparent nature of crypto allows for analyses at an entirely different layer: Who is/was doing what and when.

Here’s one example or real time wallet monitoring. 0x7a3…380cf sold 9 cryptopunks.

Source: Nansen.ai.

Doxing whales is a common tactic. Everyone now knows billionaire Mark Cuban’s wallet address, for example. But this is one wallet over several DApps. Monitoring the entire ecosystem needs scale, something a new generation of data analytics services are providing. Alpha can originate from simply following the money. If treasury, dev or team wallets are suddenly liquidating, is a rug pull imminent? Watching staking contracts can also be informative. The surge in veCRV deposits from Convex weakened CRV’s fee distribution economics, at least for now.

Messari Enterprise picks up on-chain events in real time. Nansen monitors wallets down to the transactional level. Glassnode is especially good for layer 1 data, focused on Bitcoin and Ethereum. Delphi provides additional in-depth research.

These services are not inexpensive, nor (occasionally) available to all. Nansen’s Alpha package has a waiting list for the privilege of paying $30,000 per year.

The quantum of funds under management is important when data costs are high.

It’s possible to replicate some services, but the money is sometimes better spent on experts. Dune Analytics allows the querying of in-DApp data for free, though the premium version allows for downloads.

Borrowing: Leveraging longs and setting shorts

Decentralized borrowing generally requires such overcollateralization to render some trades uneconomic. Users without credit are stuck with 150% or more collateral requirements with MakerDAO, Compound or Aave. Centralized institutional lenders such as BlockFi were established to allow for undercollateralized institutional borrowing. It’s thought that BlockFi has not experienced one default to date.

As an Eligible Contract Partner (ECP), meaning an institution managing over $10 million (which Hartmann does), lenders are able to offer flexible margin at a fraction of the borrowing cost that retail pays.

The Grayscale arbitrage was an example of where crypto institutions were able to leverage their creditworthiness to create a synthetic premium trade with almost no money down, by borrowing Bitcoin and collateralizing it with GBTC shares. While the shares could be sold at a premium (after a lock in), institutions could buy them at net asset value.

Source: YCharts.com.

Yet institutional lenders also provide assets to be sold short, facilitating option delta hedging and long/short strategies.

The regulated institutional futures markets such as the CME also allow for some leverage for size. Currently margin requirements are 40% of notional.

Retail clients do not have access to these sources of assets or funds. Being an institution in the borrowing market reduces frictions and allows for more capital efficiency.

Liquidity and execution

Just like in TradFi, over the counter (OTC) desks serve institutions that need size without spooking the (transparent) markets. Paradigm’s RFQ is one tool that allows for peer to peer trading, facilitated by a well-connected team. Without institutional access to Paradigm, the best prices and largest flows are beyond reach: 20-30% of global crypto asset option flows pass through their platform.

Source: Paradigm.

SFOX and Talos promise some of the best execution order routing connecting funds like ours to all major exchanges and market makers through one single interface, enabling position building across multiple venues with one click. SFOX also has its own dark pool for trading confidentially. Both services also enable smart order routing using approaches like TWAP and more advanced order types, to reduce the market impact and instead buy in small quantities over a period of time across multiple venues.

The takeaway here is that best execution and settlement is often only available to clients doing tens of millions in monthly volume to qualify. Once again, whales and institutions have an edge.

Custody

Institutions have obligations to safeguard client money, and crypto can be a minefield of hacks, rug pulls and tech failures. Additionally, secure, multi-sig yet flexible transacting is unavailable in most hard or soft wallets.

One is stuck between keeping funds with major custodians, and being able to trade them flexibly and partake in on-chain opportunities like staking with high yields.

Over the last 12 months, however, we have seen significant progress amongst regulated centralized custodians. Not only these custodians finally offer many assets beyond bitcoin, but also have improved ability to trade assets held in custody.

There are multiple approval options. Coinbase Custody, Anchorage, Bitgo, Kingdom Trust and Fireblocks are a few of these. “Frozen” storage secures keys in such a way that tokens cannot be otherwise used at all. HODL funds can safely be parked here. ­Exchanges offer custody through “cold wallets” that can go on-line quickly. Hot wallets offered by Anchorage, a federally chartered US bank, and Fireblocks can be used in every DeFi application. Many of these solutions provide accounting data through APIs, allowing for secure and accurate financial reporting.

Source: Bakkt.com

Custodians can also often lend against existing asset balances at a moment’s notice, competing with prime agents and crypto lenders as above.

Copper is another new custody provider that enables one to trade within a ‘walled-garden’ of prior approved exchange accounts, and even trade ones assets via crediting system (clearloop) directly from college storage.

Only institutions can benefit from these services. Many of the custody providers named above, for example, have a $1mm minimum account size restrictions and others have setup and admin fees that only make sense for larger accounts.

Institutional Crypto infrastructure is Here

Our goal at Hartmann Capital is to provide smart exposure to the digital asset markets, while keeping our clients’ assets safe. Trading for alpha requires expensive market data and analytics, time-consuming and complex analysis in house and by third parties as well as seamless cross-chain execution and post-trade financing, settlement and accounting. The services we use are often available only to institutions and/or are prohibitively expensive for smaller accounts, providing us with a further edge over a vast segment of the market. On a quarterly basis we review our tech stack and aim to improve our set-up with the most state of the art offering available in digital assets.

The infrastructure is here and Hartmann Capital is part of leading the charge in institutionalizing crypto asset management.