The Search For Yield Brings Me Full Circle
Updated: Jul 22, 2022
20 years ago, I moved from programming trading and risk management systems to working at an endowment analyzing hedge funds. The endowment had a large equity allocation, not unlike most institutions, and the “Absolute Return” team was tasked with investing in funds without long equity exposure. That meant analyzing and investing in strategies like convertible arbitrage and statistical arbitrage strategies. Over time, dollars poured into quantitative hedge funds because of their liquidity and portfolio diversification benefits when added to a net long equity portfolio. Through the enhanced computing power of the early 2000s, exchange connections and efficient leverage became increasingly important as the spreads that could be earned became smaller, and profit opportunities persisted for shorter periods of time. Our portfolio migrated to focusing on the fixed income and event driven strategies that have been the focus of my career since.
2020 was supposed to be a busy year and then Covid hit. I was given time to make calls and spend more time on research. Several years ago, I had provided capital for the loans of a revenue-based financier who was also involved in the crypto world and wanted to use his platform to develop an alternative credit scoring database. While the advances went well, increased competition caused originations to dry up and the project was shuttered in 2019. The founder went on to work on Decentralized Finance projects (Defi). One day, he mentioned something called Curve, an AMM for stable coins, where you could lock your crypto in a pool for a period of time and earn a yield that is similar to putting your money into a CD. You could earn even higher returns if you stored your crypto in a pool used to earn money in a series of transactions, such as a ‘flash loan attack.’
As this has been my long-time professional focus, I was interested in learning more about these yield-based investments and what you could do with them. As I began to do more research on AMMs and liquidity pools, I started to see similarities with the regular financial markets. These were just like exchanges and pits. Assets (coins) are traded on multiple exchanges (AMMs) in pits (pools). Like in any exchange, assets can trade at a different price at the same time. Arbitragers will borrow money and buy the asset on one exchange to then sell it on another exchange and collect the spread, minus the borrowing and trading costs (gas fees). For those of you old enough to remember this sounded an awful lot like ADR/GDR trading in stocks.
Suddenly the wheels started to turn for me. These are venues designed for electronic execution. What else could you do besides intermarket arbitrage? There are futures and options for some of these coins on more “traditional” exchanges like Coinbase. Obviously, that meant trend following would work. Then you could do pairs trading, statistical arbitrage, and with the options, even volatility trading. That’s a plethora of easily translatable strategies, many of which are market neutral. None of these require you to have a specific valuation opinion or to judge the viability of a project in the traditional venture capital sense. Basically, with the increasingly common usage of digital assets, we could go back to old school hedge fund trading strategies. That is to say, the stuff we were doing at the beginning of my career.
Over the last few months, Nishu and I began to ask old contacts if they knew people running quantitative strategies in digital assets. We were surprised at the number of firms we discovered that had multi-year track records, intuitional infrastructure, and with founders that had started at various well known institutional “traditional market” trading firms. There was also a growing number of individuals spent their quarantines as opportunities to convert strategies they were familiar with from the worlds of currency, equity, commodity and fixed income markets to the digital asset markets. We began to wonder, is there a market for a fund in the vein of Mariner, Front point or Millennium that both invests in traditional funds as well as incubates strategies and managers in potentially high returning quantitative digital asset strategies? Strategies that don’t necessarily have to focus on what the price of bitcoin will be next month or what project will be successful. Do people want to invest in a well-constructed institutional grade portfolio of “old school” quantitative hedge fund strategies or do they want to move completely to the digital markets of crypto? Is there space for both to exist successfully and congruently?
We’re asking our contacts and you, so let us know.
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