Investment

Understanding how digital asset managers approach risk amid extreme volatility is vital for family offices

For family office investors, the digital assets space looked alluring a few months ago. Now investors need to come to terms with a very different outlook. 

Crypto assets have endured a savage sell-off with Bitcoin trading as low as $17,573 this past weekend (down 44.7% in June) and an estimated $2 trillion wiped off the crypto industry ledger.

If you run bitcoin or Luna through a traditional risk model, which I have, what you find is that 90% of the risk is unexplained; it’s all idiosyncratic

As the global economy veers ever closer to recession the contagion effect has well and truly impacted digital assets, reaffirming the fact that in a bear market there is no place to hide. 

Last month witnessed the collapse of algorithmic stablecoin Terra USD (UST) and sister currency Terra (LUNA). On 13 June, crypto lender Celsius froze withdrawals citing “extreme” market conditions. The latest sign of contagion is the potential insolvency of crypto hedge fund Three Arrows Capital after it was allegedly unable to meet margin calls.

Understanding how digital asset managers approach risk management amid extreme volatility is vital for the next generation of wealth investors. There are plenty of trapdoors to avoid. 

Celsius is a case of asset-liability mismanagement. To provide Ethereum depositors with an attractive yield of up to 17% (annualised) it is believed that those deposits were staked in DeFi liquidity protocols such as Lido. But liquidity in Lido was more restricted and could lead to the equivalent of a bank run if Celsius were suddenly to be hit with a wave of withdrawals. Which is unfortunately what recent weeks have revealed to be true. 

Alex Botte is head of client and portfolio solutions at Runa Digital Assets. She held a similar role at Two Sigma, a $58 billion quantitative hedge fund founded by John Overdeck, David Siegel and Mark Pickard. In its sector, Two Sigma ranks alongside D.E. Shaw and Renaissance Technologies. 

Botte is building a proprietary risk framework at Runa from an asset class where the normal risks associated with traditional assets do not necessarily apply. It can be like comparing our everyday world to the strange sub-atomic world of quantum mechanics where the normal rules of physics take on a different hue. 

 “There are risks that are new to this space that aren’t well understood. A lot of them can’t be quantified,” she says. “The majority of us at Runa came from TradFi. We are seeking to carry over to digital assets, risk concepts and frameworks that worked in traditional investment management. It might not always work, they definitely need to be modifications for digital assets, but some of those concepts can be carried over.”

Runa is a long-term, long-bias fundamental investor, backing liquid tokens used for Web3 projects. It looks at a universe of 250 to 300 such tokens to seek out the best liquid projects across different sectors and does not look to short anything.  

In general, digital assets have exhibited higher volatility than stocks and bonds. Bitcoin has 60% to 80% higher volatility with some tokens producing annualised volatilities greater than 200%. Building a crypto-specific risk management program to analyse risk and keep on top of such elevated volatility is not without challenges.

“If you run bitcoin or Luna through a traditional risk model, which I have, what you find is that 90% of the risk is unexplained; it’s all idiosyncratic. For us, risk management is critical. We look at risk at the portfolio level, at the sector level and at the individual token level. And we have strategic risk guidelines for each of those areas.”

At the portfolio level, traditional risk tools can be applied avoiding, for example, the use of leverage. Runa holds bitcoin within the portfolio but has no bitcoin derivatives. Avoiding short selling is another portfolio technique. These two relatively simple tools are worth investors discussing with digital asset managers at the pre-investment stage. 

In respect to sector risk, investors should try to understand the extent to which fund managers are diversifying across different sectors. Ultimately, the intention should be to reduce overall volatility and exposure to a single kind of token risk factor. In her quantitative research, Botte found that, on average, the liquid tokens held across the six sectors in Runa’s portfolio display 60% to 80% correlation. 

“At the token level, we think of individual tokens in risk contribution terms in relation to everything else in the portfolio. We have different buckets that we assign things to. For example, early-stage tokens might be in there for thematic reasons. They might be associated with a really exciting team and roadmap. And so that might get a smaller risk budget. The second risk bucket is for momentum positions that are seeing acceleration in fundamentals that gives them a higher risk allocation. And then we have strategic allocations, which are projects that have really demonstrated significant network effects and are well tested,” says Botte.

There are plenty of reasons to be concerned over how much lower digital asset prices could fall. But if the long-term potential for Web3 is clear to see, then the current shakedown will accelerate Darwinism and allow institutional-quality blockchain-enabled companies to thrive. Proper due diligence and knowing which questions to ask will go a long way to getting comfortable with a manager’s investment process.

Although not exhaustive, some of those considerations might include: 1) What is the quality of a manager’s risk reports? 2) How do they take into account risks that can’t be quantified and what are the risks that they are most focused on today? 3) What risks exist in crypto that investors might not be familiar with in other, more traditional, asset classes? 4) What tools is the manager using to identify and manage those risks? 5) What are the operational risks?

Runa is developing three key components to its factor-based risk model. 

The first relates to crypto beta risk. Botte and her colleagues used the capital asset pricing model as a starting point. They looked It looked at the relationships across a sample of large-cap stocks and found that, by comparison, tokens exhibited a higher co-movement. Co-movement is used to describe the strong correlation among assets. 

“This is a good indicator that there is some crypto beta risk,” says Botte. 

“We also conducted a principal components analysis where you take a universe of tokens and look for latent risk factors within the data. And the first risk factor explained 40% of the shared risk of that crypto universe: that is, being long everything in the crypto universe. We think that can serve as the foundational risk factor in a risk factor model, just like it does in equity markets.”

The second component, or risk layer, looks at the relationship crypto has with traditional macro risk factors and as Botte asserts, “We think this relationship with traditional macro factors is the next iteration of the model”.

The third component looks at sector factors to answer questions such as: Do tokens within certain sectors, such as Defi move together more so than just tokens in general? Is there some extra shared risk element within DeFi? 

“We still don’t have that much history (or data) for a lot of these things so there are many challenges. We are one of three design partners working with a team from Cloudwall,  a vendor who are building a digital risk asset risk platform called Serenity. They are looking to build the equivalent of BlackRock’s Aladdin platform,” says Botte.

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