Crypto: Four Lessons Learned

<div>
After being the risk-asset poster child of the time and cash-abundant pandemic era, crypto assets have tumbled this year: the Blomberg Galaxy Crypto Index is down 63% (as of June 25), far worse than the Nasdaq (-26%), the S&amp;P 500 (-17%) and the Bloomberg Global Aggregate Bond Index (-14%). Apart from th<img src="https://20516260.fs1.hubspotusercontent-na1.net/hubfs/20516260/undefined-Oct-05-2022-01-01-11-21-PM.png" alt="undefined-Oct-05-2022-01-01-11-21-PM" width="1216" loading="lazy" style="width: 1216px; margin-left: auto; margin-right: auto; display: block;">
&nbsp;
&nbsp;
e increasing recession and inflation fears that have rattled financial markets, the crypto universe has also been hit by several idiosyncratic events, namely:
<ul>
<li>The recent collapse of the well-known Terra blockchain ecosystem: the company failed to maintain its peg to the US dollar – the key feature in any stablecoin (stablecoins are digital currencies that promise to be pegged to a major fiat currency in order to reduce volatility and gain market trust).</li>
<li>Increasing liquidity and solvency issues: Major digital lenders&nbsp;Celsius Network and Babel Finance have frozen withdrawals; crypto hedge fund Three Arrows Capital faces liquidity concerns; CoinFlex, a crypto physical futures exchange, paused all withdrawals on its platform citing extreme market conditions and uncertainty involving a counterparty.&nbsp;Crypto brokerage and exchange&nbsp;Voyager Digital Ltd.&nbsp;also started limiting customer withdrawals and transactions.&nbsp;</li>
</ul>
While the subsequent sell-off has been indiscriminate, the crypto universe is still backed by Wall Street firms and leading asset managers, who continue to see the asset class as a source of both risk and opportunity. In order to find the latter going forward, investors may consider the following four lessons that the past few weeks have left us with:
<ol>
<li>Crypto investing is about Finance:&nbsp;Some individuals invested in crypto assets to speculate or more because of the underlying technology than because of the assets’ risk and return profile. It is now apparent that, like any investment, capital flows into crypto assets should follow basic financial principles, including the fact that risk and return often come at the expense of each other.</li>
</ol>
Three Arrows Capital is having liquidity issues after over-leveraging its investments and therefore not being able to make margin calls when asset prices started to decline. Twenty-four years after the infamous collapse of Long-Term Capital Management (also caught in margin calls), risk management and operational due diligence practices have evolved and improved, raising questions as per why some professional crypto investors haven’t applied industry practice.
<ol start="2">
<li>Volatility, source of hedge fund alpha: As seen in&nbsp;Figure 1,&nbsp;the digital currency universe has shown far wider volatility than other asset classes, a feature also amplified by some crypto investors’ prominent use of social media. Also as seen in Figure 1, the exponential increase in the number of digital currencies has given investors a growing universe to trade in: crypto assets spiked to around $3 trillion last November, before plunging to less than $1 trillion at present (still a level similar to the entire US High Yield market).</li>
</ol>
Some hedge funds and other investors have turned this volatility and dispersion into opportunity, avoiding losses and offering investors uncorrelated returns. Crypto Market Neutral hedge funds have also offered a zero-beta exposure to tumbling markets so far in 2022, especially so in both May and June. Also seeking alpha, and in the midst of the sell-off,&nbsp;<a href="https://digital.us18.list-manage.com/track/click?u=811962e3033cd65122c0047e5&amp;id=1da1be2f69&amp;e=0d4005e5c8" target="_blank" rel="noopener">Goldman Sachs executed its first trade of Ether derivatives</a>, just over a year after its first bitcoin derivative trades and a month after its first bitcoin-collateralised loan. Fidelity, JP Morgan, Wells Fargo, Bank of America, Mastercard, Amex and Alliance Bernstein are among the institutions that have also recently backed crypto universe.
Figure 1: Volatility attracts alpha-seeking investors
<img src="https://20516260.fs1.hubspotusercontent-na1.net/hubfs/20516260/undefined-Oct-05-2022-11-08-47-64-AM.png" width="343" height="232" align="left" hspace="12" loading="lazy">
<a href="https://www.bis.org/publ/work1013.pdf">Source: Bank of International Settlements (BIS</a>)
<ol start="3">
<li>More regulation is needed: As any new industry, the crypto world remains largely unregulated, something that has allowed disingenuous companies to hide relevant factors in the small print, mis-leading investors. Most professional investors seem to agree that a better regulated sector will be in the interest of all market participants.&nbsp;<a href="https://www.bis.org/publ/work1013.pdf">A recent paper by the bank of central banks (the Bank of International Settlements, or BIS) recently said: “</a>Cryptocurrency intermediaries, including crypto exchanges, should be subject to the same types of regulation and oversight as intermediaries in economically equivalent asset classes, including with regards to financial stability, consumer and investor protection.”</li>
<li>Technology advance is unstoppable:&nbsp;Crypto currency companies are major developers of the blockchain technology, which initially focused on the verification of payments across the bitcoin network; the use now is far wider and crypto companies are more focused on the decentralisation of processes in multiple areas, including global supply chain management, clearing and settlement of financial instruments, insurance, telecoms… – the list is only growing. Progress never seems to stop – and neither seems to do the backing of:&nbsp;Figure 2&nbsp;below shows that despite the price volatility in network values in late 2018 (hawkish Fed pivot) and 2020 (Covid), technology developers managed to hold their value.</li>
</ol>
Figure 2: Investors reward technological progress
<img src="https://20516260.fs1.hubspotusercontent-na1.net/hubfs/20516260/undefined-Oct-05-2022-11-08-47-97-AM.png" alt="/var/folders/1z/5k59ynwj1b92g6ggkv6w_x9m0000gn/T/com.microsoft.Word/Content.MSO/55FC72B1.tmp" width="515" height="273" align="left" hspace="12" loading="lazy">
</div>

custom_date

linked_image

text

H2 Hedge Fund Outlook

In our 2021 year-end video we proposed 3 likely trends:

In our 2021 year-end video we proposed 3 likely trends:

<ul>
<li>Watch inflation- suggesting funds that are Macro-aware would likely prosper</li>
<li>Hedge fund talent wars to persist- with Multi-Strat positioned to attract the best</li>
<li>Diversification of alpha sources- achieved through traditional hedge fund strategies and some niche approaches</li>
</ul>
So far in the first half of 2022 saw a clear regime shift taking place in markets, as a result of&nbsp;<a href="http://localhost:3000/news/59092">rising persistent inflation</a>&nbsp;and global Central Banks’ determination to stamp it out by raising rates aggressively.
Figure 1: US 1Y1Y Forwards (Jul-20 to Jul-22)
<img src="https://20516260.fs1.hubspotusercontent-na1.net/hubfs/20516260/undefined-Oct-05-2022-01-01-12-48-PM.png" width="683" height="284" loading="lazy">
Currently there is little appetite for long duration assets, especially in growth areas of the market, such as Technology and more recently in&nbsp;<a href="http://localhost:3000/news/60243">Crypto</a>. There has been a violent rotation out of these assets at varying points of time during the year; suggesting diversification would have been crucial to mitigate losses.
Figure 2: US Growth Factor (Jan-22 to Jul-22)
<img src="https://20516260.fs1.hubspotusercontent-na1.net/hubfs/20516260/undefined-Oct-05-2022-01-01-11-75-PM.png" width="680" height="281" loading="lazy">
Leading to de-grossing across hedge funds and dispersion across strategies, as Macro, CTAs, and Multi-Strategy performed well; whilst LS Equity struggled.
Figure 3: Hedge Fund Gross and Net Exposure (Jan-20 to Jun-22)
<img src="https://20516260.fs1.hubspotusercontent-na1.net/hubfs/20516260/undefined-Oct-05-2022-01-01-12-18-PM.png" loading="lazy">
Source: Morgan Stanley
<h2>Looking ahead to H2 and beyond</h2>
Markets are increasingly pointing towards a recession, to the extent we believe we are already in one. Often for the fundamental analyst the question is no longer: “are we in a recession?”. Rather it is one of: “how long and deep will the recession be?”. EuroDollar futures curve change from May to July suggesting more front-loaded rate hikes, but into the middle of 2023 rate cuts to alleviate these fears are expected.
Figure 4: EuroDollar Curve Change 31st&nbsp;May to 1st&nbsp;July 2022
<img src="https://20516260.fs1.hubspotusercontent-na1.net/hubfs/20516260/undefined-Oct-05-2022-01-01-11-21-PM.png" width="711" height="159" loading="lazy">
What we are more certain of: elevated volatility, both at the single-name and index level, will persist with high levels of dispersion intra and inter-asset classes. Divergences will continue: both at the macro and micro-levels.
<h2>So where do we see opportunities in Hedge Funds?</h2>
Remaining in tactical nimble funds that are macro and factor aware continues to be crucial, especially in the near-term. We see value in holding:
<ul>
<li>Macro- given a&nbsp;<a href="http://localhost:3000/news/46205">divergent profile</a>&nbsp;that has been able to capture this regime shift</li>
<li>Multi-Strategy- offering a high SR profile with truncated downside due to different risk management protocols at PM and fund level. Though as we know not all Multi-Strategies are created equal, please reach out to&nbsp;<a href="mailto:ir@antarcticaam.com">ir@antarcticaam.com</a>&nbsp;for more details</li>
</ul>
Looking across other strategies:
<ul>
<li>LS Equity- we expect to remain challenging; however see opportunities in funds which can keep their&nbsp;<a href="http://localhost:3000/news/59358">core DNA and alpha generating process intact</a>, whilst adapting to the current macro trends such as through more nimble net/gross management</li>
<li>Quant- remain focused on ML given their inherent adaptability being at the core of their process</li>
<li>FI Arb- modest uptick recently in basis strategies given the volatility in rates markets</li>
</ul>
Finally, there is an increasing confidence that Converts and Credit will be able to prosper in the medium-term, given there is often a rich set of investment opportunities in downturns. The lessons from macro commodity cycles of the past, are that markets expunge excesses, bringing back discipline through a higher cost of capital. Identifying the survivors of the cycle is the key for those providing such capital. This is where opportunities arise in credit. Distressed thought process intertwined here also.&nbsp;<a href="http://localhost:3000/news/56725">Converts</a>&nbsp;continues to offer a good risk-adjusted ability to profit from volatility and uncertainty.

In our 2021 year-end video we proposed 3 likely trends:

The Case for Commodities II

After analysing what Commodities can do for investors in the first article of our series, in this second part we will look at why now it may be a good time to enter into the strategy, and what potential risks investors may face – and how to counter them.

Commodities: Why now? We see three major factors:
1. Multiple thematics to trade: Although there are multiple themes driving Commodity markets, we currently see three major ones:
<ul>
<li>Net-zero transition: As the world moves towards its United Nations-led carbon-neutral goal, governments, companies and individuals decarbonise to make the planet more sustainable. At present, fossil fuels generate about 80% of the world’s energy output, a figure planned to drop to 20% to meet the net-zero goals. This gargantuan change will require equally gargantuan investments in renewable sources of energy, such as solar, wind and tidal. Industries will have to shift entirely; cars, for instance, are in transition to become fully electric. The change will continue to generate winners and losers, offering alpha opportunities to investors who can not only see the direction of travel, but also the timing of change.</li>
<li>Energy disruption post-Russian invasion: The West has declared an economic war against Russia, imposing sanctions and embargos, although this collides with its purpose to secure domestic energy supplies. For example, the embargo slated for December 5th has already seen Russia sending less crude to the EU, India and China. This disruption may transcend the war, given the undermining of Russia’s productivity and the de-grading of its assets from a technological perspective.</li>
<li>End of globalisation: The shattering of supply chains as the world continues to be bent inwards on its own self has wreaked havoc on some Commodity markets at points in time.</li>
</ul>
2. Less competition for fundamental traders: Tougher regulation following the 2007-08 Great Financial Crises decreased bank’s presence in physical and financial markets, hampering many traditional players’ ability to execute their trading strategies. As a result, an astonishingly large number of fundamental Commodity funds closed between 2012 and 2018, including some of the biggest names in the business such as Blenheim, Armajaro, Centaurus, Clive, Jamison, Astenbeck, etc. This has resulted in less competition for active fundamental traders, meaning that they can, for instance, more easily extract alpha from something as simple as supply and demand forecast for inventories.
3.&nbsp;Large non-fundamental flows: Some of the largest market participants today, in terms of volumes, are non-fundamental funds – traders fully focused on the price moves of future contracts; as opposed to fundamental traders, these market participants have no view or interest in any underlying information on a particular commodity, or between commodities. By focusing on price, these traders find alpha by, for example, following the capital flows of macro tourists that buy commodities as an inflation hedge – paying a risk premia for it.
<h6>Risks</h6>
Volatility works both ways, as investors may enjoy the upside, but also suffer from potential downsides. Figure 1, for instance, shows this year’s double-digit losses in some commodities, such as steel, copper and aluminium – largely due to the recessionary outlook ahead. As seen in the chart, Commodity losses seem outsized relative to stocks and bonds – but so are the gains.
Figure 1: Commodities: for the good and for the worse
<img src="https://20516260.fs1.hubspotusercontent-na1.net/hubfs/20516260/Screenshot%202022-10-26%20at%2011.12.40.png" alt="Screenshot 2022-10-26 at 11.12.40" width="418" height="245" loading="lazy" style="height: auto; max-width: 100%; width: 418px; margin-left: auto; margin-right: auto; display: block;">
Source: Bloomberg as of 27 Sept. 2022
This is why at Antarctica we focus on funds that have solid risk management frameworks managing unbounded trades, or those without any fundamental limit, in either direction; for instance, this is as if US Natural Gas drew all from storage into March, before the injection season starts to properly get into full flow. In order to reduce risk, we also favour managers using scenario analysis, and not one that only uses historic cases, but one that also creates different, new and synthetic situations, as the future may bring scenarios not seen before. Investors may also beware narrative risks, or the self-serving stories spread by interested parties: for instance, there has been much talk about a Commodity Super-Cycle, mostly driven by reduced supply meeting increased, structural demand. While supply has been disrupted by the present war, it is also true that producers such as OPEC have cut output, and that the structural increased demand is hard to see given the weak global outlook ahead. Finally, we must be aware that Commodities, as a sector, is often prone to exogeneous, unpredictable shocks to the system. The most obvious example is weather conditions far outside the norm, such as a drought hitting the US in 2012 resulting in a spike in agricultural prices.
<h6>Conclusion</h6>
Commodities are a volatile, idiosyncratic asset class, traded by distinct market participants who seek opportunity in the thematic narratives and exogenous factors that drive the pricing saction. Both Fundamental and non-Fundamental strategies see in the sector’s traditional volatility an alpha rich sandpit, as they can take positions across the spectrum, given the opportunity set isn’t constant in any individual commodity or sub-sector.
&nbsp;
DON’T MISS THE FIRST PART OF THIS SERIES: THE CASE FOR COMMODITIES I

After analysing what Commodities can do for investors in the first article of our series, in this second part we will look at why now it may be a good time to enter into the strategy, and what potential risks investors may face – and how to counter them.

Insights

Crypto: Four Lessons Learned

H2 Hedge Fund Outlook

The Case for Commodities II

Thank you
for your email!

A member of our team will respond to you shortly.

Insights

Crypto: Four Lessons Learned

H2 Hedge Fund Outlook

The Case for Commodities II

Thank youfor your email!

A member of our team will respond to you shortly.

Thank you
for your email!