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Liquidity Premium or Liquidity Discount?

In general, liquidity is good. Investors are typically willing to pay a premium for liquidity. In today’s newsletter, we explore the problem that too much liquidity can sometimes bring to an asset class, such as with cryptocurrencies and blockchain currently.

A popular investing approach in cryptocurrencies is a simple “buy and hold” strategy. Although public blockchains offer transformational promise, the immediate roadmap still remains overshadowed by the early, experimental nature of blockchain technology and its inherent challenges, resulting in wildly unpredictable price swings. A ‘buy-and-hold’ across a few crypto themes is akin to a traditional VC betting on one or two key plays across a thematic smorgasbord, with the difference being that VC investments are inherently illiquid, while blockchain investments, at least in the cryptocurrencies themselves, are highly liquid. Another key difference between investing in promising technology startups and cryptocurrencies for retail investors is that technology companies are sufficiently de-risked by the time they become available to the public. In every cohort of startups that set out to solve a problem, only a handful manage to get out of the gate and have anything like a reasonable exit, while the vast majority sink without a trace. Extreme competition in the formative years kills all unsound projects/teams and the winner(s) who makes it big as a product of natural selection becomes available for retail investors to invest in.

In the blockchain world, we are right now in a phase where we have access to a number of competing experimental technologies from a very early stage, leading to extreme chaos and uncertainty over expectations around the final outcome. Reflexivity plays a part in amplifying volatility as well, and the fear (or hope) of a particular cryptocurrency going down (or up) becomes a self-fulfilling prophecy. A “Buy and hold” index strategy might be the eventual winner, but with the possibility of a 90% mark down before a 100x return from the level you enter, wise investors might want to pay heed to the Keynesian dictum – markets can remain irrational longer than you can remain solvent – The scenario today with the crypto markets therefore begs the question – Is the enhanced liquidity a blessing or a curse? Are investors paying a liquidity premium or are they getting a liquidity discount, for the enhanced liquidity embedded in crypto?

Active strategies that provide a floor to the downside exposure can be used to mitigate the risk of extreme markdowns. Some time ago, we had started tracking an index strategy (www.108token.com), that tracked the top-15, supply-adjusted market-cap weighted cryptocurrencies. This had its ups and downs, while still out-performing either BTC or ETH over the past couple of months. We then decided to devise an active strategy around our passive-style 108 token. The idea was to down-side protect the portfolio in a bearish market environment and book profits periodically in a directionally upward market.  We tracked the strategy for roughly three months, beginning from Sep 1st and until Nov 27th. Fiat Dollar returns of the active 108 strategy versus our passive 108 token, BTC and ETH, as well as traditional benchmarks such as S&P 500 and Gold are captured in the graph below.

As the graph shows, the active strategy significantly outperformed pretty much every other strategy. It significantly outperformed BTC and ETH ( both of which saw double-digit losses), as well as traditional benchmarks like the S&P 500 and Gold, in a scenario where the markets were bleeding across the board, across crypto and non-crypto asset classes.

This is still the first iteration of our active strategy and we will continue to refine this further to improve performance characteristics. Predictable returns like these lend themselves nicely to risk management and treasury portfolio solutions, among other things. Please feel free to drop us an email if you would like to have a discussion and learn more about the underlying workings of this strategy.

Meanwhile in Crypto Wonderland….

“North Korean Hackers are After Your Crypto” According to a report, North Korean hackers are now targeting individual investors to steal crypto holdings. The option to target individuals who hold cryptocurrencies is a departure from their usual model of penetrating high-value financial institutions and centralized crypto exchanges. To steal their victims’ digital assets, hackers send unsuspecting victims an email with infected file attachments.

“G20 Leaders Call for Unified Crypto Regulations” Leaders of the G20 group gathered in Buenos Aires over the weekend and discussed unified regulations and a global approach to digital currencies. The organization confirmed its commitment to using all political tools, including digitalization of the global economy and crypto assets, to promote global growth. G20 leaders are seeking to “build a taxation system for cross-border electronic services”.

“Clayton Speaks at NYT Event” The SEC Chairman Jay Clayton spoke about blockchain and cryptocurrencies at a New York Times event last week. According to Clayton, “Technology ought to be able to fit into our rules. And I think this technology has incredible promise for adding efficiency to our marketplace, but I’m not going to change the investor-protection aspects of those offering rules or those trading rules just because there’s a new technology”.

“Russia Crypto Bill Delayed”The Russian government has been working on making Russia more welcoming to the cryptocurrency community, establishing a draft bill called “On Digital Financial Assets.” However, according to a report, the bill still needs major amendments  – some so extensive that the bill has has been pushed back to the initial reading stage.

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