12 minute read
1.7 Approaches for gaining exposure to digital assets
With the increasing popularity of digital assets, investors can gain direct exposure by buying and holding digital assets or indirectly through equities and funds.
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The following table (Figure 12) illustrates the available digital asset investment options.
Figure 12. Common approaches for gaining exposure to digital assets
Approach Details
Online or crypto brokerage Enables users to trade digital assets similar to buying or selling stocks through brokers
Passive and active private placement funds Allows investors to invest in digital assets through funds
Publicly traded shares Allows investors to gain exposure to equities that are levered to the digital assets opportunity.
Advantages Disadvantages Future trend Examples
Convenient Security risk; Relatively high transaction fees; Non-competitive trade execution; Unclear compliance status. Brokerage apps and websites are increasingly popular among retail investors Coinbase, Kraken
Managed exposure to digital assets; Funds provide onestop services, including custody, trading, reporting, tax, audit etc.
Simple and straightforward Limited availability (only to accredited investors) Private funds are increasingly popular with HNWI; registered and hedge funds Pantera Bitcoin Fund (launched in 2013)
Other factors influence stocks valuations, including fund flows Increasingly popular with retail and professional investors. Coinbase, BC Group, Huobi Tech, Riot Blockchain
Direct custodial relationship
Regulated futures markets
Venture Capital Funds
ETF Trades digital assets with a custodian
Allows investors to access through future A low-cost way to gain exposure while eliminating intermediaries (fund providers).
Fully regulated; Allows individuals to use margin. Not available to smaller investors;
Costly due diligence process.
Complex costs and tax calculations
Allows investors to invest in the equity of cryptoasset startups.
Packages cryptocurrencies inside an ETF or mutual fund Way to get exposure to digital asset startups Accessing the top tier of venture capital funds can be difficult; Significant fees; Lack of liquidity.
Promising approach The variance of premiums and discounts to their NAV.
Source: CFA Cryptoassets report
Increasingly popular with buy-side, venture capital funds, family offices etc.
Increasingly popular with hedge funds and proprietary trading firms.
Increasingly popular with endowments, pensions, and family offices. Hex Trust
CME bitcoin futures market
Blockchain Capital
More asset managers are filing for cryptocurrency ETF with regulators Exchange-traded products have been approved in certain jurisdictions (e.g. US, Switzerland, Germany, and Sweden)
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Interview with Dick Lo, TDX Strategies
Key Takeaway
▪ There is a strong demand from clients on different ways to access altcoins, and derivatives on altcoins will flourish in 2022.
Dick Lo Founder, TDX Strategies
Dick has over 19 years of experience in the structuring, trading and risk management of derivatives products. He was previously the Head of Equity Structured Products at Daiwa Capital Markets and the Head of Single Stock Exotics Trading at Deutsche Bank. Dick founded TDX Strategies in May 2019, an institutional-grade investment solutions platform on digital assets that services high net-worth clients, family offices, institutions, corporates and hedge funds with a focus on derivatives and structured products.
Key Takeaway
2022 Outlook
For most investors, digital asset has become almost a necessity to participate in this rapidly growing, emerging asset class
Esme Pau (EP): What are the trends, challenges and opportunities in institutional digital asset investing in 2022?
Dick Lo (DL): Over the past 18 months, we have witnessed a highly impressive rate of adoption of digital assets across a diverse range of client segments, and we expect that will continue to accelerate in 2022. While still in its early stages, the industry has evolved and matured rapidly, with the general public's attitude and perception towards digital assets also turning considerably more positive and receptive. For most investors, it is no longer a question of whether or not to deploy a small allocation into digital assets to achieve portfolio diversification. Instead, it has become almost a necessity to participate in this rapidly growing, emerging asset class. As with any emerging asset
Regulation is shaping up to be a major theme in the year ahead
The key is for regulators to strike a fine balance that facilitates supervision and investor protection without being overly restrictive on financial, technological and product innovation x
class, participating early can bring about fantastic opportunities to generate outsized returns, which of course, is also fraught with risks and challenges.
Regulation is shaping up to be a major theme in the year ahead. The global lack of consistency and clarity from regulators has always been a major barrier to mass adoption by traditional institutional investors. The key is for regulators to strike a fine balance that facilitates supervision and investor protection without being overly restrictive on financial, technological and product innovation. Regulation should not be seen as obstructive but rather a prerequisite to widespread institutional investor adoption, which could be the catalyst for the next phase of positive returns. Regulation on stablecoins which is currently a hotly discussed topic, if implemented sensibly, should enhance the robustness of the overall industry and mitigate systematic tail risk, which may be triggered by the failure of a major stablecoin such as Tether. Whether DeFi regulation, which in itself is paradoxical, can be rationally framed and applied remains to be seen. Of course, the market continues to wait eagerly for the approval of a spot-backed ETF on Bitcoin as well as Ethereum.
We have seen outstanding returns over the past 12 months from blue chips (Bitcoin), DeFi protocols, Layer 1's, metaverse plays, etc. Outperformance could continue to come from any of these thematics or something totally different, unexpected and out of the left field. We advise our clients to be open-minded whilst being level-headed when it comes to investment opportunities in the digital asset space.
Being disciplined is crucial to the long-term sustainability of any digital asset portfolio given the volatile nature of the underlying asset class
Investment Strategies
EP: As a veteran, how would you advise professional investors to gain exposure to digital assets in a way that maximizes risk-adjusted returns?
DL: When it comes to investing in digital assets, we believe in a highly-disciplined and holistic approach. Being disciplined is crucial to the long-term sustainability of any digital asset portfolio, given the volatile nature of the underlying asset class. Whilst it may be tempting to allocate heavily into the market's latest favourite coins without much thought, and with leverage in the pursuit of short-term potentially mind-boggling returns, such an approach is also usually the recipe to have your portfolio "rekt" when inevitably, a considerable correction occurs. We do have an unwavering conviction and belief in the industry's long-term success; however, we want our portfolio to be sufficiently robust to weather the up-and-downs that are customary to this market. Therefore, we express our conviction with a methodical risk-management approach that utilizes minimal/no leverage, and we advocate the use of derivatives to protect our clients' investments against tail risks.
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We advise building a diversified portfolio of quality, value-producing assets with active rotation.
There is a strong demand from clients on different ways to access altcoins, and we expect derivatives on altcoins to flourish in 2022.
in BTC and/or ETH.
Dick Lo, Founder of TDX Strategies
Furthermore, we advise our clients to adopt a holistic portfolio approach – the market has matured a lot more quickly than many investors may think, and it is no longer about simply having a passive, concentrated exposure in BTC and/or ETH. There is a sound investment thesis across a wide variety of thematics outside the two major cryptos (which are still core holdings for any portfolio), including Layer 1's, DeFi (Decentralized Finance) protocols, GameFi, NFT, Metaverse plays, etc. We suggest building a diversified portfolio of quality, value-producing assets with active rotation but without overtrading the positions and overlaying the portfolio with derivatives for yield enhancement as well as downside protection.
EP: How do you see the crypto derivatives market developing in 2022?
DL: Although still relatively nascent, the options market has already undergone exponential growth over the last 12-18 months. Daily options volume on Deribit, the largest crypto options exchange, regularly exceeds US$1 billion in notional per day while open interest and volumes are also rising steadily at the main regulated exchange, CME. However, options volume on cryptocurrencies relative to spot volumes is still extremely low compared to traditional markets, and we expect substantial room for significant growth.
Currently, liquidity in the listed market is limited to BTC and ETH, while options on altcoins generally trade in the OTC market with only a handful of players, including TDX Strategies, providing liquidity. There is already strong demand from clients on different ways to access altcoins, and we expect derivatives on altcoins to flourish in 2022. Already, we hear plans from a couple of listed exchanges (including Deribit and bit.com) to list options on popular altcoins, and we welcome greater transparency and liquidity.
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Structured products, which is very much our core business here at TDX Strategies, is another area where we expect to see significant developments in the coming year. With higher implied volatilities than traditional markets, structured products provide clients with an alternative way to extract enhanced yield from the market and achieve their investment objectives more effectively. We launched a new product called Token Accumulation Strategy in October 2021 – a product that is similar to the popular Hong Kong Private Banking Product Accumulator – which helps clients accumulate BTC or ETH at a discount to the initial reference spot. The product has been incredibly popular and well-received by our clients. We foresee a gradual progression in terms of the sophistication of structured products as clients become more accustomed to investing in digital assets and explore smarter ways to gain their desired exposure.
Derivatives on DeFi is another area where we anticipate significant development. While several protocols have already been launched and many more are being built, there has not been a single dominant platform due to the numerous challenges such as pricing, liquidity and risk management. Platforms such as Ribbon Finance and Theta Nuts –structured products on DeFi – are gaining traction, and we expect on-chain derivatives to undergo considerable growth in the year ahead.
We foresee a gradual progression in terms of the
sophistication of structured products as clients
and explore smarter ways to gain their desired
exposure.
Dick Lo, Founder of TDX Strategies
Derivatives on DeFiis another area where we anticipate significant development
Institutionalization
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EP: Higher Sharpe ratio and low correlation with traditional asset classes have underpinned investors' appetite to diversify into digital assets. What is your expectation for digital asset volatility and returns relative to traditional asset classes in the future?
DL: Since the very early days, the fragmented market structure of cryptocurrencies has allowed investors to generate attractive returns with higher Sharpe ratios versus traditional markets. Many of these strategies are market neutral – from the early days of cross-exchange/cross-border arbitrage, to basis arbitrage, funding arbitrage and now volatility arbitrage strategies taking advantage of inefficiencies on the volatility surface. As the market matures and more professional and institutional players enter the market, the low-hanging fruit opportunities will be diminished and arbitraged out, and trading strategies will need to evolve to capture new opportunities.
We expect volatility on the major cryptocurrencies to decline structurally as mainstream adoption continues and more players look to take advantage of the relatively higher implied volatilities via yield harvesting strategies. On the other hand, volatilities on altcoins are like to remain elevated.
As the market matures and more professional and
capture new opportunities.
Dick Lo, Founder of TDX Strategies
We expect volatility on the major cryptocurrencies to decline structurally as mainstream adoption continues to take place.
EP: How do you see the longer-term interplay between institutionalization and the development of the digital asset landscape?
DL: As digital assets move away from being a retail-driven market to becoming more of an established, institutionalized asset class, institutional-grade infrastructure, products and services are required to facilitate that transition. Custody, borrow and lending,
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derivatives and structured products, prime brokerage and digital asset insurance –some of which already exist and others are in progress.
2022 is likely to be the year in which the global regulatory landscape tightens albeit at varying pace across different jurisdictions.
Regulation
EP: How do you expect the regulatory landscape to evolve in 2022 and beyond?
DL: 2022 is likely to be the year in which the global regulatory landscape tightens, albeit at varying paces across different jurisdictions. All players, if they are serious about being able to operate a sustainable business over a longer horizon, are already in the process of exploring different paths towards licensing and, in most cases, across geographical jurisdictions to cater for the various business activities. Operating in a regulatory vacuum without a license (or without a plan to obtain a license) is fraught with higher risks than ever before.
We expect regulators worldwide to take a more pragmatic approach as institutional and mainstream adoption of digital assets is no longer in question – it is happening before our very eyes. Therefore, it is paramount for regulators, who have generally been behind the eight ball, to play catch up very quickly. We see the establishment of a practical regulatory framework that focuses on investor protection as a positive and necessary step towards faster adoption by traditional investors.
Locally, in Hong Kong and Singapore, regulators are taking positive steps towards having regulatory oversight of the industry. Both are initially looking to regulate spot exchange activities, which is understandable, but we look forward to more clarity on supervision of other products and services.
EP: What would you like to see the regulators worldwide undertake?
DL: Regulators across the globe should try to gain a more comprehensive understanding of the industry that they are trying to supervise and devise a realistic, sensible framework, rather than just copy and pasting what has been done in other markets. There are encouraging signs that this is taking place as we see regulators increasingly engaging and consulting industry practitioners. We are optimistic that there will be more clarity in terms of licensing for businesses such as ours.
