Insights

Crypto index tilts heavily to the largest constituents

Addressing concentration of cryptocurrency market

Addressing concentration of cryptocurrency market 1024 536 cryptonews@arxnovum.com

How to address concentration risk in portfolio construction? Today we will explore different ways to design an index that tilts so heavily to the largest constituents while keeping an eye on tradability and risk management. 

Historically, index providers have used fixed weight capping to mitigate large concentration in one or more securities, where the extra weight is redistributed to smaller non capped constituents. Recall from our first blog in the series the weights as follows:

Market capitalization: 

Bitcoin and Ethereum represent over 80% of cryptocurrency market capitalization

Source: CF Benchmarks, as of March 1, 2022

By applying a fixed cap of 25% to these weights, bitcoin and ether would exceed the cap at inception, with no difference in weighting based on market capitalization or liquidity.  Different capping weights would result in similar results and lead to the index trading more like a fixed weight index than a market capitalization weighted index. 

The point on liquidity is probably the most impactful for a small burgeoning asset category like cryptocurrency.  For an index to be representative of the market it needs to be tradable.  Smaller constituents generally have a significantly lower liquidity profile, thus making it difficult for institutional managers to replicate the market beta when the smaller constituents receive a higher weighting that results from capping the very largest constituents. Therefore an index that significantly re-weights to much smaller and illiquid names creates a benchmark that may not be representative or tradable.

So how to solve this problem? Instead of applying a fixed cap, the index will benefit from a smoothed capitalization methodology where each additional percentage weight is discounted sequentially more than the previous one by a defined amount.  This progressive redistribution from large to small caps benefits from keeping the final index weights relatively close to free float market capitalization while still achieving diversification. 

In order to achieve the smooth capitalization redistribution, the discounting will increase exponentially using the inverse step function applied to each additional 4% bucket. The inverse stepped function basically reduces each tranche by 1/ nth tranche.  To illustrate, if we were to apply the inverse step function with a 4% tranche to the 60.31% market capitalization weight to bitcoin, you would have a process that looks like the following chart and we have a new bitcoin index weight of 37.11%. 

Bitcoin diversification step example:

BTC diversification step

Source: CF Benchmarks, as of March 1, 2022

By applying this process to the whole index you achieve a redistribution that looks like the following.

Diversified weights:

Crypto portfolio with BTC and ETH concentration lowered to 65% of the total

Source: CF Benchmarks, as of March 1, 2022

The smoothed capitalization redistribution allows investors to achieve the primary goals of a market capitalization weighted index, to be representative of the market, to reduce concentration to the largest weights and to remain tradeable. 

Our blog series continues tomorrow with a discussion on how the use of index inclusion and exclusion screens can be used to help reduce risk.

The products and services offered by Arxnovum are available to qualified investors in certain provinces and territories of Canada. Individual investors should contact their own financial professional to determine the most appropriate investment options for their financial situation. This material contains the opinions of the manager and such opinions are subject to change without notice. This material has been distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission.
 
All investments contain risk and may lose value. Investing in the cryptocurrency market is subject to risks.  Cryptocurrency, often referred to as “virtual currency” or “digital currency”, operates as a decentralized, peer-to-peer financial exchange and value storage that is used like money. Cryptocurrency operates without the oversight of a central authority or the banks and is not backed by any government. Even indirectly, cryptocurrencies such as bitcoin may experience high volatility, and related investment vehicles may be affected by such volatility. Cryptocurrency is not legal tender. Federal, state, provincial, territorial or foreign governments may restrict the use and exchange of cryptocurrency, and regulation in North America is still developing. Cryptocurrency trading platforms may stop operating or permanently shut down due to fraud, technical glitches, hackers or malware, which could have an adverse impact on the net asset value per unit of the Fund. Please consult the Funds Term Sheet for a complete list of risks.
 
Certain statements in this document are forward-looking. Forward-looking statements (“FLS”) are statements that are predictive in nature, depend upon or refer to future events or conditions, or that include words such as “may,” “will,” “should,” “could,” “expect,” “anticipate,” “intend,” “plan,” “believe,” or “estimate,” or other similar expressions. Statements that look forward in time or include anything other than historical information are subject to risks and uncertainties, and actual results, actions or events could differ materially from those set forth in the FLS. FLS are not guarantees of future performance and are by their nature based on numerous assumptions. Although the FLS contained herein are based upon what Arxnovum Investments Inc. and the portfolio manager believe to be reasonable assumptions, neither Arxnovum Investments Inc. nor the portfolio manager can assure that actual results will be consistent with these FLS. The reader is cautioned to consider the FLS carefully and not to place undue reliance on FLS. Unless required by applicable law, it is not undertaken, and specifically disclaimed that there is any intention or obligation to update or revise FLS, whether as a result of new information, future events or otherwise.
Illustration of a man and woman riding paper planes while looking through telescopes

Quarterly Crypto Market Review Highlights

Quarterly Crypto Market Review Highlights 2560 855 cryptonews@arxnovum.com

The following are the key highlights and takeaways from our June 2022 Quarterly Crypto Markets Review letter to investors.  

  • LUNA, an algorithmic-driven pair that attempted to peg UST 1:1 with the US dollar, failed miserably impacting retail and institutional investors.  We had no exposure to the LUNA/Terra/Anchor fiasco.
  • The fallout from LUNA has us keeping a close eye on other stablecoins like USDT (“Tether”) and USDC (“Circle”) as neither are bankruptcy remote from a backing point of view.
  • Furthermore, Silvergate Bank (SI-NYSE) and Signature Bank (SBNY-NASDAQ) are also on our mind for counterparty losses.
  • Bitcoin has been through such periods before and appears to move in four year cycles related to the halving events where the supply of bitcoin created with each block is reduced by half.
  • Bitcoin is perhaps best regarded as a technology with massive potential to address a fundamental human activity – value transfers – through network activity with extremely low costs outside of traditional channels. 
  • Bitcoin is and will remain highly volatile which reduces its use case as a store of value or a medium of exchange – both of which have faced a wall of anxiety by regulators and central bankers.
  • As with any risky asset, the valuation of bitcoin is sensitive to rising rates and when the Fed’s hiking turns to cutting, we expect that bitcoin will rally accordingly.
  • Staking of ETH2 is so far operating according to plan though with relatively low yields that are comparable to the yields available in Canadian bank or energy pipeline stocks.
  • The primary issues that have prevented our involvement in staking are that the ETH2 is locked until the full merge of ETH into ETH2; that yield is paid out only when the merge happens and finally there are some issues around the custody of ETH2 that has given us pause.
  • We did not invest in or with Celsius, BlockFi or any other yield farming platforms that we viewed as offering unsustainable and unsupportable yields. 

If you are interested in receiving future Quarterly Crypto Markets Reviews please sign up at investor registration.

The products and services offered by Arxnovum are available to qualified investors in certain provinces and territories of Canada. Individual investors should contact their own financial professional to determine the most appropriate investment options for their financial situation. This material contains the opinions of the manager and such opinions are subject to change without notice. This material has been distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission.
 
All investments contain risk and may lose value. Investing in the cryptocurrency market is subject to risks.  Cryptocurrency, often referred to as “virtual currency” or “digital currency”, operates as a decentralized, peer-to-peer financial exchange and value storage that is used like money. Cryptocurrency operates without the oversight of a central authority or the banks and is not backed by any government. Even indirectly, cryptocurrencies such as bitcoin may experience high volatility, and related investment vehicles may be affected by such volatility. Cryptocurrency is not legal tender. Federal, state, provincial, territorial or foreign governments may restrict the use and exchange of cryptocurrency, and regulation in North America is still developing. Cryptocurrency trading platforms may stop operating or permanently shut down due to fraud, technical glitches, hackers or malware, which could have an adverse impact on the net asset value per unit of the Fund. Please consult the Funds Term Sheet for a complete list of risks.
 
Certain statements in this document are forward-looking. Forward-looking statements (“FLS”) are statements that are predictive in nature, depend upon or refer to future events or conditions, or that include words such as “may,” “will,” “should,” “could,” “expect,” “anticipate,” “intend,” “plan,” “believe,” or “estimate,” or other similar expressions. Statements that look forward in time or include anything other than historical information are subject to risks and uncertainties, and actual results, actions or events could differ materially from those set forth in the FLS. FLS are not guarantees of future performance and are by their nature based on numerous assumptions. Although the FLS contained herein are based upon what Arxnovum Investments Inc. and the portfolio manager believe to be reasonable assumptions, neither Arxnovum Investments Inc. nor the portfolio manager can assure that actual results will be consistent with these FLS. The reader is cautioned to consider the FLS carefully and not to place undue reliance on FLS. Unless required by applicable law, it is not undertaken, and specifically disclaimed that there is any intention or obligation to update or revise FLS, whether as a result of new information, future events or otherwise.
Illustrated version of Munch's Scream painting with glitches

Rising rates and stablecoins’ stumble

Rising rates and stablecoins’ stumble 1280 720 cryptonews@arxnovum.com

Across financial assets there are new dynamics on prices and yields as the US Federal Reserve (the Fed) has moved from passively watching inflationary pressures building to economic prints of 8.3% annual inflation.  Against this backdrop there is a war in the Ukraine and Covid lockdowns in major Chinese cities.  In our opinion, the main force impacting all risky assets is the Fed’s race to deal with inflation and we see them as woefully behind the curve.

US CPI year-over-year

In order to address the rising inflation levels that have clearly moved well past transitory, the Fed has embarked on an aggressive path of increasing interest rates.  Having already increased the influential fed funds rate by 75 bps (100 bps = 1.00%) at its last two meetings, the Fed has signalled to the market to expect more increases at future meetings.  

As US rates rise, capital will flow into the US and strengthen the US dollar (USD).  This has been evident in the Yen and the Euro.  Our view is that the USD is the largest asset globally.  Its recent strength means that anything priced in USD is falling – from bond prices to equities to commodities to bitcoin and cryptocurrencies.  

The strengthening US dollar can be witnessed through the US Dollar Index (Ticker: DXY), which is an index that measures the value of the US dollar relative to a basket of foreign currencies, including Euro, Japanese yen, British pound, Canadian dollar, Swedish krona and Swiss franc.  The 15% move higher in the US Dollar Index over the last year has been driven by expectations for higher rates and by a flight to safety in the face of geopolitical tensions around the globe.

Source: Bloomberg.com

The US dollar should revert to a weakening trend if rates return to a path lower to the zero-interest-rate boundary and this will occur if there is a U.S. recession or severe market crash or both.  The US yield curve has inverted which is seen as an advanced signal of a recession.  The next signal to watch is the unemployment rate against its 12 month moving average.

The digital asset market has not escaped the drawdown we’ve seen in other risky assets. The CF Diversified Large Cap Crypto Index which measures a basket of the largest and most liquid crypto currencies is down 49% year to date.  Bitcoin which is the largest, oldest and widely seen as one of the safer crypto currencies has not avoided the market carnage with the CME CF Bitcoin Reference Rate Index down 36% year to date.

Crypto currency markets were further roiled this past week with an algorithmic stablecoin called Terra depegging from the USD$1 it was meant to maintain.  From what we have seen this was an engineered attack, but no matter, our funds have no direct exposure to Terra, Luna nor Anchor.  Part of the Terra/Luna defence was to have bitcoin reserves which may have been sold in haste causing the fall in bitcoin prices.  Bitcoin is in a time period relative to its past halving where the price tends to move sideways as we move towards the next halving, which will be in May 2024.  We are watching the markets closely and welcome questions from our investors.

Disclosures

The products and services offered by Arxnovum are available to qualified investors in certain provinces and territories of Canada. Individual investors should contact their own financial professional to determine the most appropriate investment options for their financial situation. This material contains the opinions of the manager and such opinions are subject to change without notice. This material has been distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission.
 
All investments contain risk and may lose value. Investing in the cryptocurrency market is subject to risks.  Cryptocurrency, often referred to as “virtual currency” or “digital currency”, operates as a decentralized, peer-to-peer financial exchange and value storage that is used like money. Cryptocurrency operates without the oversight of a central authority or the banks and is not backed by any government. Even indirectly, cryptocurrencies such as bitcoin may experience high volatility, and related investment vehicles may be affected by such volatility. Cryptocurrency is not legal tender. Federal, state, provincial, territorial or foreign governments may restrict the use and exchange of cryptocurrency, and regulation in North America is still developing. Cryptocurrency trading platforms may stop operating or permanently shut down due to fraud, technical glitches, hackers or malware, which could have an adverse impact on the net asset value per unit of the Fund. Please consult the Funds Term Sheet for a complete list of risks.
 
Certain statements in this document are forward-looking. Forward-looking statements (“FLS”) are statements that are predictive in nature, depend upon or refer to future events or conditions, or that include words such as “may,” “will,” “should,” “could,” “expect,” “anticipate,” “intend,” “plan,” “believe,” or “estimate,” or other similar expressions. Statements that look forward in time or include anything other than historical information are subject to risks and uncertainties, and actual results, actions or events could differ materially from those set forth in the FLS. FLS are not guarantees of future performance and are by their nature based on numerous assumptions. Although the FLS contained herein are based upon what Arxnovum Investments Inc. and the portfolio manager believe to be reasonable assumptions, neither Arxnovum Investments Inc. nor the portfolio manager can assure that actual results will be consistent with these FLS. The reader is cautioned to consider the FLS carefully and not to place undue reliance on FLS. Unless required by applicable law, it is not undertaken, and specifically disclaimed that there is any intention or obligation to update or revise FLS, whether as a result of new information, future events or otherwise.
Crypto charts on a wall-mounted monitor.

Crypto: What to expect in 2022

Crypto: What to expect in 2022 2560 1707 cryptonews@arxnovum.com

As a relatively young asset class, the cryptocurrency space is evolving rapidly. In today’s post we review some recent developments and provide a brief look into what we expect from the cryptocurrency market in 2022.

Crypto volatility creates opportunity

Historically cryptocurrency investors have experienced very high volatility. Since 2014, Bitcoin has had an annualized volatility of 81%. This eye-popping number is nearly six times higher than the realized annual volatility for the S&P 500. (Source: portfoliovisualizer.com BTC Jan 2014 – Dec 2021)

Over the period, Bitcoin fell 44 times yet still managed to generate cumulative returns of 6023%, or 67% annualized.

(Source: portfoliovisualizer.com BTC Jan 2014 – Dec 2021)

Last year saw a similar trajectory. Even though Bitcoin was up 59%, volatility still remained high at 80% with negative returns in six of the 12 months.  (Source: portofoliovisuializer.com BTC 2021)

I write this not to scare you, but to illustrate that volatility can be a good thing. If paired with a dollar cost average strategy, volatility can capitalize on opportunities to access this new and developing technology. We see no reason for this volatility to change in 2022, with the first few weeks of the year serving as an admittedly small sample size.

SEC likely to approve BTC ETF

In 2021 the U.S. Securities and Exchange Commission (SEC) approved the first bitcoin ETF,  which follows a futures-based strategy.

However, a futures-based strategy may not live up to investor expectations of accurately tracking the price of the underlying asset. Bitcoin futures typically trade in “contango,” a futures market situation in which longer-dated contracts trade at a higher price than shorter-dated contracts.

This can result in significant underperformance, which may persist for as long as Bitcoin remains in contango.

According to the SEC, its mission is “to protect investors; maintain fair, orderly, and efficient markets,” and it “strives to promote a market environment that is worthy of the public’s trust and characterized by transparency and integrity.” Given the potential short-comings of a futures-based strategy, we believe the SEC will likely approve a spot Bitcoin ETF before the end of 2022.

Ethereum moves to PoS

The primary goal of an effective decentralized network is to ensure that nobody spends the same money twice. In order to ensure this goal holds true, networks use consensus mechanisms to validate legitimate transactions. Proof of Work (PoW) and its newer sibling Proof of Stake (PoS) are the two consensus mechanisms used by most cryptocurrencies. PoW networks include Bitcoin and Ethereum, while newer cryptocurrencies like Ethereum 2.0, Cardano and others rely on PoS validation.

While PoW networks have developed a well-established technology and trusted network, there are limits to their growth. Steady increases in the number of transactions result in a serious drawback of PoW networks, the significant energy consumption needed to validate these transactions. In a quest to solve this dilemma, the cryptocurrency community set out to solve the energy consumption issue by creating PoS. Improved energy efficiency is a major driver for the validators staking the network and the driving force behind Ethereum’s move to a PoS network from PoW. It’s expected that this transition will take place during the second quarter of 2022.

Countries adopt Bitcoin as legal tender

2021 proved to be a milestone year for Bitcoin as it continues to evolve from being a small technology project into fulfilling its promise as a medium of exchange. El Salvador was the first country to adopt Bitcoin as legal tender. The rationale for the adoption was threefold:

  • to formalize the country’s economy, as most Salvadorans don’t have bank accounts;
  • to make it faster and cheaper to send remittances abroad; and
  • to attract foreign direct investment into the country.

We fully expect to see other countries to follow El Salvador’s lead and adopt bitcoin as legal tender.

The Global Crypto Adoption Index tracks the on-chain cryptocurrency value received, on-chain retail value transferred and the peer-to-peer exchange trade value, all weighted against the purchasing power parity per capita.

This index shows that Vietnam is well ahead of the world on Bitcoin adoption and is a likely candidate to consider adding crypto as legal tender. Asian countries round out the top three adopters with India and Pakistan coming in second and third, respectively. Ukraine leads adoption in Europe, while Kenya and Nigeria lead in Africa.

These developments suggest 2022 to be an important year in the continuing adoption of cryptocurrencies. Stay tuned for future posts on how to weight cryptocurrency within a well-diversified portfolio.

Source: https://blog.chainalysis.com/reports/2021-global-crypto-adoption-index/

Disclosures
The products and services offered by Arxnovum are available to qualified investors in certain provinces and territories of Canada. Individual investors should contact their own financial professional to determine the most appropriate investment options for their financial situation. This material contains the opinions of the manager and such opinions are subject to change without notice. This material has been distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission.
 
All investments contain risk and may lose value. Investing in the cryptocurrency market is subject to risks.  Cryptocurrency, often referred to as “virtual currency” or “digital currency”, operates as a decentralized, peer-to-peer financial exchange and value storage that is used like money. Cryptocurrency operates without the oversight of a central authority or the banks and is not backed by any government. Even indirectly, cryptocurrencies such as bitcoin may experience high volatility, and related investment vehicles may be affected by such volatility. Cryptocurrency is not legal tender. Federal, state, provincial, territorial or foreign governments may restrict the use and exchange of cryptocurrency, and regulation in North America is still developing. Cryptocurrency trading platforms may stop operating or permanently shut down due to fraud, technical glitches, hackers or malware, which could have an adverse impact on the net asset value per unit of the Fund. Please consult the Funds Term Sheet for a complete list of risks.
 
Certain statements in this document are forward-looking. Forward-looking statements (“FLS”) are statements that are predictive in nature, depend upon or refer to future events or conditions, or that include words such as “may,” “will,” “should,” “could,” “expect,” “anticipate,” “intend,” “plan,” “believe,” or “estimate,” or other similar expressions. Statements that look forward in time or include anything other than historical information are subject to risks and uncertainties, and actual results, actions or events could differ materially from those set forth in the FLS. FLS are not guarantees of future performance and are by their nature based on numerous assumptions. Although the FLS contained herein are based upon what Arxnovum Investments Inc. and the portfolio manager believe to be reasonable assumptions, neither Arxnovum Investments Inc. nor the portfolio manager can assure that actual results will be consistent with these FLS. The reader is cautioned to consider the FLS carefully and not to place undue reliance on FLS. Unless required by applicable law, it is not undertaken, and specifically disclaimed that there is any intention or obligation to update or revise FLS, whether as a result of new information, future events or otherwise.