After FTX's collapse, scornful critics widely ridiculed Caroline Ellison's approach to stopping the losses. “I just don’t think they’re an effective risk management tool,” she ruefully told an audience at FTX’s heyday. But was she right?
Venturing into the crypto asset management space presents a unique set of challenges that differ significantly from the traditional funds space. In this introductory article, we will examine the obstacles that aspiring fund managers face when launching a Bitcoin sector fund and examine the key differences that exist when moving outside the world of traditional asset management.
Volatility and risk management
One of the most significant challenges facing funds in the Bitcoin sector is the extreme volatility that exists in the cryptocurrency market. The price of Bitcoin has experienced strong bullish surges, sparking investor enthusiasm. However, it has also seen strong bearish declines, leading to substantial losses for those who are not prepared for such price fluctuations. Managing risk in such a dynamic environment requires sophisticated strategies, rigorous risk frameworks and assessments, and a deep understanding of market trends.
Unlike most traditional and mainstream blue-chip assets, which often experience relatively stable price movements, the price of Bitcoin can change significantly within a matter of hours. Therefore, fund managers in the Bitcoin sector must be well equipped to deal with sudden price fluctuations to protect their investors' capital. Traditional stop loss structures may not work to the expected extent because the market close order may be executed well below the predefined trigger price due to order book slippage and rapid price movements, the proverbial “catch a falling knife”. Using tight stop losses as a fundamental risk management mechanism can be your enemy. For example, in a flash crash scenario, positions may be automatically sold at a loss even if the market has reversed itself a few minutes (or seconds) later.
Although stop losses are an alternative, they are not a option! Options are contracts that you can buy that give you the right to buy or sell a given asset at a predetermined price (i.e. the strike price) at a specific time (this is i.e. the expiration date). An option to buy an asset is a call and an option to sell one is a put. Buying an out-of-the-money put (i.e. well below the current price) can provide a floor to your potential losses if the price collapses. Think of it as a premium paid to secure your position.
Sometimes, to defend against binary outcome events or periods of particularly high volatility, you simply need to flatten your positions and take no risks, living to fight another day in the Bitcoin market. Think for example of key protocol update dates, regulatory decisions or the next Bitcoin halving; note, however, that the market anticipates these events, so you may need to take action in advance.
Creating an effective risk management plan for a Bitcoin sector fund may involve the use of various hedging techniques, diversification of products and instruments (potentially across asset classes), risk rating on risk-adjusted trading platforms and allocations, dynamic deal sizing, dynamic leverage settings, and the employment of robust analytical tools to monitor market sentiment and potential market and operational risks .
Guard and security
Custody of Bitcoin and other cryptocurrencies is a key aspect that sets Bitcoin sector funds apart from their traditional counterparts. A key difference is that unlike traditional exchanges that only match orders, Bitcoin exchanges perform order matching, margining, settlement and asset custody. The exchange itself becomes the clearing house, concentrating counterparty risk instead of mitigating it. Decentralized exchanges also carry a unique set of risks, from defending against value extracted from miners to wanting to move assets in the event of a protocol or bridge hack.
For these reasons, protecting digital assets from theft or hacking requires robust security measures, including multi-signature protocols, cold storage solutions, and risk monitoring tools. The responsibility for securely managing private keys as well as choosing and monitoring reliable trading platforms lies entirely with the fund manager. The burden of monitoring the market infrastructure itself introduces a level of technical complexity absent in traditional funds management where custody and settlement are standardized and commoditized stand-alone systems.
Custody solutions for Bitcoin sector funds must be carefully selected, ensuring that assets are protected against cyberattacks and insider threats. With the history of high-profile cryptocurrency exchange hacks, investors are particularly concerned about the security of their assets; any security breach could result in significant financial losses and harm the reputation of the fund.
Launching a Bitcoin sector fund is an exciting endeavor that offers unprecedented opportunities for investors seeking exposure to the rapidly growing cryptocurrency market. However, it is important to understand that launching a fund is no easy feat and has pitfalls that go beyond the success of the trading strategy. It's no surprise that every quarter, fund closings are in the same range as fund launches.
Those entering the Bitcoin sector fund business should approach it with a pioneering spirit, staying informed and embracing the dynamic nature of this exciting emerging market. While the path may be difficult, the potential rewards for successful Bitcoin sector fund managers could be astronomical.
If you're already ready to get started with fund creation or simply want to learn more, contact us at Advisory@satoshi.capital.
This is a guest article by Daniel Truque. The opinions expressed are entirely their own and do not necessarily reflect those of BTC Inc or Bitcoin Magazine.