Analysing Crypto Fund Returns

A common question we receive at Apollo is what return can investors expect from investing in the Fund. It is an impossible question to answer. Yet, while the disclaimer “Past performance is not a reliable indicator of future performance” is suitable, it is interesting to examine past returns from crypto funds. Such analysis doesn’t necessarily answer the previous question, but it does offer insight into the range of possible returns and volatility for which investors should be prepared.

At Apollo Capital, we undertook this research by examining the returns of the average crypto hedge fund, made available by Eurekahedge. Eurekahedge maintains a database of over 30,000 hedge funds, including crypto hedge funds. The Eurekahedge index provided 58 monthly data points from June 2013 to April 2018. The data relates to the average performance of crypto funds monitored by Eurekahedge. For ease of reference, we can consider this data to represent the average crypto fund return.

From analysing the data, we can extract results like Average Returns and the Largest Monthly Return. A deeper dive reveals even more insightful information like the Average Return in Up Months and Average Return in Down Months.

The Return for the period was 21,710%, which equates to a compound annual return of 304%.

The Mean Monthly Return from June 2013 to April 2018 was 16.1%. The Median Monthly Return was 7.6%. The difference between the Mean and Median return can be explained by a few bumper months which dragged the Mean return up.

The Largest Monthly Return was 405.3%, recorded in November 2013.

The Largest Monthly Drawdown was -29.9% in March 2018.

There were 36 Up Months compared to 22 Down Months.

The Average Return in Up Months was 33.9% and the Average Return in Down Months was -12.9%.

The lowest return in an Up Month was 2.0% and the highest return in a Down Month was -1.4%.

Crypto Fund Return Analysis.png

We also charted a histogram of the returns.

Average crypto fund returns.png

We can see that most returns fell within the range of -20% to +30%. It is easy to observe this without stopping to reflect. A -15% return in a given month has not been uncommon.

On the positive side, we can see that large returns have been frequent. There were a total of 5 months that returned greater than 50% for the month. Returns of +30%, +40% and greater have not been uncommon.

Returns that are common in crypto would be classed as extreme in nearly every other asset class. We could imagine the mayhem that would follow a monthly return of -15% in global equities. The same return in crypto is just another month. We believe the reason for this is clear - crypto is a young asset class and will likely continue to be volatile as it matures. We believe volatility will settle as institutional money enters the space. 

For us, the most important lesson is that crypto investors need to be prepared. Returns that can otherwise be classed as extreme are not uncommon in crypto and most importantly, should not come as a surprise to investors.

The Apollo Capital Fund has been set up with a philosophy of long term investing. We believe that in crypto, and arguably other asset classes, the largest returns are had over the long term. To some extent, we are indifferent to the monthly volatility. We believe patient investors with an understanding of the investment thesis and an understanding of the expected volatility of returns will be rewarded.

Ethereum Announcement Rings Bell for Unregistered Securities

The big news this week is that the Securities and Exchange Commission (SEC) declared that Bitcoin and Ethereum are not securities.

The long-awaited decision brings a lot of clarity to investors as to what will be considered a security going forward and why. The principle factor in determining whether a crypto-asset is a security seems to be its level of decentralisation. The Director of the division of Corporation Finance William Hinman:

“…putting aside the fundraising that accompanied the creation of Ether, based on my understanding of the present state of Ether, the Ethereum network and its decentralized structure, current offers and sales of Ether are not securities transactions.”

There’s an implication here that Ethereum was likely a security at the time of its ICO, but now is not because it’s decentralised. This is in line with past comments by the SEC which has emphasised the possibility of definitional change over time. SEC Chairman Jay Clayton:

“If the network on which the token or coin is to function is sufficiently decentralized — where purchasers would no longer reasonably expect a person or group to carry out essential managerial or entrepreneurial efforts — the assets may not represent an investment contract.”

At what point is a crypto-asset sufficiently decentralised to be exempt from securities regulation? Many ICOs are no doubt biting their nails thinking about this question. And none more than Ripple, whose XRP was notable in that Hinman didn’t mention it at all. This omission rang loudly, but the SEC’s silence will not last long. Based on the 13 criteria outlined as guidance, it’s hard to see how XRP could go the same way as Bitcoin and Ethereum and be spared the fate of securities regulation. From our perspective, XRP isintimately connected to Ripple Labs.

What will happen when regulators come down heavily on unregistered securities masquerading as decentralised crypto-assets? There are arguments to be made that several of the top 10 cryptocurrencies by market capitalisation are securities. This list may include not just XRP, but also EOS, Stellar, Cardano, IOTA, and TRON. If the SEC begin to enforce, which seems likely, the impacts could be immense. Legal battles between the SEC and Ripple Labs and the attempted closure of exchanges that have been selling unregistered securities would just be the beginning. All this would create uncertainty in the market. Projects that are not securities (i.e. Ethereum and Bitcoin) may benefit from a flight to quality. But there’s also the possibility that investors simply panic and sell back into fiat.

Nothing is certain, but expect this announcement to have consequences for the whole crypto-asset ecosystem going forward. A close reading of the announcement implies that many other projects will be considered a security going forward. The announcement was more interesting for what was unsaid and implied than what was stated overtly.

For more information, read the full transcript of Director of the division of Corporation Finance William Hinman’s speech here, along with Fred Wilson’s take.

Securities, Tokenised. 

At Consensus this year, security tokenisation was a theme that kept cropping up. I met up with some leading projects in the area, including the Polymath team; Joshua Stein of Harbor; Philipp Pieper from Swarm; and also saw a great talk on tokenised securities at Token Summit lead by William Mougayar. Last week, securities and Exchange Commission declared that Bitcoin and Ethereum are not securities. Many tokens sold in initial coin offerings, on the other hand, will likely be considered securities at least until the network is launched, and because most aren’t decentralised.     Coinbase acquired a FINRA-registered broker-dealer for its licences. If approved, Coinbase will be capable of offering blockchain-based securities, under the oversight of the US Securities and Exchange Commission (SEC) and the Financial Industry Regulatory Authority (FINRA). Goldman Sachs backed Circle is following a similar path and seeks registration as a brokerage and trading venue.

All this chatter has led me to think about the concept of a security more broadly. Some questions that have been turning over in my head:

  • What are securities?
  • How are they regulated? 
  • Why are they regulated? 
  • Would it be possible to make a token that bakes in the necessary jurisdictional compliance for the legal sale of a security?
  • What projects are trying to create protocols for compliant security tokens? 
  • What issues are there with the whole concept of security tokenisation? 

The intention is for this piece to cobble together these conversations, as well as give some context to securitisation. I hope this proves to be a sober and balanced investigation into the possible opportunities and threats of tokenised security offerings. 

What is a Security? Why are they regulated? 

The Oxford English Dictionary defines a security as “A certificate attesting credit, the ownership of stocks or bonds, or the right to ownership connected with tradable derivatives.” Securities thus encompass a significant proportion today’s financial ecosystem; they are a broad category that can be divided into three principle areas:

  • Equity securities (e.g., common stocks) i.e. an ownership interest in an entity that entitle the holder to some control of the company on a pro rata basis, via voting rights, and often a companies earnings. 
  • Debt securities (e.g., banknotes, bonds and debentures) i.e. money that is borrowed and must be repaid, with terms that stipulate the size of the loan, interest rate and maturity or renewal date. They generally entitle their holder to the payment of interest and the repayment of the principal, and are typically issued for a fixed term. 
  • Derivatives (e.g., forwards, futures, options, and swaps) i.e. a security where the value is reliant (derived) from an underlying asset or group of assets and where its price will fluctuate in accordance with the fluctuations of price of the underlying asset.

What is the common thread that tie these three security types together? How do you determine whether a financial offering should be considered a security? An instructive and often used test derives from from the US Case, Securities and Exchange Commission v. W.J. Howey Co. (1946). The “Howey test,” put simply, asks:

  • Is there an investment of money?
  • Is there an expectation of profits?
  • Is the investment of money in a common enterprise?
  • Do profits come from the efforts of a promoter or third party?

If the answer is affirmative to these questions, the investment product must comply with a bundle of regulations that are aimed to promote market confidence, financial stability, consumer protection, and reduce financial crime. To understand why these regulations came about, we need to cast our minds back to 1920s America. 

The ‘Roaring 20s’ preceded the enactment of US federal securities regulation that are still relevant today. Much like how internet and ‘dot-com’ stocks rallied markets in the 1990s, the new technologies of electricity, automobiles, radio, and penicillin, helped fuel massive speculation in 1920s America.  It was a period was marked by strong economic growth, technological change, and speculative investment. The Radio Corporation of America (RCA) is the classic example of this speculation. Despite warnings of then Secretary of Commerce Herbert Hoover who described “the growing tide of speculation” in 1925, the market remained manic. In the five years prior to the Great Crash of 1929, RCA stock soared from about $11 to a September 1929 high of $114 before crashing to a nadir of less than $3 per share in 1932. The dramatic correction of October 1929 began a a prolonged period of economic depression that lasted for about a decade, and during which almost a quarter of the American workforce was unemployed. The following regulations were enacted in order to restore confidence in the securities markets in light of the excesses of the 1920s. They remain the cornerstone of public trust in the US securities markets, domestically and internationally, and exist in order to avoid the mania of markets from affecting the broader economy. 

The regulations are:  

    •    Securities Act of 1933 – that regulates the distribution of new securities

    •    Securities Exchange Act of 1934 – that regulates the trading of securities, brokers, and exchanges

    •    Trust Indenture Act of 1939 – that regulates debt securities

    •    Investment Company Act of 1940 – that regulates mutual funds

    •    Investment Advisers Act of 1940 – that regulates investment advisers

Circling Crypto-Assets In

Most regulators have not expressed interest in creating new regulation to fit the industry, but will regulate in accordance to the above. Industry, on the other hand, have put forward legitimate arguments that ask for regulators to adapt to crypto assets, not the other way around. Some tokens don’t clearly fit into the exisiting definition of a security or currency, it is argued, but function as something different. For example, a token may be bought at a seed round, before the product is built. Here there is an investment of money, an expectation that the token will rise in value, and it is issued from a common enterprise. Later, however, when the product is live, when the network is sufficiently large, the very same token may be used to pay for products, to fuel the network, and be used as a high velocity utility token. But regulators have been clear here as well, arguing that definitions can morph over time, from security to utility token. Jay Clayon, the current SEC Chairman, has been even clearer and said “we [the SEC] have been doing this a long time, there's no need to change the definition.” 

A major hurdle to tokenise securities is thus compliance with this inevitable regulation. Know-your-customer (KYC), Anti-Money Laundering (AML), income, the total number of investors, the implementation of vesting or holding periods are just some of the regulatory measures that are specific to jurisdiction. These regulations apply not only to the initial offering, but to all secondary trades, where responsibility is also placed on the seller. To further complicate matters, compliance with both the issuer’s jurisdiction as well as each investor’s jurisdiction is required. On top of these securities regulations, private real estate assets have additional legal requirements that must be enforced under the Internal Revenue Code (IRC) and the Foreign Investment in Real Property Tax Act of 1980 (FIRPTA). 

Security Compliant Tokens

What security tokenisation does is imbed the security with its compliance requirements into smart contracts so that its security tokens can be traded on secondary blockchain-based exchanges anywhere in the world. A security token may thus be less an invention than an innovation - it could improve traditional financial products, removing middle men from transactions, reducing cost, and linking more buyers with sellers. 

Potential Benefits

Rapid and trustless settlement - The NASDAQ and NYSE execute trade very quickly but still settle in a number of days. The SEC recently adopted a settlement cycle of T+2 meaning that ownership doesn’t change hands until the passing of two days after execution. Transfers of LP and LLC positions often take longer than that. Back home, the ASX has announced that by 2020 they will be moving to a T+1 system. Bitcoin has been doing global financial settlement every 10 minutes for almost 10 years. Protocols that bake in security compliance into the token itself will be able to make the settlement of securities as efficient as any ERC-20 token, i.e. in minutes not days. Harbor, for example, is creating a ‘whitelist’ of KYC’d addresses, meaning that your Ethereum address, if compliant, could buy any security on a decentralised exchange should your address meet the regulatory standards stipulated in the smart contract. 

Liquidity & increased market depth (24/7 markets, global investor base) - Currently security markets are open from 9am - 4pm every day, and closed on weekends. The crypto markets are always open. 

Fractional ownership - Fractional ownership has been around since at least the issuance of shares in the Dutch East India Company in 1607 and is certainly not unique to the blockchain. However, some currently illiquid asset classes, such as art, wine, and real estate, remain off limits to the retail investor given high cost barrier to entry due to a lack of fractional ownership. Fractional ownership could mean owning 0.00001% of the Empire State Building, or building your own diversified REIT with 0.00001% of 10,000 properties around, say, New York. This fractional ownership could dramatically improve the liquidity of securities, and create secondary markets for  illiquid assets. It would increase price discovery, expose retail investors to venture capital, private equity and many more assets that were traditionally the exclusive domain of the sophisticated (read very wealthy) investor. 

Automated compliance - When securities are tokenised, compliance may be automated, which means that regulated trade will no longer be restricted to walled gardens. Security tokens could trade anywhere, including on decentralised exchanges. This is because security tokens are by definition programmable meaning that many elements of the contracting environment can be hardwired into the architecture of that security. 

Be your own banker - There are also really creative use-cases for tokenised securities, like using these securities to collatorise and then draw out a stablecoin such as Dai. While speaking to Josh Stein of Harbor, he mentioned the possibility of collateralising tokenised property in a smart contract and then drawing debt.  This aims to be less volatile than the current standard collatoralisation of ether. Because ether is volatile it is recommended that the liquidation price is conservative, but with property this could be closer to the borrowed amount. If the consumer could bypass banking institutions in this way, this could have large consequences of the structure of the current economy. And the consumer pull factor is strong: the current interest rate on MakerDao is only 0.05%. 

Projects to watch

Harbor has devised the R-Token standard, which stands for ‘regulated token’. Harbor is attempting to create an open-source standard that defines a mechanism in which crypto-securities can be compliantly transferred on blockchains. The R-Token Standard enables ERC-20 tokens to become compliant crypto-securities that can be traded across any ERC-20 compatible platform because KYC, AML, tax and other regulatory requirements are baked into the token itself. Harbor has a particular interest in private real estate assets (including LP interests in real estate investment funds, fractional ownership in land/buildings, and private REITs) primarily because this asset class could benefit greatly from the improved efficiency, liquidity and fractional ownership possibilities of blockchains as described above.

Swarm is creating a security token standard called the SRC20 standard. I met with Philipp Pieper from Swarm last month and have been in touch since then. Put simply, they are tokenising LP positions in Private Equity funds. This means that the barrier to entry to invest in venture capital, for example, would collapse dramatically, and liquidity for current investors would improve by an order of magnitude.

Polymath is also a platform for automated KYC and security complaint security tokens. Their PLY token is live. Platforms for trading these securities are Open Economy and TZero

A Sober Final Word

The main issue I see with tokenised securities is that they often are associated with an underlying physical asset. These assets are regulated by the jurisdiction it happens to be in. This means the security is connected with something in addition to the smart contract created. Because of this, possession in a smart contract doesn’t necessarily mean possession in the real world and because of this the security suffers from the same trust problem as normal contracts. Many tokenised securities that use a smart contract that trusts a third party necessarily removes the killer feature of trustlessness. It’ll be interesting to see whether the world of crypto will be able to connect real world ownership to decentralised and global trading through smart contracts; I’m very uncertain about it, although we hope that  further work will go into bolstering security, oracles, and the legal enforceability of smart contracts. 

It is also worth mentioning that tokenising traditional securities is not a game changer. It presents an improvement on the current securities infrastructure (faster settlement, higher liquidity, price discovery, lower fees). However, it is simply an incremental innovation that will likely keep current power structure status quo largely intact. The reimagining of societal organisation through decentralised governance is not efficiently achieved via this route, but rather via digitally native, decentralised, censorship resistant, and distributed token powered networks like Bitcoin. 

Conclusion

We sometimes think of crypto-assets as a distinct asset class, separate from traditional equity, debt, and derivate markets, but what if blockchain-based tokenisation could be used in traditional markets to improve the way society records ownership and trade assets, and thus re-engineer large swathes of today’s financial plumbing. This is the grand hope of security tokenisation, which hopes to increase the settlement speed, liquidity, and increase fractional ownership. Tempered with this are the great and difficult problems of demonstrating compliance in the token itself and  crucially the tethering of real world assets to a blockchain without obviating the whole purpose of a blockchain: trustlessness. 

References 

http://www.jgbm.org/page/5%20Larry%20Bumgardner.pdf

https://en.wikipedia.org/wiki/SEC_v._W._J._Howey_Co.

https://caselaw.findlaw.com/us-supreme-court/328/293.html

https://hackernoon.com/the-security-token-thesis-4c5904761063

http://www.fsa.gov.uk/about/aims/statutory 

https://www.cnbc.com/2018/06/14/bitcoin-and-ethereum-are-not-securities-but-some-cryptocurrencies-may-be-sec-official-says.html 

 

Crypto Regulation: The Latest

 

Last week the Apollo Capital team dialled into a webinar focused on crypto regulation. The webinar was jointly held by CoinDesk and DLA Piper. A panel of experts reported on the recent gathering of the Organisation for Economic Co-Operation and Development (OECD) on crypto regulation. The session was one of the most comprehensive meetings of senior regulators, bringing together central bankers, the Financial Conduct Authority (UK), the European Securities and Markets Authority (ESMA) and the Financial Stability Board.

Here is a summary of key points from the webinar:

  1. There are two broad competing tensions facing regulators: promoting growth while protecting consumers. On one hand, crypto is viewed as a huge opportunity to drive forward growth on a global scale. On the other hand, regulators are wary of protecting consumers and investors from unscrupulous operators, ICOs trying to circumvent existing regulation, and ensuring financial stability.

  2. Regulators are taking different approaches. China has banned ICOs, India has expressed concerns. Gibraltar and Switzerland have proactively encouraged development of token products. Approaches differ despite the umbrella regulator for the regulators, the International Organization of Securities Commission (IOSCO), issuing principles and guidance. Christine Lagarde, the Managing Director of the International Monetary Fund (IMF), recently stated that “because crypto-assets know no boundaries, international cooperation will be essential.” It’s heartening to see global regulators promoting intergovernmental cooperation. Apollo Capital supports this but is also aware of the difficulties in establishing regulatory frameworks at a global level.

  3. Forum shopping is a concern. Regulators are concerned about ICO issuers ‘shopping around’ for the most favourable jurisdictions. In an increasingly globalised society, jurisdiction shopping is becoming prevalent. Countries that take an anti-crypto stance risk losing innovative projects to more friendly jurisdictions.

  4. This is a different type of technology may not fit the paradigm that applied when laws were set out in 1930s and 1940s.

  5. In the US, Federal laws are the biggest obstacles pushing ICO issuers outside of the US. Despite progress from States like Wyoming, Federal securities laws trump State laws. While State laws have frequently been test grounds for new Federal regulations, the US risks losing the battle of crypto innovation. In terms of enforcement, the SEC hasn’t yet reprimanded anything that hasn’t been outright fraud. For example, the SEC highlighted the DAO as a security that contravened securities laws. However, the SEC hasn’t taken any enforcement action.

  6. We are seeing signs of progress. Earlier this year in February, the US State of Wyoming unanimously passed two pro-crypto Bills. HB 70 defines utility tokens as neither traditional money nor securities. HB 19 exempts cryptocurrency from money transmission laws. Combined, the bills recognise utility tokens under law as a new class of property.

 

From an investor’s perspective, Apollo Capital’s approach to regulation is clear - buyer beware. As managers of an actively traded portfolio, we remain careful not to invest in crypto assets that likely contravenine current securities legislation. It’s not worth the risk.

 

Apollo Capital will continue to watch the global regulatory framework evolve. We look forward to keeping you updated.

The Future Tokenisation of Everything — Part 2

In the first part of this series,  I wrote about how a diversified portfolio may look like in world of tokenisation. I envisioned a world where investors’ portfolios will contain crypto assets in the form of digital gold (i.e. Bitcoin), stable coins and a series of traditional assets (both private and public) that will be tokenised. Here I look at the likely long term value of native tokens used to fuel decentralised crypto networks compared with utility tokens used to pay for goods and services within a network.

Crypto tokens were invented for used in decentralised blockchains to incentivise its stakeholders to contribute positively to the network (think of it as fuel for the network - just like money is to any market).

Screen Shot 2018-06-01 at 10.01.13 am.png

Today, there are over 1,600 crypto assets actively traded. Some digitally native startups are doing token sales to facilitate a network of early users. This is called open network design; tokens help overcome the bootstrap problem by adding financial utility when application utility is low.

 Open network design. Source: https://medium.com/@cdixon/crypto-tokens-a-breakthrough-in-open-network-design-e600975be2ef   

Open network design. Source: https://medium.com/@cdixon/crypto-tokens-a-breakthrough-in-open-network-design-e600975be2ef

 

Many of these crypto tokens are utility tokens which are used as payment for services sometimes on a centralised platform. These utility tokens are issued on top of other networks, such as Ethereum’s ERC-20 coins.

We are entering a world where we have hundreds of utility tokens that enable payment on crypto networks for specific goods and services. It is, however, unlikely we would want to hold a portfolio of all these different tokens, one for our internet provider, one for streaming music, one for the car-sharing network etc.

We are likely to see a massive increase in the tradability and fluidity between crypto assets. Decentralised markets with common liquidity pools will make trading into, between, and out of utility tokens effortless, seamless, instantaneous, and potentially unknown from the consumer’s perspective. A stable crypto coin may serve as the base transactional currency in this future world where money is streaming like data and where machines pay humans or other machines.

For this reason, in a world where everything is tokenised, the value of crypto assets are likely to consolidate along native crypto assets used to run blockchains, not in utility tokens. These native crypto assets are needed for blockchains to provide incentives for network resources such as processing power, bandwidth, or storage.

With coming interoperability between blockchains, we might even see consolidation within the blockchain ecosystem. Separate smart contract platforms could be run on a single blockchain hub that talks to these different blockchains.

It is too early to say how many different crypto assets will accumulate the vast majority of value. However if this future materialise, they will be part of an investor's overall tokenised portfolio. That portfolio will be:

  • Liquid. Tokenisation will create new markets that didn’t exist in the past.

  • Much more diversified. Assets not previously accessible will be accessible (think a fraction of land, real estate, or hedge fund interests)

  • Instantly rebalanced. Decentralised markets with instant liquidity will enable a portfolio to be rebalanced at any time.

Finally, in this brave new world where we can take direct ownership of assets and software is programmed to handle trade, payment and settlement, a lot less intermediaries will be needed.