Arrington XRP Capital, founded in late 2017, is a crypto-focused hedge fund with a multi-pronged investment strategy. We invest in private companies with new products and protocols, and we employ a variety of trading strategies for the liquid part of our portfolio. We are based in the United States and have additional offices in Asia. We are aggressive investors, fight hard for our companies and trade to win. We are expanding our team to include two new positions:
The software engineer role is ideally Asia based, but we will happily look at all qualified candidates. Our analysts can live anywhere as long as you are willing to travel to the home office at least a couple of times per year. If you think you might fit the roles above or know anyone who could, please send an email to firstname.lastname@example.org. We look forward to hearing from you!
The macro storm of quantitative easing and record low interest rates has depressed yields in traditional
finance beyond measure. Anchor is the first protocol in Decentralized Finance (DeFi) designed to capture
the growth of the cryptocurrency ecosystem to offer savers fixed income yield.
The Anchor Protocol is a money market built on the Terra blockchain, leveraging the only stream of
unlevered, reliable yield in cryptocurrency: Proof-of-Stake (PoS) block rewards. Anchor synthesises DeFi
yield with PoS rewards, creating a fundamentally new economic primitive – the Anchor Rate – providing
lenders a stable rate of return. In time, we believe the Anchor Rate will become the reference rate for
DeFi investment – a Decentralized Funds Rate – and eventually the gold standard for passive income on
Anchor launches with LUNA as the initial primary collateral asset for borrowers, with a roadmap to integrate other PoS assets including DOT, ATOM and SOL, and decentralize ownership of the ANC governance token through a liquidity mining program.
The emerging world of synthetic assets is one of DeFi’s most powerful bridges into traditional financial markets. With the backdrop of macro change accelerated by COVID-19, we argue that synthetic assets can create a gravitational pull on capital, as investor appetite moves deeper into the risk spectrum. Notably, we examine the growing international demand for US equities and the challenges faced by investors in the existing e-brokerage model.
This context leads us into the primary focus of the report, Mirror: a new protocol for synthetic asset creation. Mirror synthesizes the primary innovations of DeFi – including Automated Market Makers (AMMs), oracles, stablecoins and liquidity mining – to enable permissionless minting and trading of traditional assets. Mirror is uniquely positioned as a capital efficient system using stablecoins, reducing collateralization requirements to only 150%, a vast improvement over comparable systems which are typically collateralized upwards of 300-400%.
Mirror will launch with support for a select number of US equities, and will decentralize ownership of its native governance token MIR via a community-first distribution strategy.
Risk management frameworks are rare in the world of Bitcoin. For overexposed market participants, the asset’s volatility invites extremes in investor psychology at a pace unlike any other market. Somehow, Bitcoin continues to dance between two distinct worlds: today on the brink of a death spiral and tomorrow the future of currency destined for world reserve status.
Arguments for Bitcoin exposure stress its long run outperformance, yet often fail to address the concerns of the non crypto-native investor. Since inception, Bitcoin has outperformed virtually every other asset class. This outperformance is undeniable, point-blank. Still, traditional portfolio managers stick to their skeptical guns, cautious of a one-sided focus on returns when the answer to double digit drawdown is HODL.
In this piece, we attempt to build a framework for risk-adjusted Bitcoin investing. Our goal is to filter out the noise of investor psychology and find the nuances of Bitcoin risk and reward at different stages of the macro cycle. We do this through a simple rolling Sharpe Ratio that analyzes Bitcoin risk-adjusted returns over time.
Ultimately, we conclude that timing matters: while the individual investor may be satisfied with long-run outperformance, Bitcoin’s macro cycles urge further nuance. We find that historically, the trade following the Halving represented the most attractive risk-adjusted opportunity. As the next Halving is just around the corner, we briefly speculate on why this was the case.
Looking beyond returns: the Sharpe Ratio
For the professional money manager, Bitcoin’s systematic risks are daunting. How can a conservative PM embrace Bitcoin as part of a diversified portfolio given the frequency and severity of its drawdowns? Investors with personal savings and unconstrained time horizons seek comfort in the story of Bitcoin’s long-run outperformance. This is not enough for newcomers with fiduciary responsibility. For the traditional PM, every market risk represents redemption, career and reputational risk; and for this reason, we need a more serious understanding of Bitcoin’s relationship with drawdown.
Even if over 90% of all Bitcoin days are profitable, individual paths to profitability range from months (buying December 2018’s bottom) to years (buying the 2014 global top). This illustrates the concept of path dependence: while long term Bitcoin returns are disproportionately skewed to the upside, timing matters. Much like a call option, Bitcoin risk-adjusted returns rapidly decay or improve depending on market timing.
We look to the Sharpe Ratio to analyse the path dependence of Bitcoin returns. The Sharpe Ratio is a simple yet powerful metric, measuring the ratio of excess returns to excess return volatility:
If we view volatility as a placeholder for risk, the Sharpe Ratio measures how much reward is generated per unit risk. A highly volatile portfolio would thus have a low Sharpe Ratio if returns were not extraordinary, and vice versa. A Sharpe Ratio of 1 is considered the baseline standard for investment performance.
Animal spirits, why a long-run Sharpe Ratio doesn’t cut it
Over any rolling four-year period, Bitcoin’s Sharpe Ratio historically outperformed virtually every other asset class. If an investor had held for at least four years during any point in Bitcoin’s history, they would have demonstrated superior risk-adjusted returns relative to almost all other investment opportunities.
This still falls short for most non crypto-native investors. Thinking about Bitcoin’s Sharpe Ratio over four year intervals may be correct in theory, but it is limited in practice. In reality, markets are governed by animal spirits – the swings of fear and greed – and most investors are more likely to enter the market after periods of non-linear growth. Many new entrants are thus destined to enter mid to late-cycle, fated to experience grueling drawdowns after buying local or even global highs. The assumption that investors can and will HODL underwater positions for multiple years is unfeasible, especially with the prospect of underperformance relative to other asset classes. The financial and emotional burden of drawdown will likely lead many to capitulate their positions before they are able to realise an entire four year cycle.
Given the path dependence of returns, the long term Sharpe Ratio fails to adequately capture Bitcoin risk.
The one year forward looking Sharpe Ratio
Instead of four-year intervals, we search for the optimal entry within a macro cycle. To do this, we employ a one year forward looking Sharpe Ratio.
Figure 1 calculates the Bitcoin Sharpe Ratio at any point in time looking forward one year. This metric is inherently forward looking, describing the Sharpe Ratio at any point in time based on future data. It is thus a lagging, descriptive (rather than predictive) variable. We select the one year period as it is approximately the time required to capture the brunt of a Bitcoin bull or bear market.
Oscillating around a value of 1, the one year forward looking Sharpe Ratio peaks at the beginning of Bitcoin’s price inception, the 2012 Halving and several months following the 2016 Halving. After these three periods, we find an interesting dynamic at play: aggressive Sharpe Ratio decay from a high of 3 (spectacular) to a low of −1 (abysmal).
Further, examining the 1-4 year forward looking Sharpe Ratio for Bitcoin from the Halvings (see Table 1), we find a similar effect:
Exposure to Bitcoin for 1 year after the 2012 Halving nets a Sharpe Ratio of over 3, and holding for an additional 3 years degrades this to approximately 1. From a spectacular investment to a “good” investment.
Exposure to Bitcoin for 1 year after the 2016 Halving nets a Sharpe Ratio of over 2, and holding for an additional 3 years degrades this to less than 1. From a great investment to a sub-standard investment.
How important is market timing when managing Bitcoin risk?
Analysing Sharpe Ratio decay gives us a powerful risk framework. Not all Bitcoin investments are made equal: Bitcoin acquired at different points in a macro cycle should be treated differently as part of a diversified portfolio. To illustrate this concept, consider the idea of “time-to-profitability” (TTP) demonstrated in Figure 2:
Bitcoin acquired at the 2011 high has a ≈2 year TTP
Bitcoin acquired at the late 2013 high has a ≈3 year TTP
Bitcoin acquired at the 2017 high is yet to achieve profitability.
Not only were investors who purchased Bitcoin at these highs faced with absolute drawdown, they were also faced with relative underperformance against worldwide equity indices (and possibly other asset classes). Bitcoin can be an excellent tool within a diversified portfolio, but most professional investors cannot simply buy and HODL for extremely long periods of time if they are likely to face both absolute and relative underperformance.
The legacy wisdom of financial markets sometimes cautions investors against market timing, captured by the dominance of indexing strategies and the underwhelming reputation of the modern hedge fund. Whatever the merits of this argument in traditional markets, we find a fundamentally different heuristic exists for Bitcoin.
This doesn’t mean that other strategies like buy and HODL are not valid. It is simply to say that for investors focused on managing risk, timing matters.
A once-in-cycle trade, but don’t forget to expect the unexpected
The above analysis leads us to conclude that, historically, the best risk-adjusted entry existed at or within several months following a Bitcoin Halving. This heuristic is based on historical data and is not a trading guideline. The market may prove our analysis entirely wrong for future Halvings. Our goal is to build frameworks based on history but there are no certainties in markets, least of all in Bitcoin. We present this Halving idea with its obvious limitations in mind.
While the crypto market’s focus on long-run outperformance might convince some pioneering and brave money managers, it won’t convince the drawdown-conscious. However, Bitcoin doesn’t need to be perfect to make its way into the world of traditional investing. Even today, the argument shouldn’t be to HODL and hope, but to think about Bitcoin with a nuanced vision for risk. This post-Halving window, when combined with hedging practices like protective puts or a managed stop loss, help build a case that, on a risk-adjusted basis, Bitcoin may outperform other asset classes.
If Bitcoin springs to new highs within the next several years, the reality is that investors will eventually demand exposure. Ironically, as these requests pile in mid to late-cycle, money managers will be faced with a dicey dilemma: remain on zero as Bitcoin makes weekly headlines or enter a drawdown-prone asset at local or absolute highs. Rather than enter as greed floods the market, the post-Halving window may grant investors an early buffer to incorporate Bitcoin into their broader macro strategy.
Are there fundamentals that explain this finding?
Why does the Halving trade demonstrate superior risk-adjusted returns? We can only speculate, but PlanB’s Stock-To-Flow model provides some insight. If we slightly modify PlanB’s model to calculate “flow” as a rolling sum of new Bitcoin minted over the past year (as opposed to the past day), as per Figure 3, we find that the market tops as the S2F ratio begins to level off. This makes intuitive sense: assuming demand stays constant, the supply reduction means there is less float for buyers to absorb, shifting prices upwards over time until a new equilibrium is reached.
This could also explain why, in addition to the two Halvings, the early years following Bitcoin’s inception also represented a very strong risk-adjusted entry. With a low initial float (starting from S = 0 at launch), the 1-year S2F ratio grew at a rate comparable to the post-Halving windows.
We speculate that these periods of rising S2F following the Halving are the only times where there is a fundamental driver (outside of speculative demand) for Bitcoin price: a real shift in the supply and demand curve. Thus, it is possible that our conclusion about the Halving trade is not random, but a result of S2F fundamentals.
In this piece, we have shown that long term metrics such as the four year Sharpe Ratio are inadequate at capturing the real risks of Bitcoin investing. Extreme swings of the market result in rapid Sharpe Ratio decay and make timing critical for the drawdown-conscious investor. The post-Halving window may represent a rare time to add high expectancy, low-downside Bitcoin exposure. We hope that our analysis builds a case that the Halving is not merely a speculative catalyst, but a fundamental macro driver that may present crypto-natives and newcomers alike with a powerful risk-adjusted opportunity.
On the dawn of the Terra Genesis Block, the Arrington XRP Capital team is in the final stages of preparing a Genesis Validator for MainNet launch.
After many months of technical and business development, the countdown finally comes to a close.
Terra will launch tonight–April 23rd–at 23:00 PST.
From the moment Michael met the team last year, he knew there was something special about this project, likening Terra to his early investments in Uber and Pinterest. And for myself, as a new partner to the fund, there is no better way to be part of the network than to work closely with the Terra team and launch a Genesis Validator.
Terra represents the first real deployment of a non-collateralised, algorithmic stablecoin at scale. It is not a stablecoin science experiment. Rather, Terra is the first project of its kind to come to market with an existing and sizeable network of e-commerce merchants. More importantly, it is the first consumer-focused stablecoin, targeting non-crypto online shoppers who care more about discounts than they do about blockchains.
Alongside Cosmos & Binance Chain, Terra is one of the few public chains built on Tendermint Core. Tendermint Core is a Byzantine Fault Tolerant (BFT) mechanism designed to achieve agreement if no more than 33% of the network is malicious or faulty.
Deploying Tendermint Core publically needs another mechanism: sybil deterrence. This is where Terra’s Delegated Proof of Stake (dPoS) mechanism comes into play. By allowing LUNA holders to delegate to MainNet validators, Terra empowers token owners with real skin-in-the-game, as they ultimately decide who will secure the network.
There are plenty of challenges in deploying validators in adversarial environments, especially on high value networks like Terra (all we need to do is look to the history of chains victim to 51% attacks). Without proper node design, key management & security auditing, validators are sitting ducks, honey-pots, prey to malicious hackers & DDoS attacks.
After many months of defining availability demands & security requirements with the Terra team, we are very excited to launch our Genesis Validator.
It is not everyday that you have the opportunity to be a foundational part of what is potentially a multi-billion dollar e-commerce economy.