Bitcoin Risk and The Once-In-Cycle Trade

Contributions From: Michael Arrington, Ninos Mansor, Ron Palmeri, Heather Harde

The contents of this report are the opinion of Arrington XRP Capital and do not constitute financial advice. We cannot guarantee the accuracy and completeness of the information contained herein.

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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.

Figure 1: Bitcoin’s one year forward looking Sharpe Ratio.

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.
Table 1: Forward looking Sharpe Ratio at 1-4 year intervals following the Halvings.

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.
Figure 2: Bitcoin’s days to 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.

Figure 3: Bitcoin Stock-To-(1-Year)-Flow

Conclusion

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.

Blockfi, A Crypto Bank, Announces New Financing.

We’ve long been fans of crypto lending; we’ve made investments in two companies over the last two years, and are active in both borrowing and lending cryptocurrencies. We’ve now also invested in Blockfi, and this is our first equity investment in what is essentially a nascent, and regulated, crypto bank. Blockfi has been added to our portfolio page.

The round was announced late last week: $30 million raised in a Series B, following $18m in a Series A last year. Besides Arrington XRP Capital, investors in the round include Morgan Creek Digital, PJC, Akuna Capital, CMT Digital, Winklevoss Capital, Avon Ventures, Castle Island Ventures, Purple Arch Ventures, Kenetic Capital, Arrington XRP Capital and HashKey Capital.

The company is absolutely killing it, even in the largely moribund crypto markets over the last two years. Revenue is up 20x over the last year, and deposits grew from $250m in August 2019 to $650m today.

These guys are winning. Very happy to join their team!

See more coverage: Coindesk, Bloomberg, CoinTelegraph and The Block.

Notes On Upcoming Skale Token Sale On ConsenSys Activate

News broke this morning that our portfolio company Skale will partner with ConsynSys’ Activate platform to sell tokens via a dutch auction.

Importantly, purchasers will be required to stake purchased tokens, which should discourage participation from pure speculators hoping to flip tokens for an immediate profit.

Read more about the news on Decrypt, Coindesk, CoinTelegraph, The Block, FinanceMagnates, VentureBeat, Kyle Samani and Spencer Noon.

Read our previous post on Skale here.

Crypto Wars: A New Hope

Nakamoto.com, a new initiative founded by crypto investor and entrepreneur Balaji Srinivasan, launched quietly last Friday evening. There was no initial press coverage, just a series of tweets to announce the purpose of the new website and link to some of the initial posts.

.A battle quickly erupted on Crypto Twitter about the use of the Satoshi name for a website that includes authors that are not approved by the high priests of the bitcoin fundamentalist sect.

Regardless, Balaji’s initial post was a rallying cry for the future of crypto, and Bitcoin’s rightful place as the flag of a new wave of technology.

I think this is a much needed resource to help heal some of the senseless fighting in crypto today. Many outsiders see a lot of chaos in crypto, insane infighting that appears meaningless to newcomers but quickly demands that someone take a side. Pro BTC or anti-BTC (just saying “Pro-Bitcoin leads many to ask “WHAT Bitcoin do you mean!!!). Pro this alt coin or that one.

Healthy debates are wonderful and happen every day in crypto. But unhealthy debates, spectacularly dramatic, drown out the good conversations. Nakamoto appears to be an effort to bring together the more reasonable people in crypto to celebrate what’s good about the technology.

“That’s why we’re launching Nakamoto. We want to create a venue for quality technical, philosophical, and cultural writing that is of general interest to the crypto community as a whole, for beginner and expert alike.”

I’m a contributing writer to the site. My first post is titled It Will Take Years for Smart People to Understand Cryptocurrencies. You can read it here.

Anyone can write for the site. There is more information about contributing here.

Ethereum-Friendly Skale Raises Pile Of Money

Arrington XRP Capital participated in the just announced Skale funding round – some $17.1 million in total. You can read the details, soundbites and thoughtful quotes on the news sites. Here’s CoinDesk and TheBlock.

Yes, I’m a little salty today. I flew home last night on a redeye flight from New York. In coach. I was supposed to write about Skale at a designated time that coincided, I believe, with the exact moment on the flight where I, shuddering from cold, purchased two $5 blankets that I was told I was free to keep. When did we start having to buy blankets on flights? Will they install a credit card reader on the toilets next?

I’m convinced those bastard on Jet Blue turned the temperature down just to sell more blankets.

Anyway, I’ve had a solid 2 and a half hours of sleep now and I want to use my cheerfulness to explain why I think Skale is going to make us enough of a return that I will never, ever, have to fly coach again.

There are two reason. First, Skale has the best team I’ve ever seen. With the possible exception of any other founders I’ve invested in that happen to be reading this post, Skale has without a doubt the finest crypto team in the business. (I joke, but I’m serious. We invest in teams first, products second. It works).

Second, Skale can fix Ethereum. Even Joe Lubin, founder of Consensys, would admit this, and that’s why the venture arm of Consensys invested along side us.

If you are building in crypto, Skale might be an excellent partner and help you build things that actually work. And, well, scale. Mainnet is coming, soon, but you can test now.

Thank you, Skale, for including us in the round. Everyone wanted to invest, and we appreciate you finding room for us.

Arrington XRP Capital Welcomes Alex Shin, Former #Hashed Partner, As New Venture Partner

Many of you in the industry know Alex Shin well. He was a cofounder and partner at Seoul-headquartered #Hashed, one of the largest crypto venture capital and accelerator funds in the world.

Today we welcome Alex to Arrington XRP Capital as a Venture Partner. Alex will help us find new growth opportunities in Asia, the U.S. and the rest of the world.

Alex is American but speaks Korean natively and has lived in both San Francisco and Seoul for the last several years.

We are excited to work with Alex, helping us grow our footprint in Asia and beyond.

Algorand’s First Australian Tour, A Welcome from Arrington XRP Capital

Next week, Algorand is launching its first official Australian tour, where Founder Silvio Micali and Steve Kokinos will host a packed week of events in Sydney and Melbourne.

As Australian partners at the fund, Ninor and I are thrilled to welcome two of crypto’s brightest minds to our very own backyard. 

Silvio and Steve are a dynamic duo to say the least and definitely a pair you don’t want to miss live. As part of the roadshow, Algorand is hosting a big week of events from lectures at Australia’s top universities to a series of meetups and panel discussions with industry leaders from the local scene. 

Arrington XRP Capital will be joining the tour alongside partners Mozaik Capital, Blockchain Australia, Sydney Blockchain Professionals and the Blockchain Centre.

For our Aussie readers, here’s a summary of Silvio and Steve’s week ahead:

September 4 – Melbourne

September 5 – Sydney

September 6 – Sydney

On the 5th, I will moderate a panel discussion between Silvio and Steve, where we will be joined by legal mind Hannah Glass from King & Mallesons and blockchain engineer and Deepyr founder Adrian Guerrera. 

One of the best parts of being a crypto fund manager is the opportunity to not only invest in projects and founders globally, but to make friends and build communities across the world. It’s events like these that make the 24/7, timezone-agnostic chaos of the crypto markets well worth their permanence.

Algorand is one of the most ambitious projects in crypto. The team’s vision for a “borderless economy” aligns very closely with our own guiding principles at Arrington XRP Capital: our team is spread across continents and we invest globally in technologies and teams that are unbounded by the closed walls of a legacy financial system.

Hopefully the first of many. Welcome!

Our New Investment In Algo Capital

We are very pleased to join forces with Algo Capital, a new $200 million venture fund founded by David Garcia and Arul Murugan. We have invested in the fund, which will focus on the Algorand ecosystem.

See Coindesk: Arrington XRP Backs Fund’s $200 Million Raise for Algorand Blockchain

We join our friends at the Algorand Foundation, Neo Global Capital, Eterna Capital, GSR, Cognitive Blockchain, Rokk3r, Wibson, 11-11 Ventures, DG Ventures, Winslow Strong, Invermaster and other investors in supporting this new fund.

Algo Capital only takes commitments in Algos, much like our own XRP-only policy. We are very excited to be investors in the new fund, and look forward to co-investing in new blockchain projects with them in the future.

Additional coverage:

The Block: Bakkt investor backs $200M VC fund focused on Algorand blockchain

Finance Magnates: Algo VC Fund Raises $200M to Promote Algorand Blockchain

Yahoo Finance: Arrington XRP Backs Fund’s $200 Million Raise for Algorand Blockchain

BusinessWire: Algo Capital Closes Algo VC Fund at $200 Million

hypepotamus: ATLANTA-BASED VCS RAISE $200M BLOCKCHAIN FUND

Blockchain News: Algo Capital Closes Algo VC Fund at $200 Million – Doubling Expected $100 Million

Ron Palmeri Joins Arrington XRP Capital

Ron Palmeri is a seasoned silicon valley entrepreneur and investor. Today we welcome him to the Arrington XRP Capital team.

I first met Ron shortly after launching TechCrunch nearly 15 years ago. At the time he was a partner and cofounder at Minor Ventures, an early incubator and fund that launched a slew of amazing startups. Companies he helped start include Grand Central (which later became Google Voice) and Open DNS.

Ron later started and invested in more companies, including most recently Layer, a communications infrastructure company that was recently acquired.

That acquisition was lucky for us because it made Ron, an incredible leader and mentor, available to us. He has joined as a strategic advisor and consultant. We’ll keep him as long as we can, either until I convince him to join full time as a partner, or he goes off to start his next operating company.

Follow Ron on Twitter @Ronp.