July 3, 2024

Insights and analysis for the professional investor

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Welcome to Crypto Long & Short!

This week, Q Rasi, co-founder of Lindy Labs says insurance can help improve security and compliance standards in DeFi, just as insurance helped reduce risks for cars, buildings and other industries.

Then, Adam Guren of Hunting Hill makes the case for investing in crypto index funds.

As always, get the latest crypto news and data from coindeskmarkets.com.

– Ben Schiller, head of Consensus Magazine at CoinDesk

From the Analyst

Insurance Is the Silent DeFi Guardian

Insurance companies have historically shaped standards and promoted safer practices throughout society. In the automobile industry, they drove the development and adoption of now-ubiquitous safety measures – like seatbelts and airbags. By reducing premium payments for vehicles equipped with safety features, insurance companies helped align incentive mechanisms for car manufacturers and drivers and enforce higher safety standards. Similarly, by making liability coverage insurance contingent on adherence to safety protocols, insurance companies played a pivotal role in establishing safety standards in buildings and in the manufacturing sector.

The digital asset ecosystem has grown substantially in recent years and will continue to maintain its momentum as more institutions like BlackRock bring real-world assets on chain via tokenization. Despite this growth, the absence of regulatory guidance has created uncertainty, posing challenges for widespread adoption and rapid integration into the broader financial ecosystem.

In a similar vein, during the early days of the internet, cyber insurance emerged as an important tool to promote online security and reliability. Insurers offered coverage against risks such as hacking and data breaches, but only to companies that implemented stringent cybersecurity measures. This incentivized businesses to adopt best practices in cybersecurity, such as regular software updates, strong password policies, and comprehensive data protection strategies. Just as cyber insurance fostered a more secure digital environment, the development of regulatory frameworks and risk mitigation strategies will be crucial in ensuring the stability and trustworthiness of the growing digital asset landscape.

In this stage of its evolution, DeFi is exposed to a myriad of risks including smart contract vulnerabilities and regulatory, economic, and governance risks. This creates an opportunity for insurers to step in and act as a de facto regulator to enhance the resilience of the on-chain ecosystem and foster more trustworthy on-chain finance where user funds are protected at all times.

Traditional Insurance offerings are offered on a "guaranteed cost" basis, meaning the premium (rate based on exposure) is fixed for the policy term, regardless of the number or amount of claims that occur during the term. Although this model has made insurance available to billions of individuals and organizations worldwide, it has also created limitations for risk areas where insurers lack data, expertise or regulatory support. Due to this limitation, industries such as DeFi, have been left exposed, which ultimately affects the public.

So far, insurers have relied upon organizations such centralized exchanges and DAOs to create the framework for possible insurance offerings. Centralized exchanges still have fairly limited markets, and mostly utilize insurers to re-insure their exposure. Users seeking protection against their exposures on exchanges that don't offer coverage, now are being offered coverage by DAOs (example: Nexus Mutual) for their individual risks. Although this provides a short-term solution to the limited capacity, the piecemeal implementation lacks the efficiency required to bring coverage to the nearly $2T (and growing) digital asset sector.

Many of us are accustomed to our personal funds being insured at chartered financial institutions up to a certain amount. For digital assets to be fully adopted by the general public, the framework for insurance must likewise be fully integrated into the institution. This integration helps give the public the confidence that their digital assets are protected to the same degree they are accustomed to with their real world assets.

Starting with insuring funds on Sandclock, Schwarzschild insurance is one service provider aiming to pioneer the protection for user funds across DeFi protocols. By seamlessly integrating with decentralized protocols, Schwarzschild aims to establish a model for comprehensive DeFi insurance that mirrors the depositors' insurance at chartered banks. This approach includes rigorous security audits and compliance checks to ensure that only the safest and most reliable DeFi protocols are covered. Schwarzschild's framework will provide users with confidence and peace of mind, knowing their digital assets are protected against potential vulnerabilities and risks inherent in the DeFi ecosystem. This pioneering effort represents a significant step towards mainstream adoption, where the public can trust that their digital assets are as secure as their traditional financial holdings.

- Q Rasi, co-founder of Lindy Labs

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Institutional Outlook

The Case for Crypto Index Funds

The crypto assets market has grown remarkably over the past 15 years, peaking at a $3 trillion valuation in 2021, with over 26,000 listed cryptocurrencies. This growth has attracted retail and high-net-worth investors, family offices, university endowments, and even pension plans.

The entry of reputable TradFi firms such as Goldman Sachs, Fidelity, and Blackrock into the crypto space underscores the growing institutional acceptance and maturity of digital assets and has facilitated broader market participation.

Despite the strong demand for digital assets, there is still debate as to how to best to gain optimal exposure and manage risks. Many investors hold cryptocurrencies like Bitcoin or Ether, or have invested in spot BTC ETFs, but a third option exists: crypto index funds. These funds offer diversified exposure to digital assets.

Sophisticated investors recognize the need to diversify portfolios, anticipating that as inflows into Bitcoin ETFs slow, so will volatility, reducing the potential for attractive risk-adjusted returns. Institutional investors are increasingly seeking exposure to a broader set of cryptocurrencies that complement traditional equity holdings, which is where index funds come in. Crypto index funds are investment vehicles that track the performance of a basket of various cryptocurrencies, offering investors diversified exposure to the digital asset market without the need to buy individual cryptocurrencies directly. Currently, over a dozen crypto index funds are marketed to investors, ranging from $1 million to several hundred million dollars in assets under management.

Historically, good or bad news (idiosyncratic risk) about a specific crypto asset tends to be priced into the market quickly. That is to say that current market prices generally reflect what is currently known about these assets, creating some degree of price efficiency. Ideally, investors need to rebalance their portfolios frequently to capitalize on market movements and manage volatility. However, most active managers do not offer sufficient liquidity for this frequent rebalancing, consequently, most investors maintain very small position sizes. Given these challenges and the market's nascency, adopting a diversified index strategy is sensible for those seeking broad exposure to this opportunity set.

Cryptocurrency index funds provide institutional investors with a streamlined approach to gain exposure to digital assets. Although typically distinct from venture capital investments, these index funds share a similar strategy in managing risk through diversification. By investing in the top crypto assets by market capitalization, they offer a way to mitigate some of the infancy risks associated with individual cryptocurrencies, much like how venture capital spreads investments across numerous startups to balance the high failure rate with the potential for substantial successes.

A key consideration for index funds is the number of cryptocurrencies they represent. While opting for the ten largest cryptocurrencies by market capitalization has been the norm, expanding the index to 25 accounts for 92% of the total crypto market capitalization. Some might seek to diversify even more with the top 50, but this would only marginally increase market cap coverage by 3%.

There are downsides to extending the universe of cryptocurrencies included in an index fund. It is advisable for investors to note whether an index fund includes meme coins, which have minimal developmental goals and are typically seen more as artistic expressions or cultural commentary. The higher volatility associated with meme coins also makes them unsuitable for an institutional portfolio.

For long-term investors who can forgo intra-monthly liquidity, staking assets held by the index can help protect against dilution as the coin supply of protocols grows over time. Staking assets allows investors to participate in the transaction verification process of proof-of-stake blockchains, with the chance to earn rewards, similar to equity dividend yields.

As institutional adoption of digital assets continues, it is imperative for investors to assess how best to gain exposure to the space and work with trusted partners to navigate the complexities of the crypto ecosystem. While an index fund is not the only way to invest in digital assets, there are strong arguments for it to be viewed as a foundational building block for an institutional portfolio to gain a more controlled and diversified exposure.

– Adam Guren of Hunting Hill

Takeaways

Here's some news worth knowing, from CoinDesk deputy editor-in-chief Nick Baker:

MEMECOINS TALK: Say what you will about memecoins, they generate the cash flow. Celebrity-inspired meme coins spurred a surge in revenue for token launchpad Pump.fun recently, lifting the protocol's daily revenue above the Ethereum blockchain's for the first time. Pump.fun racked up $2 million in daily revenue this past , pipping Ethereum's $1.91 million and making it the largest revenue generator of any blockchain, according to data on DefiLlama. Data from Dune Analytics shows that 11,528 tokens were deployed on Monday bringing the cumulative total up to 1,199,685. (That number is not a typo.) Cumulative revenue on the platform has now reached $50.9 million. In March, Pump.fun was on track to hit $66 million in annual revenue, a figure that is likely to be surpassed before the year is out if current activity continues.
BITCOIN BULLISH: With the price of Bitcoin sluggish over the last few weeks, it may have appeared that crypto markets were headed for a slow summer. But data from the options markets shows that better days may be ahead. BTC has traded between $59,000 and $74,000 since April, weighed down by billions in sales, upcoming selling pressure, outflows from exchange-traded funds (ETFs), and peak negative sentiment among retail traders. But July has historically been a decent month for the leading crypto and the first day this year saw U.S.-listed ETFs record nearly $130 million in inflows – their highest since early June, after more than $900 million in outflows over the month. "Bitcoin has a median return of 9.6% in July and tends to bounce back strongly, especially after a negative June (-9.85%)," Singapore-based QCP Capital flagged in a Telegram broadcast Monday. "Our options desk also saw flows positioning for an upside move last Friday into the month-end, possibly in anticipation of the ETH spot ETF launch. Many signs point to a bullish July," QCP added.