With Tesla recently adding US$1.5 billion in Bitcoin to its balance sheet and multiple cryptocurrency ETFs applying for regulatory approval, it would appear that cryptocurrencies are entering the investment mainstream. But there are not yet any out-of-the-box solutions available for investment managers that define the terms and risks of cryptocurrencies. So this creates two crucial questions:

  • What type of financial instrument are cryptocurrencies?
  • How can you manage cryptocurrencies within your trading and portfolio management system?

What type of financial instrument is crypto?

What type of financial instrument are Bitcoin, Ethereum, and other cryptocurrencies? Are they currencies, commodities, equities, or something else?

  • Currency?

Bitcoin and others do not really fit the definition of a currency from the perspective of financial risk management. There is little to no market for borrowing and lending cryptocurrencies, and holding a cryptocurrency does not attract interest like a regular currency does. While futures on Bitcoin do trade, there is only a very limited over-the-counter OTC spot and forward market in cryptocurrencies, compared to a huge OTC market in traditional currencies. Due to these differences, hedging financial risk in cryptocurrency looks materially different to the same activity in traditional currency markets. 

  • Commodity?

Cryptocurrencies do share many features with traditional commodities. The easiest way to trade cryptocurrencies for most investors is through futures contracts, which trade on many of the same exchanges, and with similar characteristics, as other commodities. Despite similarities in financial traded products, however, the physical side of the commodities market, involving transporting and storing complex assets, is quite different to the distributed ledger side of the cryptocurrency markets.

  • Equity?

It would seem obvious that Bitcoin is not an equity, as there are no corporate assets or revenue behind it. However, as a traded asset with relatively fungible characteristics, along with traded options and other derivatives, they do have some similarities from the perspective of financial risk management. 

  • Other?

This is the central issue involved in adding and managing investments in cryptocurrencies. If they are an intangible asset and do not fit the definition and details of an existing financial instrument, how do you value them and quantify the risk?

What do you need to change to manage cryptocurrency investments?

There are a number of steps necessary to manage crypto investments within your portfolio. 

    • Add new category: First, you need to define the asset type. At a minimum you want a new category so that these assets do not get lumped in with other equities or commodities. 
    • Ingest market data: Then you need to connect to market data for current pricing. With multiple cryptocurrency exchanges operating at varying degrees of transparency and oversight, this is not as easy as with other asset types, and you most likely want to use multiple data sources.
    • Adjust price variances: Not only does there tend to be greater variance in crypto pricing between exchanges than there is with commodities or equities, the price differences are the result of several factors, including available volume, margin requirements, and transaction fees. So you probably want to run some adjustment or weighted average calculations on the pricing variances between crypto exchanges.
    • Select trading exchange: When it comes time to buy or sell some cryptocoins, you will also want the ability to select the exchange that you want to execute the transaction, and to make any necessary pricing and fee adjustments. These need to be distinct so that you can easily buy coins on one exchange and sell them on another, and easily split or combine transactions across multiple markets.
    • Choose pricing model: Options traded on cryptocurrencies use the traditional Black-Scholes model, but more complex derivatives require more complete models for the dynamics of the cryptocurrency prices. These will evolve as the market gains liquidity.  
  • Model implied volatility: The cryptocurrency options market is still quite illiquid, which means that Black-Scholes implied volatilities are sometimes difficult to calculate, and must be estimated from limited and noisy data. In addition, risk managers need to have a view on how those implied volatilities change as cryptocurrency prices move, so that they can proxy-hedge some of their implied volatility risk with the underlying asset.

The benefits of Beacon’s buy and build model

While none of the above changes sound overly complicated, it can be difficult to quickly add or modify the necessary features in traditional portfolio and risk management systems. Beacon’s buy and build model and transparent source code license makes it quick and easy to add new instruments and asset classes, ingest different data sources, and modify functions and algorithms to suit the needs of traders and clients. For example, it only took one month for a leading alternative asset manager to adapt Beacon’s system to handle their cryptocurrency pricing and trading needs and deploy it into production. With crypto assets properly integrated into the portfolio, cross-asset risk management is more effective and new possibilities such as using crypto assets for loan collateral will open up.