Risk management in the context of crypto
As many of you, especially our investors, already know, The Well was not affected by the FTX fallout. Based on healthy scepticism, we chose not to use FTX as an exchange partner. We are confident that the movement towards decentralization will not stop with the massive failure of one centralized bad actor. All decentralized protocols have performed as intended throughout this turbulent time.
In light of recent events, we were once more reminded of the high standards every manager with fiduciary duty should be held accountable to.
Not every risk can be resolved, even with extensive due diligence. However, counterparty risk is something that can be resolved in a quant trading context.
With the majority of our assets held diversified in various forms of custody, we have only ~10-20% of AUM on exchanges. We can achieve this because we almost exclusively trade futures. Hence, we have minimal counterparty risk, and we spread our risk across multiple top-tier exchanges, all of which we have personal relationships with and we re-vetted after the FTX collapse. (If you are interested in how we assess exchanges, please reach out.)
In delta 0 (arbitrage trades), beta neutral (zero to very little exposure to the overall market) or a delta 1 (trading decision timing) context, there exist nuances that influence how far one can stay away from counterparty risk. The availability of futures (perpetuals and/or delivery futures) makes it easy to take on healthy amounts of leverage on individual trades to reduce exposure to counterparty risk, whilst having no leverage at the fund level.
An example:
Suppose we found a great way to profit from BTC movements, based on some metric. To trade a $1M AUM account, we could put $1M on an exchange and invest whatever exposure to BTC our model suggests. This would expose us to a $1M loss potential in case the exchange collapses.
The more prudent approach would be, if the exchange allows leverage in e.g. perpetual futures with a leverage of up to 10x, to only pledge 1/10th of the $1M on the exchange but gain full exposure via leverage. In that case, if we want to have 100% exposure to BTC, it would be sufficient to deposit $100k USD on the exchange to take on a $1M position in BTC. We would have to monitor variation margins and pledge more capital if the trade goes against us, but at any point we could have the remaining $900k in safe custody and only the collateral on the exchange exposed to counterparty risk.
This approach has been battle tested by most futures trading market participants that hold something to their name. Especially CTAs live and breathe the concept of capital efficiency and risk reduction. Futures and derivatives were invented as a hedging tool in the first place, whether that is to hedge the price or other risks. And a hedge fund should live up to its name. There are further approaches involving synthetic default trades, but the process described above offers a substantial reduction on risk even if used on its own.
Side note: There is also the option to trade without any exposure to exchanges and settle directly out of custody on some larger exchanges in the space.
Our performance has been positive and fully in line with our expectations. An update on our monthly returns since we launched the strategies on August 28th. (Net returns are calculated after considering the management fee, performance fee and all fund related expenses).
• September +2.38% (net)
• October +0.06% (net)
• November +3.70% so far (gross)
We are pleased with how we managed our risks and grateful for the opportunity to demonstrate that we can succeed even in less-than-ideal circumstances. We sincerely hope that you were able to weather the crypto storm well and are always happy to assist with crypto related questions, not only regarding our fund.
The information presented above does not constitute an offer to sell or a solicitation of an offer to buy any securities associated with The Well US Feeder LP, a Delaware Limited Partnership or The Well Zero LP and The Well Cayman Feeder LP, both Cayman Islands exempted limited partnerships, together (“the Funds”).
Any offer or solicitation may only be made pursuant to a Confidential Private Placement Memorandum for each of the Funds, which will only be provided to qualified offerees and should be carefully reviewed by any such offerees for a comprehensive set of terms and provisions, including important disclosures of conflicts and risk factors associated with an investment in the Funds.
The Funds make no representation or warranty, express or implied, with respect to the accuracy, reasonableness or completeness of any of the information contained herein, including, but not limited to, information obtained from third parties. The information contained herein is not intended to provide, and should not be relied upon for accounting, legal or tax advice or investment recommendations.