Data-crunching algorithms have become a popular—and controversial—tool on Wall Street in recent years. Now, they’re starting to be used to guide investments in cryptocurrencies, too.
The emerging strategy raises a number of interesting questions for the young and volatile cryptocurrency market. Among them: What types of data should be considered when trying to predict the future value of cryptocurrencies, which—unlike the decades of information available to stock traders—didn’t really take off until the past several years? Will the algorithms be sufficiently transparent for investors and regulators (a criticism that often dogs their developers)? How predictive can algorithms actually be in this sector? How might this all affect traditional stock markets and the rest of the financial sector?
It’s hard to say how things will play out, but Flipside Crypto will be one of the early test cases. The Boston-based startup helps wealthy individuals invest in cryptocurrencies, and it develops algorithms to help steer the investment picks. Today, the company announced a $3.4 million venture funding round led by True Ventures, money that Flipside says will help it hone its algorithms and improve its services. The Chernin Group, Resolute Ventures, Boston Seed Capital, Converge, and Founder Collective also contributed to Flipside’s funding round, according to a press release. True Ventures partner Adam D’Augelli will join Flipside’s board.
To date, Flipside has operated as a sort of data-driven angel network, but instead of making equity investments in startups, investors are pouring money into cryptocurrencies. Flipside has devised algorithms—some modeled on lines of code that equity hedge funds use to guide trades, says co-founder and CEO Dave Balter—to recommend investments in “baskets” of about 15 cryptocurrencies. Flipside also manages the process of acquiring cryptocurrency and storing it—handling potentially confusing things like encryption and digital wallets, for example.
Balter says he thinks that many of the recent investments in cryptocurrencies have been driven by hype, not “the fundamentals of how you might evaluate good companies.” (Of course, skeptics might argue there’s not a lot of substance in today’s cryptocurrency market, but that’s a discussion for another time.)
“Our algorithms are all tuned to look for long-term, sustainable projects,” Balter says. “In the short term, we might miss that thing that pops because everybody is talking about it. But in the long term, our projects will be here and doing well.”
The idea is to find the mix of cryptocurrencies most likely to deliver the best return on investment. That means backing not just the two most popular cryptocurrencies, Bitcoin and Ethereum’s ether coins, but also potentially overlooked and lesser-known digital assets. For example, Flipside’s first “investment club” also put money into Siacoin, the digital token that powers the blockchain-based cloud data storage service run by Boston-based Nebulous, and LBRY, a New Hampshire-based venture that operates a blockchain-enabled content sharing and publishing platform.
Flipside says its strategy is paying off so far—though it’s early, of course. In its first five months, the group of cryptocurrencies that Flipside’s first “investment club” invested in delivered a 141 percent return, compared with 92 percent for Bitcoin and 115 percent for the Coinbase Index, Flipside says. Coinbase operates one of the leading online platforms for buying and selling digital currencies, and the Coinbase Index tracks the performance of the digital currencies listed on Coinbase’s cryptocurrency exchange—Bitcoin, Ethereum, Bitcoin Cash, and Litecoin—which are weighted by market capitalization.
Flipside says its second investment vehicle, launched in November, has delivered a 79 percent return in that time, versus 43 percent for the Coinbase Index and 11 percent for Bitcoin itself. (Investors in Flipside’s baskets of cryptocurrencies can cash out their holdings at any time, but none of the 105 investors in its six investment vehicles created thus far have done so, Balter says.)
The bigger trend here is that more businesses are being built to take advantage of rising interest and investments in cryptocurrencies and blockchain technology, even as the sector contends with scams, intensifying scrutiny from regulators, questions about technological scalability, and other challenges.
While many blockchain ventures eschew conventional business models and descriptors, some companies in this sector are adopting more traditional approaches from the world of finance and other industries. Balter says Flipside is evolving into something akin to a Vanguard for cryptocurrencies, referring to the company that manages people’s investments in things like 401(k) plans and mutual funds.
In Flipside’s early investment vehicles, once investors agreed which cryptocurrencies to put their money into, the mix of investments didn’t change. But now, Flipside is becoming an investment manager that will actively buy and sell cryptocurrencies for each of its funds, Balter says. (Technically, Flipside is establishing itself as an “exempt reporting advisor,” which means it must comply with rules meant to safeguard investors and it has to report certain information about its activities to regulators, but the requirements are less stringent than for other types of investment advisors, according to an article on the American Bar Association website.)
Balter notes that the firm will not operate like a day trader, but it might “re-balance” each fund’s mix of cryptocurrencies once a month, say. “When we see a trend in data, we make a change,” Balter says.
Flipside isn’t the only company enabling people to invest in multiple cryptocurrencies at a time. Bitwise runs an index fund that lets people invest in the top 10 cryptocurrencies, determined by market cap. Iconomi lets users customize their basket of cryptocurrency investments. And Coinbase announced in early March that it’s launching an index fund, which gives investors exposure to the digital currencies listed on its cryptocurrency exchange.
It appears Flipside isn’t the only company deploying algorithms to guide crypto asset investment decisions, either. For example, Mutual Coin Fund, a crypto hedge fund manager, says on its website that it is testing “algorithmic bots and trading strategies to provide better returns.”
Although market cap makes sense for valuing companies in the stock market because it’s based on a firm’s publicly reported financial earnings and stock price, Balter argues it’s a “flawed” metric for evaluating cryptocurrencies and other digital assets. For one, a cryptocurrency’s market cap can be moved by issuing more digital tokens, he says. Or the value can climb because of buzz, not because of any concrete data, he says. (That can happen in the stock market, too—look at companies such as Long Island Iced Tea, whose stock price jumped after it changed its name to Long Blockchain.)
“I believe market cap means zero” for cryptocurrencies, Balter says. “The number of companies in this space with ‘billion’ behind [their] value is staggering, and it’s complete B.S. ‘X company’ is worth $300 billion. How?”
If the algorithmic approach to cryptocurrency investments eventually wins out, then the question becomes: who has the best lines of code?
Flipside’s algorithms analyze three metrics, Balter says. The first is a “speculation” analysis adapted from hedge fund trading algorithms, he says. Basically, it runs simulations of about 40 different trading strategies to see which ones might perform the best, based on historical and real-time cryptocurrency pricing data.
The second algorithm examines the activity of software developers working on cryptocurrencies. “The philosophy is follow the engineers—where people are building, good things will come,” Balter says. Conversely, when the level of developer activity fades early on, it might signal a doomed digital token—or even a scam, he adds.
The third algorithm tries to gauge the “utility” of the cryptocurrency by tracking transactions executed by the network of computers running the blockchain system underpinning the digital currency. Part of the idea is to identify when a small number of users are executing a large number of transactions, which could indicate a “pump and dump” scheme, where there are “a few people trading between each other in order to make it look like there’s movement,” Balter says.
Some of these data points are starting to prove themselves, but “there is still quite a bit of work to do to create longer-term, sophisticated models,” Balter admits. Still, he says, there’s a “huge opportunity if you can get all of the algorithmic data working together.”
[Pictured left to right in top photo: Flipside executives Eric Stone, Dave Balter, and Jim Myers. Photo courtesy of Flipside.]