Blockchain Disrupts Asset Management Using “Proof of Performance”
For the past few months, the rise of ICOs has challenged the venture capital industry in its ability to finance early stage projects. Now quantitative managers are starting to use Blockchain
The ICO market
For the past few months, the rise of ICOs has challenged the venture capital industry in its ability to finance early stage companies and projects.
As shown by the graph below (from CB Insights), the ICO trend is fairly recent but exponential. From almost nothing in 2015, the funding accounts for an estimated $757 mln in Q2 of 2017. That figure exceeds by more than 3x the disclosed funding amounts by venture capitalists for Blockchain companies and projects.
When such a massive flow of capital appears, two main phenomenon usually follow: frauds and failures. It is almost certain that the current market will see numerous examples of both.
”We are in a bubble, a lot of projects will fail.”
- Vitalik Buterin, Founder of Ethereum
But the forecasted failures will not hide the tremendous disruptive potential of the Blockchain in many of industries and markets. Among these, the asset management industry may be most ripe for disruption.
Asset management, quantitative management and Blockchain
Among the successful projects of the first ICO wave, several, as Melonport, are bringing classic tools of the asset management industry into the crypto world. But the biggest disruption lies in more complex tools. Quantitative management, in particular, has extraordinary potential.
Quantitative strategies are algorithms producing sell/buy signals on a set of underlying assets when provided with data such as prices. Contrary to what most people imagine, pure quantitative management in traditional finance is still a small portion (around 10%) of the $75 trln asset management industry.
In the crypto universe, quantitative strategies such as trading bots naturally emerged and found a niche. Other examples of Blockchain’s disruptive power in the asset management industry are tokenizing of assets, or projects like Iconomi trying to create a diversified performing fund from a basket of digital currencies. Other examples include Blackmoon which will launch a high yield fund or NaPoleonX which will launch a series of absolute return funds based on traditional equity indices.
Separate the wheat from the chaff
With more trading bots and funds being established, digital currency investors find themselves wondering how to assess the quality of quantitative manager, and how to separate the one who was lucky in the past from the one who has a strong expertise that should lead to sustainable performance.
When a young market has grown exponentially for some years, many of “wannabe quants” have produced working and well-performing algorithms. But what does that tell you about their ability to generate strong returns in different market conditions?
A new concept yet a natural solution: proof of performance
According to the CEO of NaPoleonX, Stéphane Ifrah, the company’s founders were asset managers managing billions in tier 1 banks; as such they faced the issue consisting in “convincing investors to make you manage their money.” Backtesting is usually the first step to convincing customers that you’ve developed a quality algorithm.
This process involves using the algorithm on past data to determine whether its predictions would have been accurate. Backtesting isn’t perfect, because the testers can use overfitting and/or undisclosed algorithm modifications to get the desired result. That’s why NaPoleonX invented the proof of performance concept.
Proof of performance consists of using a public Blockchain as the trusted third party to validate in real time the trading signal flow of any low-to-medium frequency trading strategy. It’s a two step process: first, the signal is sent in a hashed and obfuscated way to the Blockchain, and then, several days after, the signal is sent again, but in the clear, with the random string enabling the hash verification.
As a consequence of doing so, the manager is able:
- To prove the trading signals at the time they should have been executed on the financial markets
- To compute the gross performance the quantitative strategy would have achieved in a trusted manner
Proof of performance could revolutionize the quantitative management industry, particularly with respect to digital currencies. It remains to be seen whether this concept will work on a large scale, or whether other projects will make further enhancements.