Hedge Funds Are Hacking Blockchains to Guide Crypto Investments

  • Proliferation of ICOs raises risk of faulty, fraudulent deals
  • Crypto hedge funds have raised more than $800 million

Polychain CEO Says Blockchain Tech Is Moving Quickly

Lucas Ryan of MetaStable Capital took a deep dive into the computer code underpinning the digital currency Monero to see if it worked as promised. He even took a core piece written in C ++, and rewrote it in the programming language Python.

The extra effort paid off. After taking the time to vet Monero before its investment, the San Francisco-based hedge fund has seen a 100-fold return, said Joshua Seims, who started MetaStable with Ryan three years ago.

MetaStable, backed by venture-capital firms including Union Square Ventures and Sequoia, isn’t alone in trying to hack and understand what tech startups often promote as impenetrable software. That’s become especially important with the proliferation of initial coin offerings that have raised about $2 billion this year and swelled the ranks of digital tokens to more than 1,100.

"If you don’t have a deep understanding of this technology, you don’t know what you are buying," Olaf Carlson-Wee, chief executive officer of Polychain Capital, said in a phone interview. "There are a lot of projects right now launching. Most of them make very little sense, and the vast majority will fail."

The surge in ICOs had also led to an abundance of scams, prompting U.S. regulators to warn investors of fraudsters.

"What a lot of funds will do for their technical due diligence is, they’ll read the white paper, but our experience is, it’s very easy to make amazing claims in a white paper, but it’s hard to create the working code," Seims said in an interview.

There are now more than 68 crypto hedge funds focused specifically on digital currencies, and they have raised about $800 million -- and are aiming to raise $1.2 billion more, according to Autonomous Research LLP.

But while many of the funds were started by day traders, attracted by cryptocurrencies’ wild price swings and often easy-to-find arbitrage, such opportunities are likely to close up fast.

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"Cryptomarkets today are extraordinarily irrational," Kyle Samani, managing partner of Multicoin Capital, said in a phone interview. "There are so many inefficiencies. There’s a bunch of guys from Wall Street coming up right now and picking up money left and right. Once enough of these guys get into the market, these inefficiencies are going to go to zero. We can generate real money by catching some really large winners."

Multicoin’s first fund debuted in August, with its second debuting this month. Samani, who started programming at the age of 10, is hiring software engineers with experience in the technology underpinning digital tokens. Protos Cryptocurrency Asset Management, whose team includes a computational neuroscience PhD. and had previously started Canada’s first regulated crypto investment firm, First Block Capital, hopes to raise its funding in September and October by issuing its own cryptocurrency. And Polychain Capital, headed by the first employee of blockchain startup Coinbase Inc., was started a year ago and now has $250 million of funds under management from the likes of venture firms Andreessen Horowitz and Founders Fund.

Read more on the variety of unique initial coin offerings

The funds have stayed mum on exact returns.

MetaStable’s analysis helped it avoid investing in the DAO, a venture-capital fund whose code wasn’t secure enough, so hackers stole its users’ investments. The fund eventually bought the DAO users’ digital tokens -- effectively, shares in the project -- for cents on the dollar, right before money was returned to their owners via a software fix. Partly as a result, over the past three years, MetaStable has already managed to earn "significantly" higher returns than people who simply bet on bitcoin, which appreciated nearly nine fold, Seims said.

"It’s helpful in determining which cryptocurrencies are scams, which are derivative works of others, which have incredible stories that will emerge as winners," Seims said.

For hedge funds without their own technology gurus, a number of consulting firms have sprung up. Among Zeppelin Solutions’ clients are cryptocurrency-focused, as well as traditional hedge funds, for whom the firm’s team of software engineers can stress-test potential investments’ code.

"We’ve seen an increase in the number of hedge funds approaching us in the past month," co-founder Demian Brener said in an interview. He attributes the jump in interest to the huge rise in the price of bitcoin and another popular cryptocurrency, ethereum. The two cryptocurrencies have a combined market value of about $80 billion, according to CoinMarketCap.

"You have code that’s powering real economic value,” Brener said. “You need to make sure that you are doing things safely and correctly."

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