So You Want to Trade Crypto - Hedging with Cryptocurrency and correlation structure (Part 6)

As a new asset class with historically low correlation to traditional financial products, many see Cryptocurrencies as a useful hedging tool against global downturns. However, the structure of Crypto volatility and correlation relative to market capitalization may prove somewhat detrimental to this use-case.

Photo by  Tyler Milligan  on  Unsplash

A story of Volatility

(Raw data from  coinmarketcap.com . These charts show the mean of the 60 day annualized volatility from 1st Jan 2017 to time of writing.)

(Raw data from coinmarketcap.com. These charts show the mean of the 60 day annualized volatility from 1st Jan 2017 to time of writing.)

As within equity markets, we see a small decrease in volatility as the market cap of coins increase (albeit with a relatively low correlation). This can be likened to blue-chip stocks vs mid-caps, with the former providing greater stability due to their established dominance in their respective sectors.

Although market cap is a slightly misleading metric when applied to Cryptocurrencies, it at least implies a higher value to a coin - thus requiring more money to shift its direction dramatically. That being said, volatility has been higher across the board over the last couple of years as Crypto shifted from the accumulation phase post 2013 into the major bull run. Finally pushing to record high as we moved into the final phase of the bull run and subsequent bear market as we entered 2018.

This structure of volatility allows Crypto portfolios and indexes to be constructed similarly to those of equities: high-cap only selection for reduced risk and volatility; mid-caps for higher risk and reward; or a more diversified index to try to capture a middle ground.

The Trend of Correlation

(Raw data from  coinmarketcap.com . These charts show the mean of the 60 day Pearson’s Correlation Coefficient against Bitcoin USD from 1st Jan 2017 to time of writing.)

(Raw data from coinmarketcap.com. These charts show the mean of the 60 day Pearson’s Correlation Coefficient against Bitcoin USD from 1st Jan 2017 to time of writing.)

Here we see nearly zero correlation between the market capitalization of a coin and its average correlation to Bitcoin (the historical leader of the Cryptocurrency space).

While this disproves the theory of high cap Cryptos holding a closer correlation to Bitcoin, it highlights the extremely high levels of correlation present throughout the market. This, as mentioned in previous posts, is likely due to the highly speculative and sentiment driven nature of the market, along with its relative immaturity compared to more traditional traded assets.

Interestingly, there isn’t much difference between the mean of correlation and the mean of absolute (positive only) correlation, meaning that we rarely see any negative correlation between ALT/USD pairs and BTC/USD.

Cryptocurrency as an Asset Class for hedging

Crypto holds the useful property of historically low correlation to other asset classes, such as equity and commodities, suggesting it to be a good hedge against external global factors. However, there are two main issues to this plan: Cryptocurrency has never weathered a global financial crisis; and the internal correlation within the Crypto space.

Since Bitcoin, and the rest of the Cryptocurrency market, has been experiencing its own market cycles due to its rapid growth over the past few years, any fluctuations due to correlation with equity markets has been almost unnoticeable - leading many to speculate that Cryptocurrency would continue this trend and make a good hedging tool against global downturns.

This observation happens to come on the back of a decade of huge growth in both US and global equity markets. Investors have been increasingly complacent in their gains over the past few years, and are happy to take greater and greater risks, betting money on more speculative assets such as Cryptocurrencies. However, such high yield assets are always the first to tumble at the onset of a recession, as investors scramble claw back their risk as their other positions drop.

Always "Different This Time"

Many will claim that its somehow “different this time” - it always is until the inevitable pullback. This was true of the dot-com bubble and I wouldn’t be surprised if the same fate will hold true for Cryptocurrency during a global dip. Not to say that Cryptocurrencies won’t be successful long term - the internet didn’t exactly disappear after 2000. But it should be approached with the same caution as any other high risk investment.

As alluded to in the first half of the article, the levels of volatility and correlation in Cryptocurrency make it difficult to create a well diversified portfolio - no matter what you pick you’re still at the mercy of Bitcoin and can incur the same volatility spikes and drawdowns.

While it may be possible to hedge a portfolio by shorting Bitcoin itself and creating synthetic ALT/BTC pairs, this won’t be able to eliminate the sensitivity of low-mid cap coins to shifts in market sentiment, so would have to be more actively managed.

All-in-all, Cryptocurrencies provide an interesting new opportunity for traders and investors alike - with high risk but much higher reward possibilities. They will not be a miracle financial product, nor a get rich quick scheme - but they can provide something truly new and different for those who have the time to understand and appreciate them.

By Matthew Tweed

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So You Want to Trade Crypto - Exploiting Cryptocurrency Correlation (Part 5)

There is correlation within any sector or asset class, however there are particularly interesting patterns in Cryptocurrency due to the new and speculative nature of the market, along with its historical pairs structure.

Weakness and Strength

(Raw USD pairs from  coinmarketcap.com , raw BTC pairs from  poloniex.com )

(Raw USD pairs from coinmarketcap.com, raw BTC pairs from poloniex.com)

Historically, the Cryptocurrency space has been dominated and led by Bitcoin, with Bitcoin’s 80% — 90% of total market cap only starting to be challenged in the last couple of years, as covered in “Market Cap Distribution and Rise of Altcoins”. This huge shift in capital distribution caused a bloom in many Altcoins during the major bull run of 2017.

However, despite this redistribution of power in the market, a correlation between different altcoins and Bitcoin stayed strong throughout 2017, suggesting that the market is still centering around Bitcoin both as an indicator of general sentiment and health and, as a safe haven asset.

During the bulk of the bull run, correlation of USD pairs stayed high, with the notable exception of periods prior to Bitcoin pullbacks, such as the dips from $3k and $5k. This seems to form a bit of a leading indicator (albeit a very noisy one), as a divergence in altcoin movement appears to precede a local top and a pullback.

Correlation and investor sentiment

The BTC pairs also tell an interesting tale, moving into negative correlation as the Bitcoin trend weakened before bouncing back once a bottom had been reached.

This view of combined market correlation can also give clues to the sentiment of investors. During bull markets, projects have a high-value premium based on the expectation of future success, meaning that while correlation stays generally positive, the price movement of projects will shift around based on their own news and merits — lowering overall correlation.

However, if we look to 2018 and the bearish trend, we see a very different pattern as fear enters the market. Correlation tends towards 1.0 in a bear market, as sell-offs are sharp across the board due to the cycle of panic. Individual projects are no longer values on their own merits, instead being sold off at whatever price they’ll fetch as the market falls in unison.

This fear can be seen clearly as Bitcoin’s first sell-off from $19.6k to $6k takes effect, followed by a very slight regaining of hope after the bounce (drop in correlation) before tending back towards 1.0 as we moved for a retest of $6k.

ALT/BTC pairs and hedging

Historically, most Cryptocurrency trading was done with Bitcoin as the base pair, and even now we still see $100Ms daily through Bitcoin pairs. Back in the days where both regulation and market volume was limited, this made a lot of sense. A Crypto-Crypto exchange didn’t need to deal with the hassle of accepting and storing fiat currencies, nor the regulatory issues of handling money.

This had the effect of tying the USD value of altcoins closer to the shifts of Bitcoin, which is still a factor today (although to a lesser extent). This, along with the psychology of fear during a bear market, has lead to the levels of correlation we see in the USD pairs during large pullbacks.

In theory, this makes ALT/BTC pairs extremely useful for trading: during a bull market you’re betting that your chosen coin does better than Bitcoin on its technical merits; during a bear market you expect the ratio to stay relatively level as your coin maintains a correlation near to 1.0 against BTC/USD.

However, in reality we also start to see correlations between the ALT/BTC pairs and Bitcoin also rising during major downturns, suggesting that Bitcoin is used as a safe haven asset to hedge against pullbacks, as people rotate out of higher risk and reward altcoins.

This causes issues in the assumption of a hedged market exposure from trading Bitcoin pairs during a pullback. This does, however, provide yet more signals as to market sentiment. Since you will often see sharp dips in BTC/USD being mirror across ALT/BTC pairs, a deviation from this trend is a helpful indicator of market strength and bullish sentiment.

Trading the correlation

An understanding how different Cryptocurrencies react within the market allows you to optimize portfolios and reduce beta to Bitcoin during downturns, while maintaining upside during the bulk of a bull run.

Well established coins with higher market caps tend to keep high correlations to Bitcoin throughout the market cycle along with lower volatility (at least in terms of crazy Crypto volatility). Meanwhile, low-mid cap coins tend to be used as high risk high reward speculation tools during bull markets, but drop sharply as market sentiment shifts.

The optimal portfolio would likely re-balance periodically between a mix of mid and high cap coins, weighted by a market sentiment metric, while also hedging some exposure by shorting Bitcoin to create synthetic ALT/BTC pairs.

While it is impossible to hedge away all risk in such a new and underdeveloped market, such a portfolio may help to ease the nerves of the more risk averse investor, while maintaining exposure to Cryptocurrency as a whole.

by Matthew Tweed

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So You Want to Trade Crypto — Market Cap Distribution and Rise of Altcoins (Part 4)

Bitcoin dominating >90% of the total value of the market to <40%

From the start of 2016 to the end of 2017, we’ve gone from Bitcoin dominating >90% of the total value of the market to <40%.

This flow of capital has lead to a boom in alternative Cryptocurrencies, which offer newer technologies and wider use-cases.

Market Cap Misconceptions

The first point to address is the issue with market capitalization as a metric when applied to Cryptocurrency. For a stock, the market cap is calculated as:

     Price per share * shares outstanding

Which makes sense, as each share represents a stake in the assets and profits of the company. This same calculation is applied to Cryptocurrencies:

     Price per token * tokens available

This starts to cause issues due to the ease that a new token can be made and added to one of the dozens of small exchanges.

If someone creates a new coin with a total supply of 100B and manages to get it listed on a small exchange and trades it a few times with their friends for $1 per coin, it technically has a market cap of $100B. But in reality, is has no true value and no trading volume to sustain any kind of selling pressure.

Maintaining an artificially inflated market cap

Adding to this, there are many coins that do have significant daily trading volumes while maintaining an artificially inflated market cap as the majority the of the supply is locked up by developers and isn’t tradeable. This raises serious questions about how the investors and traders price in total supply of a token and whether the theoretical value of a project lines up with reality.

Many people also misunderstand what market capitalization means in terms of capital flow.

A market cap of $100B does not mean that $100B has been invested into the token, as shown earlier. Nor does a token’s market cap changing from $100B to $150B or $50B mean that $50B of capital has changed hands.

Not enough money in the system to redeem every token

The profit from a Cryptocurrency investment should be treated as “paper gains” until cashed out or hedged — there is simply not enough money in the system to redeem every token to anywhere near the value of its market cap.

Despite this, for a Crypto with sufficient trading volume and age, market cap can be useful for rough comparison, but make sure to always take it with a grain of salt.

Shift in Market Cap Distribution

(Market Cap Values from  coinmarketcap.com )

(Market Cap Values from coinmarketcap.com)

As we can see, the last few years have not been kind to Bitcoin’s historical dominance of the Crypto market, with many new projects taking off in the first half of 2017.

For many years, Bitcoin has held onto its “first mover advantage”. However, political issues surrounding the development of Bitcoin caused a slow down in advancement — creating a void for a multitude of altcoins to fill.

Result of “ICO Mania”

Over the past year this new crop of development has accelerated, with smart contract platforms taking many of the top spots. 2017 also saw the rise of “ICO Mania”, with dozens of new tokens and projects gaining investment from speculators looking for yet higher yields on their equity.

In the long term, Bitcoin will likely continue its decline in market share, as its older technology simply cannot compete with new offerings. As long as the political issues surrounding development continue, this will not change. Bitcoin made for an excellent proof of concept, but if it can’t adapt, it risks becoming the Myspace of the Crypto world.

Trading the Altcoin Boom

With altcoins making consistent gains in market share and the relative stagnation of Bitcoin development, Bitcoin is likely to drop from the top spot over the next couple of years (if not sooner) in favour of a newer generation Cryptocurrency.

This shift will likely see a huge change in the attitude and composition of the market as a whole, as everyone tries to pile into the new top coin and related technologies, so that they can ride the hype train.

As always, it is best to keep a level head and stick to your trading and investment strategies. A firm understanding of the underlying technology and use-case of a wide range of Cryptocurrencies will serve well in positioning yourself to take advantage of this shift.

There are a wide variety of projects which all have their use-cases

While smart contract focused Blockchains are some of the leaders at the moment, in the long term their value and success will be measured by the applications and businesses that run on top of them. Meanwhile, we shouldn’t forget the other uses of Blockchain, such as ledgers for supply chains, auditing or even Internet of Things devices. There are a wide variety of projects which all have their use-cases.

Cryptocurrency investments should be managed like a stock portfolio. You wouldn’t place your entire value into a single stock, similarly you shouldn’t be overly dear about a single coin. A well balanced holding of different projects across different areas can help hedge against black swan events in the market while profiting from the broad growth of Crypto as an asset class.

by Matthew Twee

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So You Want to Trade Crypto - Technical Analysis (Part 3)

A healthy balance between fundamental and technical analysis is necessary when trading any financial product, especially so in Cryptocurrencies, due to both the nature of the asset class and the types of traders in the market.

Technical Analysis of Crypto

Technical analysis in any market is broadly the same, you look for repeating patterns that can be exploited to increase your odds of success. This may be through moving averages, oscillators, support levels or more complex methodologies. All of which serve to reduce the noise in the price data to produce cleaner trading signals.

I’ve seen many arguments about whether or not technical analysis actually produces viable strategies, most of which boil down to the same misunderstanding as to what TA really sets out to achieve.

You will not create a system which can always predict where the market will go. In fact, it will not even be able to predict where the market is likely to go the majority of the time.

Instead, you are looking for system which will deliver signals whose success rate is justified by its risk:reward ratio. The signals may only be correct 10% of the time, but if its profits outsize its losses 10:1, it can still break even.

Technical analysis is not designed to predict the future, it is designed to allow you to understand risk and adapt accordingly. 

Some of the most simple and successful strategies can just take a position aligned with the long term trend and occasionally adjust exposure to keep downside risk at a comfortable level.

Due to the huge bull run Cryptocurrency saw in the past few years, it is important to make sure you back-test and verify strategies during long term downturns too, such as post 2013.

It would be easy to look at the bull run from late 2015 to the start of 2018 and conclude that the most effective method is to “buy the dip” at every opportunity. This only looks at half of the picture, a market always acts in cycles of bullish and bearish periods, whether that be the longer term trend or the short term pullback.

Methods such as the use of an “equity curve” can be used to produce an adaptive trading system, where different strategies will only be trading during favorable market conditions. You may even with to use long term moving average crosses to help differentiate between a pullback and the shift into a new bear/ bull market.

Types of Traders and Investors in Cryptocurrency

Due to the extremely new and highly technical nature of Cryptocurrencies, it has taken a long time for institutions to even acknowledge Crypto, let alone become involved in the market. This has left a market filled with experts in technology rather than the world of finance and trading.

This may be one of the contributing factors to the huge levels of historical volatility, as inexperienced traders and investors playing around with a highly speculative asset are prone to being caught up in the hype and fear cycles of market swings, adding yet more momentum and irrationality to the mix.

In trading, you don’t have to be the smartest in the market (although it can certainly help), simply keeping your head above the emotion of trading cycles and sticking rigidly to a trading strategy is one of the most important factors in success. Emotional trading drives us to FOMO into assets as they near the top before panic selling as it comes crashing back down.

This need for simple and objective decision making is one of the main benefits of algorithmic trading over manual trading. 

A trading bot will not get tired, stressed or emotional. It sticks to the rules of your tried and tested strategy.

Algorithmic trading can be particularly successful in Cryptocurrency due to the level of inefficiency still present. We’re not even past the point where retail traders can still profit from arbitrage strategies — imagine the numbers of other strategies that haven’t been tapped yet!

There are many trading strategies that will give you very limited results in more mature financial markets, such as basic moving average crosses. Every strategy has a limit to the effective capital it can support before it becomes infeasible due to diminishing returns. When everyone knows the same basic strategy, it becomes a race as to who can trade the signals first — and a retail trader can’t compete with a well funded institution.

Final Words

This effect is lessened as the time-period of the strategy increases, but it still pays to find a truly unique strategy, as you will have more opportunity take advantage of its capital limits, rather than fighting to be first on each signal.

by Matthew Tweed

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So You Want to Trade Crypto  -  Volatility (Part 2)

The Cryptocurrency market is extremely new and has yet to mature with greater regulation and institutional involvement, leading to sharp moves and high volatility as the market grows. This is a double edged sword — heaven for day traders looking for a bit of excitement while adding significant risk to those wishing to trade longer term.

Historical Volatility

Historical Volatility comparison of asset classes.

  • GVZVIX — CBOE Volatility index for Gold
  • VIX — CBOE Volatility index for the S&P 500
  • EUVIX — CBOE Volatility index for Euro/USD pair
  • BTCVIX — Bitcoin 30 day historical volatility (Bitcoin volatility on right axis as it’s so much higher)
Volatility_comparison.png

As we can see, there is a clear correlation between the volatility of more traditional traded assets, especially so during events such as the 2009 bounce. Bitcoin, on the other hand, seems to hold limited correlation to any of these other classes of products, even when factoring out the huge difference in average volatility.

Even the volatility of equities, currently at 13.4% from the VIX, is completely dwarfed by that of Bitcoin, coming in at 70% (down from 150% earlier in the year) — and Bitcoin is historically one of the less volatile Cryptocurrencies. Cryptocurrency markets represent a huge shift in gear, incurring more risk while giving the possibility of greater reward.

How to manage the volatility

Managing downside risk is an important part of any successful trading strategy, more so in the extreme volatility of Cryptocurrency. I personally prefer to define a hard stop-loss level prior to each trade, however a “soft” soft-loss/ exit parameter can be sufficient depending on the frequency of the trading strategy.

Very few Crypto exchanges cater to higher frequency trading at the moment, making faster trading strategies more difficult if not impossible in many cases. High frequency market making or scalping strategies are less concerned with hard stop-losses, due to the extremely short exposure to directional risk.

As hold duration for each trade moves into the span of minutes, absolute risk is still relatively limited in most cases. However, as in any market, there are occasional spikes in volatility — but these can be amplified too.

12th Apr 2018 — A move of $1200 — greater than the entire span of previous 2 weeks

12th Apr 2018 — A move of $1200 — greater than the entire span of previous 2 weeks

The risk:reward ratio of each trade is an important factor to a profitable trading system, along with the success rate 

If there is no plan for risk management, a black-swan event (such as the margin cascade seen above) could undo a week’s profits — or even wipe out a while account.

Moving into longer term strategies, such as swing trading

Volatility makes common strategies trickier. The simplest way to reduce the risk on a trade is to reduce position sizing on signals with lower confidence. For example, in forex trading, leverage is widely used to make efficient use of capital on relatively smaller movements. Meanwhile, it’d be madness to take that level of leverage on a Crypto swing trade. Risk doesn’t have to be any higher between asset classes, as long as volatility is adjusted for.

From active trading strategies into indexing, the Cryptocurrency market has provided huge returns over the past couple of years, with the total market capitalization rising from $18.3B at the start of 2017 to $613B by the start of 2018 — over 3000% growth. Unfortunately, past performance isn’t indicative of future returns — it would be impossible to continue at such a rate. Between Jan 2018 and Apr 2018, there was a pullback of 60% from which we’re still recovering.

An automatically re-balanced Cryptocurrency index fund can offer a simple but effective way to gain diversified exposure to the market, but be warned that you will have to be able to stomach the possibility of high drawdowns.

Volatility and Speculative Assets

As I mentioned in the first post of the series, Cryptocurrency cannot be analyzed in the same manner as traditional assets. You have no physical item or stake in a company to which the price is tied. The whole valuation of your token is based on the expectation of future demand, and is thus very susceptible to changes in sentiment.

A stock will be priced above the value of its dividends and assets to account for the expected growth in the business over time. However, during a market downturn, investors become less optimistic about the future as the economy constricts, driving down prices. The business itself may lose some revenue as consumers of the economy have less cash to spend, but there is still a functioning business with value.

Meanwhile, the whole success of Cryptocurrency relies on the ability of a project to attract businesses and developers to use the platform. Speculators are betting that the project will be successful in this goal long term, but there is no tangible asset to retain value if the project falters or market sentiment shifts against it.

This is one of the main reasons why the Cryptocurrency market remains so volatile compared to any other asset class

While this effect will reduce over time, as successful applications and businesses form in the ecosystem, it will not be a quick or easy process.

by Matthew Tweed

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So You Want to Trade Crypto  - Fundamental Analysis (Part 1)

This will be a mini-series looking into: 

  • the nature of Cryptocurrency trading and investment, 
  • the key factors which shift the markets, and
  • the important differences between Crypto and more traditional traded assets.

Fundamental factors of Cryptocurrencies vs traditional assets.

In terms of investing and long term trading, Cryptocurrency can be analyzed somewhere between a stock and a commodity.

It should be seen very much as a speculative investment — in the case of most Cryptocurrencies, you’re buying into a token which represents no stake in a company nor any voting rights, similar to a commodity. However, you’re not investing into a physical asset either. You’re simply betting that over time the use-case and thus demand for your token will grow, driving up the price.

Since price over time will be relative to the success of product, it can be analyzed similarly to an investment in a start-up. The main focus when looking at a token should be the team and their ability to deliver a working product that will actually be used. Not only this, you should also take
into consideration the use of the token itself within their product.

Will growth of the product actually lead to higher demand for the token, or is it simply tacked on as an after thought?

Additionally, Cryptocurrency projects seem to have a very different valuation split to previous technologies. A shift in valuation from the applications built on top of a protocol to the Blockchain protocol itself. No-one is investing in creating a new protocol layer for the internet, as the captured value comes from the applications and companies build upon it, such as Google, Facebook and Amazon.

On the other hand, Cryptocurrencies such as Bitcoin and Ethereum have market caps of $100B while very few applications have even been produced yet, let alone applications in wide use outside of the sphere of Crypto-enthusiasts.

This may be a symptom of a wider speculative bubble around the Cryptocurrency market as a whole, or simply a fact of the technology — requiring a sufficient valuation to be maintained to allow efficient flow of payments. That being said, we haven’t seen a truly successful product built
on Blockchain yet, maybe the Blockchain killer app will dwarf current valuations in the long term - only time will tell.

What to look for in projects

The core proposition of Cryptocurrencies over the traditional financial system is the fact that you don’t have to trust a third party. 

Trust-less decentralization

A transaction can be sent to anyone anywhere in the world without needing a bank or escrow account in the middle. This property of trust-less decentralization should be the backbone of any good Cryptocurrency.

However, simple transactions are a very basic and limited use-case, which has been offered by Bitcoin since its first release in 2009. A project has to offer a unique and useful advancement on basic Blockchain technology. Many new Cryptos are becoming “smart contract platforms”.

Smart contracts are pieces of code which can be run on top of the Blockchain, in the same decentralized and trust-less manner as payments. This allows the easy creation of full applications on top of the basic transaction layer, providing much wider uses for businesses and developers.

Longterm Scalability

Longer term, one of the fundamental issues that needs to be solved in Blockchain technology is that of scaling. Since the basic Blockchain model relies on all connected nodes to process every transaction, it quickly runs into limitations of how fast a payment can be distributed and verified, not to mention that of storage.

While there are many projects out there which claim “1,000,000 transactions per second”, almost all of these approaches are either impractical in real life or break the fundamental premise of a Cryptocurrency being trust-less and decentralized. Its relatively easy to achieve “1M tps” when running high powered servers in the same location that all have implicit trust.
However, in reality, flow of transactions is limited by latency between nodes around the globe and the fact that we shouldn’t rely on a central node for verification — otherwise why don’t we just use a regular bank?

The scaling issue is being progressed on with such technologies as “sharding” or a change from a traditional Blockchain to a “DAG”. In the long term, these are the kind of advancements which will achieve reliable scaling, rather than misleading promises from certain projects.

Product Value w/ Blockchain

Finally, and most importantly, you should consider who the Cryptocurrency is developed for and whether it is truly a useful product to them. Many have tried applying Blockchain in a misguided manner to any and all systems to join in with the hype. However, unless you need the very specific properties of a decentralized and trust-less system, Blockchain is no more than a glorified
database.

Final thoughts

While there is innovation left and right in the Cryptocurrency space, caution is still strongly advised. Out of the over 1500 coins and tokens in existence, only a handful of projects are likely to survive. While the vast majority will fail in the long run, due diligence pays off — helping us sift through the rubbish to find those which have a chance at leading the revolution of decentralized finance.

by Matthew Tweed

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