Why asset managers should care about privacy
Table of Contents:
Proprietary investment strategies have always been among the most closely guarded secrets in finance. Traditionally, these strategies were protected by the nature of how trades are transacted, giving brokers and financial institutions the ability to leverage their proprietary strategies to their advantage. The rise of blockchain and decentralized finance (DeFi) has introduced a new level of transparency. This openness, while fostering trust, poses significant risks as it exposes sensitive trading patterns and strategies to public scrutiny.
Exposure of investment strategies
In traditional finance, investment strategies are often the real value of what is being provided to the client or fund. Hedge funds, asset managers, and brokers invest significant resources into developing proprietary trading strategies that provide them a competitive edge. However, in the realm of blockchain and decentralized finance (DeFi), the inherent transparency of public ledgers poses a significant threat to these proprietary strategies.
Every transaction on public blockchains like Ethereum and Bitcoin is recorded in a publicly accessible ledger. While this transparency promotes trust and verification, it also means that anyone can analyze transaction data to uncover trading patterns and strategies. This exposure can be detrimental to asset managers, brokers and financial institutions that rely on the confidentiality of their trading methods.
Blockchain analytics tools such as Nansen have made it increasingly easy to scrutinize and interpret blockchain data. Nansen, for instance, labels and analyzes millions of wallet addresses, providing insights into the activities of various market participants. These tools can track large transactions, identify trends, and even link transactions to specific entities. For asset managers, this means that their trades can be monitored, virtually in real-time. It’s possible that their strategies could be reverse-engineered by competitors or malicious actors.
When proprietary trading strategies are exposed, the risk of financial loss increases substantially. Competitors can replicate successful strategies, diluting competitive advantage. Worse still, malicious actors can engage in counteracting strategies such as front-running, where they anticipate trades and execute their own trades in advance to profit from the price movements triggered by the asset manager’s transactions.
For example, if an asset manager plans to purchase a large amount of a specific cryptocurrency, front-runners can detect the initial buying activity and buy the cryptocurrency themselves, driving up the price. By the time the purchase is complete, the price has increased, causing the asset manager to pay more than intended. Once the asset manager’s purchase is complete, the front-runners can sell their holdings at a profit, leaving the asset manager at a disadvantage.
In addition to financial losses, the exposure of investment strategies undermines the trust and credibility of asset managers and other financial professionals. Clients expect their asset managers, brokers and other advisors to maintain the confidentiality of their strategies and transactions. If asset managers cannot guarantee this privacy, they risk losing clients to non-crypto or private alternative investments.
Front-running
One of the most significant issues that comes with transparent blockchain ledgers is front-running. Front-running occurs when malicious actors observe patterns that suggest an impending transaction is coming and execute their trades ahead of it to capitalize on the expected price movement. For example, if an asset manager intends to buy a large amount of a particular token, front-runners might detect the client’s typical pre-cursory activity and purchase the cryptocurrency first. This buying activity drives up the price, and by the time the transaction is completed, they end up paying a higher price than anticipated. The front-runners then sell their holdings at the increased price, profiting from the transaction while the portfolio suffers from the inflated costs.
This lack of privacy not only results in financial losses but also erodes your ability to execute effective trading strategies. With open blockchains, competitors can analyze trading patterns, replicate successful strategies, or even devise counter-strategies that exploit your clients’ positions. This constant surveillance can lead to a loss of competitive edge, as asset managers, brokers and others are unable to maintain the secrecy of their clients’ strategies.
MEV Bots
MEV (Maximal Extractable Value) bots underscore the importance of privacy in the trading strategies used by asset managers. These bots are sophisticated algorithms that monitor blockchain networks for pending transactions and exploit opportunities to extract additional value. By analyzing transaction data in real-time, MEV bots can execute trades such as arbitrage, front-running, and sandwich attacks, allowing them to profit from price discrepancies and transaction sequencing. The transparency of blockchain networks, while beneficial for trust and verification, makes it easier for these bots to operate, emphasizing the necessity of maintaining transaction confidentiality for all users, but asset managers who engage in high volume or high frequency trades on behalf of clients may be at higher risk. According to Flashbots, MEV bots extract around 500M USD off Ethereum alone per year.
Options are limited
As of this writing, your options as an asset manager are limited if you wish to preserve your privacy and that of your clients. Many of today’s best-known privacy-enhancing technologies can create regulatory issues. For example, the virtual currency mixer Tornado Cash was infamously sanctioned by the U.S. Treasury and faced investigations and actions from other regulators around the world, due to its involvement in illicit activities. Regulators recognize that there is an opportunity for privacy-enhancement for DeFi trading, and are calling for innovations that can simultaneously preserve the privacy of users while also enabling AML/CFT obligations. It is worth noting that Panther Protocol is being built to address this challenge.
Panther Protocol
Panther’s cutting-edge decentralized privacy protocol will empower enterprises with customizable, private operating environments to manage portfolios and assets. Leveraging Zero-Knowledge proofs and a proprietary Multi-Asset Shielded Pool (MASP) design, Panther Protocol will deliver a suite of features that provide unparalleled privacy, security, and compliance support for public on-chain transactions.
Benefits For Asset Managers (In development)
- Private Portfolio Management Supports confidential client portfolio management, ensuring transaction details and holdings remain private, maintaining investor confidentiality.
- Custom Investment Strategies Tailored investment access with specific DeFi applications and asset lists, optimizing returns while adhering to client risk profiles.
- Compliance and Reporting Encrypted data storage for transactional details, simplifying compliance and reporting processes with secure transaction detail exports.
Conclusion
The transparency of blockchain technology presents both opportunities and challenges for asset managers and financial institutions. While it promotes trust and accountability, it also exposes proprietary strategies to potential competitors and malicious actors. This exposure necessitates that asset managers take steps to enhance their privacy measures and stay vigilant against threats like front-running. Navigating this landscape requires balancing the benefits of blockchain transparency with the need to protect confidential trading strategies.