The relationship between hedge funds and crypto
Marios Roussos 09:22 - 31 July 2023
Hedge funds around the world are showing confidence, but there is also some hesitancy, creating a divide within the investment world, with traditional hedge funds and those that only operate with crypto-assets, displaying significant differences in their position and exposure.
A report by PwC Global shows that, on the one hand, traditional hedge funds are hesitant, and on the other crypto hedge funds, remain certain in their strategies despite market turmoil in 2022.
Before looking in detail at the main findings of the report, it is worth mentioning that several investment funds operate or have a presence in Cyprus, with the Central Bank of Cyprus recording approximately 450 (click here to view them). Most of them fall into the traditional part of investments, however, some of them have also added cryptocurrencies to their portfolio.
A comprehensive picture
The PwC Global report presents the findings of research conducted in Q1 2023 by CoinShares, which focuses on actively managed crypto hedge funds that trade or invest in liquid, publicly traded crypto assets. -assets) and other financial instruments.
This year's survey differs from previous years as significant changes were made to the types of questions asked of crypto hedge funds. The aim of the research is to identify the main issues in the field that concern crypto hedge funds and to provide a comprehensive picture of the field.
The main findings of the report note a decline to 29% in 2023, from 37% last year, in the number of traditional hedge funds investing in crypto-assets. As the report points out, the value proposition and long-term viability of cryptoassets appears to be strong despite the decline.
It is further emphasised that no traditional hedge fund plans to reduce its exposure to cryptoassets in 2023, instead, it will either increase its holdings or maintain its position, regardless of market volatility and regulatory barriers that have generally weakened trust in the property sector.
The report also finds that over the past year, the average allocation to crypto assets managed by the traditional hedge funds surveyed rose from 4% to 7%.
The consecutive interest rate hikes by the SEC in the US, and the intense pressure exerted by the US authorities on the crypto space, have led traditional hedge funds (23% of them) to re-evaluate their strategy regarding this part of their investment portfolio. Furthermore, 12% of crypto hedge funds are considering relocating from the US to crypto-friendly jurisdictions.
When asked about their plans to increase their exposure, more than a third (37%) of traditional hedge funds that do not invest in cryptoassets say they are “curious” but are waiting for further asset maturity—an increase from the 30% reported last year.
In contrast, 54% of respondents said they were unlikely to invest in cryptoassets in the next three years, up from 41%.
Another point that stands out in the report is that 93% of crypto hedge funds expect the capitalisation of cryptoassets to be higher at the end of 2023 than in 2022.
Also, 31% of traditional hedge funds see the process of creating tokens (tokenisation) as the biggest opportunity for 2023. 25% of traditional hedge funds—including those not currently investing in crypto—say they are exploring its part tokenisation.
The investment spring
So what element are crypto hedge funds, as well as traditional ones, looking for more in order to join or engage more with the world of crypto? The answer is in the words 'transparency' and 'regulation'.
According to the report, Crypto hedge funds, those that invest exclusively in crypto-assets, require greater transparency and regulation. Especially after the collapse of major platforms and exchanges in 2022, in order to mitigate risk for investors and increase confidence in the asset class.
These demands include mandatory asset segregation, which is highlighted by 75% of all survey respondents, mandatory financial audits (62%) and an independent statement of reserves (60%).
Liquidity - which was once considered the dominant factor when choosing to trade - is now considered as important a parameter as the safety of the platform. Specifically, 21% of crypto hedge funds surveyed chose it as the most important element—up from 10% last year.
On the other hand, traditional hedge funds with exposure to crypto assets have also expressed concern about the evolving regulatory environment - mainly in the US - with 23% noting that it will have a significant impact on them or lead them to reconsider their viability of their exposure to cryptoassets.
Just over half (54% of traditional hedge funds not currently investing) confirmed that they would change their approach and become more interested in the asset class if industry hurdles and uncertainties were resolved.
This figure is up 29% from last year. In contrast, crypto hedge funds seem relatively less troubled by these regulatory developments, with only a third expecting higher legal and compliance costs, and 12% noting that the current regulatory environment in the US may lead them to be more the cryptographic jurisdictions.
With an eye on developments
Whether they are for, against, or thinking about it, hedge funds are closely monitoring any developments in the cryptocurrency space, with the goal of taking advantage.
Survey respondents fresh in their minds were the events of the cryptocurrency market—including the collapse of some crypto service providers—in 2022, which were overwhelmingly viewed as negative. Regarding traditional hedge funds, 57% said their outlook was negatively or strongly negatively impacted. Of these hedge funds, 70% manage more than $1 billion.
More than two-thirds (71%) of traditional hedge funds surveyed do not currently invest in cryptoassets, rising to 63% in 2022. The top four reasons for not investing in cryptoassets among traditional hedge funds—according to last year's responses—are:
Customer backlash or reputational risk;
Lack of regulatory and tax clarity,
Inadequate or unreliable third-party data and
Outside the scope of the current investment mandate.
In contrast, crypto hedge funds surveyed appear undeterred by market volatility, with half (50%) noting that it has had any impact. Nearly a third (27%) feel positive about the current market, likely as a result of greater investment opportunities as a result of the broad decline in cryptocurrency valuations.
In light of last year's events, 53% of crypto hedge funds reported updating their counterparty risk management processes.
A matter of strategy
As we mentioned, hedge funds tend to change their strategy depending on market developments.
"General diversification" or "long-term outperformance" are the most common reasons given by traditional hedge funds for including crypto assets in their portfolios.
More than half (54%) of traditional hedge funds currently investing in cryptoassets intend to maintain the same capital levels. 46% say they plan to deploy more of their funds in the asset class by the end of 2023 (up from 67% last year).
The vast majority (91%—up from 67% last year) of traditional hedge funds with exposure to cryptoassets say they have invested in the two largest cryptoassets by market capitalisation and trading volume—Bitcoin and Ethereum—indicating a shift to large-cap currencies and reflecting a more conservative investment approach.
None of the respondents reported investing in non-tradable tokens (NFTs)—compared to one in five traditional hedge funds in 2022—a significant decline from the peak of NFTs in 2021.
Among the crypto hedge funds that participated in the survey, the Market Neutral strategy remained the most popular strategy, although its use decreased from 30% to 20% compared to the last survey.
In contrast, the use of Discretionary Long Only Crypto increased from 14% to 19%, while the use of Quantitative Long/Short Crypto decreased from 25% to 18%.
This development likely has more to do with the current market environment than a longer-term change in overall trading strategies. All crypto hedge fund strategies—with the exception of Market Neutral—posted losses, the report notes.