Billions of dollars are pouring in. How are hedge funds changing the cryptocurrency landscape?
Pure hedge funds are not bound by such regulatory red tape. Instead, they are considered a high-risk, high-reward investment tool.This article is from Babbit, author: Glendon.
Since the market crash in March 2020, hedge funds have flooded into the world of cryptocurrency in search of profits.
Currently, companies like Galaxy Capital, Grayscale, and Pantera dominate the cryptocurrency hedge fund market. These funds collectively manage about $60 billion in disposable capital. Their clients want exposure to the world of Bitcoin and Ethereum without having to buy and hold Bitcoin themselves.
Given that Bitcoin's price has doubled in the past 12 months, this is not surprising, but interestingly, the behavior of this group of investors is changing the landscape of cryptocurrency. While many early cryptocurrency investors viewed purchasing cryptocurrencies as a way to support their favorite ecosystems and benefit from price increases, hedge funds clearly do not share this loyalty when it comes to profits.
According to Eurekahedge data, the return on cryptocurrency hedge funds in the first quarter of 2021 was 116.8%, surpassing Bitcoin's return of 104.2%. How did they achieve this? By betting, in some cases driving Bitcoin prices down and profiting from price movements. As hedge funds grow in size, their ability to influence relatively small markets in terms of circulating supply also increases.
What are cryptocurrency hedge funds?
While most short-term traders bet their money on predicting Bitcoin prices, hedge funds are different. Hedge funds are essentially fund managers targeting ultra-high-net-worth individuals and institutional investors. To invest in a hedge fund, the threshold typically requires a net worth of $1 million (excluding the house) and an annual income of about $300,000—this amount varies by the investor's region.
After that, these fund managers have complete autonomy in choosing their investments. The most famous example might be Michael Burry, the hedge fund manager portrayed by Christian Bale in the movie "The Big Short."
Burry had complete control over investors' funds and once bet $1 billion on the collapse of the real estate market. Of course, in this case, he was right. But his investors were not pleased, as they had little power to stop his actions.
However, if Burry managed a mutual fund, he would be regulated by the U.S. Securities and Exchange Commission (SEC), his investment strategies would be restricted, and he would have to comply with regulations when reporting his actions. In contrast, he can freely engage in unrestricted trading. Roles like Burry's are increasingly managing cryptocurrency hedge funds.
Cryptocurrency hedge fund managers differ from other financial entities, such as Grayscale's Bitcoin Trust. The company has created a digital currency investment product that individual investors can buy and sell in their brokerage accounts. It is registered with the SEC and regularly shares its reports with the commission.
Pure hedge funds, on the other hand, are not bound by such regulatory red tape. Instead, they are considered high-risk, high-reward investment vehicles, making them unsuitable for the faint-hearted.
Lyxor Asset Management states that as more hedge fund managers join the digital currency space, the simple long bets on assets like Bitcoin, Ethereum, or Ripple are giving way to more complex asset-linked strategies, including swaps, futures, and options indexed to cryptocurrencies, as well as bets on revenues generated by related technologies.
With this increase in complexity, the cryptocurrency landscape is also undergoing some changes.
Different types of investors
The composition of hedge funds is important because it highlights their purposes and methods when entering the market. According to a report published by PwC, the composition of these cryptocurrency hedge funds is:
Quantitative (48%)—funds that use "automated" trading rules rather than having fund employees identify and assess.
Discretionary long (19%)—long-term investments that believe asset prices will rise.
Discretionary long/short (17%)—a conversion strategy that allows hedge funds to go short and long simultaneously based on market conditions.
Multi-strategy investment (17%)—the combination of the above.
Among these funds, the vast majority trade Bitcoin (97%), followed by ETH (67%), XRP (38%), LTC (38%), BCH (31%), and EOS (25%).
About half of the cryptocurrency hedge funds engage in derivatives trading (56%) or are active short sellers (48%). Derivatives trading is used by traders to speculate on the future price movements of related assets without having to purchase the actual assets themselves, in hopes of making a profit. Meanwhile, short sellers take a short-term investment perspective, deliberately betting that cryptocurrency prices will fall.
Volatility is a hedge fund's friend
Bitcoin's price volatility is an indicator of the degree of price fluctuation of an asset. For most of 2020, Bitcoin's price volatility hovered around 2.5%. However, since the bull market began, this index has started to rise, peaking at 6% in March and April of this year.
Former Goldman Sachs hedge fund manager Raoul Pal said, "Without this volatility, you can't have a 230% compound annual return. In this case, volatility is your friend."
This is the appeal of cryptocurrency to hedge funds that crave risk, as they thrive on market fluctuations.
It is well known that demand for Bitcoin is speculative and emotional, rather than necessarily based on fundamentals, such as the adoption of virtual currencies for everyday payments. Additionally, supply can be artificially squeezed, not limited to algorithms.
This is why hedge funds are rushing in. One of Europe's largest hedge funds, Brevan Howard, announced last month that it would allocate a portion of its $5.6 billion fund to purchase Bitcoin. Since then, it has joined the ranks of companies like Galaxy Digital and Tudor Investment Corp, which have quietly bought hundreds of millions of dollars worth of Bitcoin, effectively squeezing supply.
According to research firm Chainalysis, 60% of Bitcoin's supply is hoarded, while 20% is "lost" or neglected.
Glassnode reports that as more hedge funds enter the market, this squeeze is further exacerbated. The tighter the supply, the easier it is for prices to fluctuate. Hedge funds are well aware of this.
Dan Morehead, CEO of the first U.S. Bitcoin hedge fund Pantera Capital, wrote in an investor note, "Cryptocurrency is starting to trade independently of other assets. While most asset classes are down, cryptocurrency is rising… Would you rather put your savings in Lehman Brothers in 2020 or in tokens you control?"
Due to this volatility, hedge funds have been able to leverage their positions to create new income opportunities. The primary way they do this is by acting as market makers. How does this work?
Hedge funds look for discrepancies between the spot price, the current price of assets like Bitcoin, and the value of derivative contracts that expire months later. This is often referred to as basis trading. For example, at the time of writing, Bitcoin's price is about $55,000.
However, there are futures contracts, such as those from the CME Group, predicting that Bitcoin's price will reach around $60,000 in July.
A hedge fund buys Bitcoin at the spot price and then sells futures for July, meaning that if Bitcoin drops, the derivative contracts will increase in value. By doing this, a so-called "spread" is created between today's price and tomorrow's bet. As these spreads widen over time, they can generate substantial returns.
This trading is also beginning to seep into Ethereum, pushing its price to new highs this month, thanks to investors using similar strategies to achieve 700% returns.
As previously mentioned, hedge funds are risky, and if one of the market makers faces a margin call, the risks of this market-making game become very real.
This situation has occurred in the fiat market, when hedge fund manager Bill Hwang's investment firm Archegos went bankrupt after a margin call, dragging down several major banks. When the dust settled, one of the world's largest banks, Credit Suisse, suffered losses exceeding $5 billion.
As Bitcoin's volatility increases, time will tell whether cryptocurrency can sustain hedge funds' risk appetite.
