HEDGEWEEK
I N S I GH T R EPO RT
Institutionalisin g Digital Assets: POWE R I NG TH E H E D G E F U N D C RYPT O SUR G E J A NUARY 2022
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IN S IG H T R E P ORT
KEY FINDINGS Digital assets are now a major area of focus for hedge fund managers Digital assets-focused hedge fund strategies generated triple-digit returns last year, outperforming all other hedge fund sub-sectors in 2021. Roughly a third of hedge fund firms now plan to roll out a digital assets-focused strategy in the next year, but launch costs remain high. Concerns over regulatory oversight continue Regulation of cryptocurrencies and blockchain remain a work-in-progress, with global co-ordination among different regulators seen as a key challenge. Hedge funds believe regulation is the biggest obstacle to launching a digital assets strategy. Advances in combating counterparty and custody risk will help build institutionalisation Investors want to ensure safe custody and security of assets in exchanges before they step into crypto. Custodians and other service providers are responding with a range of products which look to replicate those in traditional assets classes and markets in order to assuage allocator concerns. Crypto’s ESG credentials remain in sharp focus Amid the rise of sustainable investing, bitcoin’s energy consumption remains a live issue among those investors and managers keen to tap into crypto’s burgeoning investment opportunities while also strengthening their green credentials. Institutional investor interest is building Institutional investors are steadily realising the potential of digital assets as a viable and successful part of a diversified investment strategy, with cryptocurrencies, NFTs and blockchain infrastructure piquing allocator interest. Research shows asset owners are taking a more positive stance, pointing to strong capital growth, clearer diversification benefits, and improving custodial services in crypto.
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Performance
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New launches Managers
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Regulation Custody ESG
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A BANNER YEAR: L AYI N G T H E FO U N DAT I O N S FO R A C RYPTO B O O M
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anticipated triple-digit growth thanks partly to a hefty December sell-off of some 20 per cent, it nevertheless advanced more than 60 per cent over the past year. Further afield, the market began to decouple from the long-running dominance of core assets like BTC and ETH, as industry focus turned to emerging opportunities in expanding areas such as NFTs, DAOs, Layer 1 protocols and decentralised finance (DeFi). “In 2017 and 2018, and even prior to that, bitcoin was the dominant asset – it had north of 90 per cent market cap dominance. Now that’s completely changed,” says Samed Bouaynaya, portfolio manager, Altana Digital Assets
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companies and other distributed ledger technologies – advanced 198.5 per cent between January and December 2021. The surge was powered by strong double-digit returns in the first four months of the year, which built on 2020’s 189.3 per cent gain. The stellar performances reflect the ongoing march of digital assets, which enjoyed a banner year across its various constituent components, marking what industry participants see as a “validation” of this rapidly-evolving but often misunderstood asset class. Both bitcoin and ethereum reached all-time highs last year, with bitcoin the world’s foremost cryptocurrency – at one point topping USD67,000. Though it fell short of a widely-
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ear-end analysis by Hedge Fund Research shows managers investing in cryptocurrencies outflanked all other hedge fund strategies between January and December 2021. HFR’s Cryptocurrency Index – which tracks the investment performance of hedge fund strategies trading bitcoin and other digital currencies long and short – scored a 214.5 per cent annual gain, with managers withstanding a 20 per cent loss in December to rise above the previous year’s 193 per cent advance. Meanwhile, HFR’s Blockchain Index – a measure of the gains and losses made by those funds trading both cryptocurrencies and digital assets infrastructure, such as blockchain
Funds trading crypto show stellar performance in 2020/2021
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Despite sharp price shocks, the upward momentum in cryptocurrencies and the broader digital asset sector has heralded eye-catching returns for hedge funds over the past 12 months, underlining the asset class’s status as a key area of focus in alternatives
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As an asset class, for the first time we became a multi-trillion-dollar industry
Fund at Altana Wealth, a multi-asset investment manager which entered the cryptocurrency sector in 2014. “The game has shifted towards obviously more use-case tokens, and we are seeing bitcoin dominance shifting downwards below 40 per cent; currently it stands at around 35-38 per cent.” “As an asset class, for the first time we became a multi-trillion-dollar industry,” Anatoly Crachilov, founding partner and CEO at London-based Nickel Digital Asset Management, says of last year’s growth, noting that crypto remains the best-performing asset class across one, three, five and tenyear horizons. “At the beginning of 2021, the whole crypto industry was at USD780 billion. Now, we are over USD2 trillion, even touching at some stages during the year the USD3 trillion mark.” Meanwhile, total value locked (TVL) – a key metric for measuring the growth of DeFi activity on Ethereum – topped more than USD100 billion. “That’s an important indication that the liquidity and capital is flowing in the DeFi space,” Crachilov adds. Other key growth metrics include
the surge of the stablecoin sector, which grew some 388 per cent, from almost USD30 billion at the start of 2021 to USD140 billion. Meanwhile, the market for non-fungible tokens (NFTs) – which are often tied to artwork and other collectables beyond the financial services arena – has swelled to some USD7 billion, according to JPMorgan analysis. UniSwap, the decentralised trading platform, saw its cumulative market volumes top USD1 trillion, reflecting the growing importance of decentralised exchanges as key players in the digital asset landscape.
DAOs go mainstream
Another burgeoning area of interest – decentralised autonomous organizations (DAOs) – came into mainstream view when ConstitutionDAO, which was formed to purchase an original copy of the US Constitution, was outbid at auction by US hedge fund titan Kenneth Griffin, founder, CEO and co-CIO of Citadel, who paid USD43.2 million for the document. DAOs, which are comparable to crowdfunding communities, are built
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around crypto assets, blockchain technology and smart contracts, pooling and deploying capital in ways similar to venture capital or investment firms. “Structurally you will see far greater growth coming from DeFi because it’s innovation-driven,” remarks Crachilov. “Last year was a good validation of that point because while bitcoin has grown by 60 per cent, which is very respectable, other challengers in the DeFi space have increased by multiples, and that’s just a reflection of innovation.” Bouaynaya adds: “In terms of market adoption, we have 200 million users now using the sector across multiple chains, trying obviously first of all to exchange their tokens in decentralised exchanges, but also trying to chase yield and farm yields in what we call yield aggregator protocols. We also have derivatives exchanges now. It’s so much more diverse now in terms of utilisation and use cases – it’s no longer the 2017-18 era where people were afraid of the technology.” Reflecting on crypto’s landmark year, Lisa Fridman, president and
PAU L F R O ST- S M I T H , FOUNDER AND CEO OF CORINTHIAN DIGITAL ASSET MANAGEMENT
“2022 is going to be a challenging year for crypto, and having profitable strategies in 2022 is going to be more difficult than it’s been in the preceding three years. There are winds of interest rises coming from the Fed, inflation is soaring, and at the end of the day cryptocurrencies do not inherently pay yield. So as soon as you have rising interest rates, a non-interestbearing commodity may face challenges.”
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HFR Cryptocurrency Index Performance
ASEN KOSTADINOV, COPPER
2021
HEAD OF STRATEGY,
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“Investors are looking for new asset classes now because, in the macro context, traditional views of portfolio construction are challenged. In the current interest environment, bonds do not provide as good diversification as in the past. Hence, investors need other instruments and other assets that they can trade, and crypto and bitcoin have turned out to be a good alternative for them. That’s driving this whole interest, and then in turn that’s driving the service provision in this space and the development of the market.”
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co-founder of Quadrata, and former partner and global head of research at PAAMCO Europe, draws parallels between the growth in investment opportunities in crypto today and the meteoric rise of the hedge fund industry 20 years ago. “It is similar to the environment in which I started my career in the early 2000s, where a number of institutions were quite intrigued by the tools that hedge fund managers could be using to achieve the returns they were targeting,” Fridman says. “Those institutions did not always have dedicated internal resources to
fully underwrite hedge fund exposures. Today, as well, what we see is that there is quite a bit of interest from institutions in blockchain and DeFi. However, there is active dialogue, knowledge sharing and an educational aspect to those relationships, where institutions are gaining more and more capabilities in this space. We expect that cryptocurrencies, blockchain technology and decentralised finance exposure will become a meaningful part of portfolios going forward if compliance-aware framework is created and data issues are addressed.”
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READY TO LAUNCH? COSTS AND COMPLEXITY UNDER THE SPOTLIGHT Roughly a third of hedge fund managers are considering launching a digital assets-focused strategy over the next 12 months, underlining the depth of appetite
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ith such a sizable chunk of the hedge fund community keen to step into this fastpaced, constantly-evolving sector, the scale of the challenges confronting prospective market entrants are coming into ever-sharper focus, with those having already made the splash flagging up an assortment of costs and complexities posed by the 24/7 nature of crypto. Hedgeweek quizzed more than 50 alternative investment firms, managing a range of hedge fund strategies across the globe, on their interest in digital assets, as well as on the perceived barriers and risks within the market. The survey findings show around 30 per cent of the sample are preparing to roll out a digital assetsfocused fund in the next 12 months, with a further 7.5 per cent “possibly” launching within the same timeframe. The data also hints at the growing
interest in crypto among allocators and the extent of investor inquiry, with close to 39 per cent of respondents said they have been asked by allocators to offer a digital assets vehicle. Against this backdrop of surging interest on both sides of the manager-investor dynamic, and the prospect of a slew of new participants in the coming year, crypto-focused hedge funds say the process of successfully launching and running a crypto-focused hedge fund can be a challenging and sometimes painful exercise.
Vast space
Indeed, one in five participants in Hedgeweek’s study pinpointed launch costs and complexity as the greatest obstacle to launching crypto strategy currently. One respondent who said they were “possibly” launching a fund
this year described digital assets as a “vast space with a lot of new knowledge to be learned.” Another manager, not planning to enter the market, fears a “loss of credibility from doing something quite different from core strengths.” Those crypto managers on the front-line point to higher startup costs, with the asset class demanding a sizable technology spend, along with the ability to source service providers that offer crypto capabilities, and find the talent and expertise within the sector. “The overhead costs that a crypto hedge fund has are significantly higher compared to a more traditional, say, long/short equity fund which is based on fundamental analysis,” says Carlos Betancourt, founding principal at New York-based BKCoin Capital, who flags up tech costs as a key issue. The 24/7 round-the-clock nature of
Do you plan to launch a digital assets hedge fund strategy in the next 12 months?
Yes 31%
No 61% Possibly 8%
Source: Hedgeweek readers survey, January 2022
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The first thing you notice when you come into crypto is that many of the things you took for granted in traditional markets don’t actually exist here
digital assets mean risk management systems have to be adapted to run across multiple venues and time-zones, which can be a major step-change for even the most aggressively-traded hedge fund strategies. “Right off the bat, if you think about exactly what it is that we are doing, if we’re not investing heavily in technology, we effectively become obsolete very quickly,” Betancourt tells Hedgeweek, adding how the firm has “poured a ton of money” into its tech capability since launching in 2018. BKCoin founding principal Kevin Kang says: “We’re competing against some of the biggest high frequency trading firms now, so some of the upgrades that we’ve been making on the tech fund are very costly.” Others point to significant premiums for both auditor and administration services, while the service providers themselves face hurdles in managing and maintaining crypto hedge fund services in what is a rapidly-developing environment. “The first thing you notice when you come into crypto is that many
of the things you took for granted in traditional markets don’t actually exist here,” says Asen Kostadinov, head of strategy at Copper.
Discovery mission
“Custody is a fairly obvious thing; however, you also need a lot of other things. At the very least you need a law firm; you need to assess where the best jurisdiction is in which to set up the fund. You need to find technical providers to help you get into the market, for example, order management systems. How do you actually connect to the different exchanges? How do you get the data that you need? “All of these things are generally easily solved in traditional finance. But here you need to go on a discovery mission, and these are some of the questions we are being asked by clients who are new to this space.” Meanwhile, Anatoly Crachilov, founder and CEO of Nickel Digital Asset Management, points to an assortment of other challenges facing prospective crypto hedge fund launches. These include the
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sizable cost and limited availability of directors’ insurance, while opening bank accounts (“it can be a sixmonth struggle”), and obtaining exchange accounts (“a demanding process which is not what it used to be five years ago”) can be equally difficult. “You have new trading venues and new instruments being launched which the service providers adapt to, and that is not an easy process,” Crachilov says. “Once you establish the relationship with an exchange, if you are an aggressive or high-frequency trader, you may need to rewrite all the APIs, as you may need a different latency on APIs,” Crachilov says. “Portfolio management systems, order management, execution systems, exchange access – these are all things that are taken for granted in traditional finance that generally either have to be heavily adapted from other systems – say from commodity trading in order to handle crypto – or have to be built from scratch,” he adds. “Those are the challenges that hedge funds are confronting today.”
A N A T O LY C R A C H I L O V , FO U N D I N G PA RT N E R AND CEO, NICKEL DIGITAL ASSET MANAGEMENT
“As the opportunity set increases and volumes of this market skyrocket, and the liquidity pool expands, that will lure a number of traditional hedge funds into crypto, given that the margins are much healthier. They will transition, but we can see how for many of them it’s going to take time to adapt. There is at least a six to 12-month period which requires these operations to come to life for many of them.”
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HOW HEDGE FUNDS ARE TAPPING INTO A W E A LT H O F C R Y PT O O P P O R T U N I T I E S While the volatile nature of cryptocurrencies – coupled with the still-unfolding shape of regulation – has kept some investors on the sidelines, outsized returns offered by digital assets continue to draw in hedge fund managers
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long with a slew of smaller, crypto-native managers, there’s a growing list of established, brand-name firms from both sides of the Atlantic stepping into the space. Among the eye-catching roll-call of hedge fund heavyweights is Brevan Howard Asset Management, which last year expanded its focus both with the launch of BH Digital, a new division dedicated to managing cryptocurrency and digital assets, and through its Brevan Howard Master Fund, which opened to crypto assets in May 2021 also saw US hedge fund veteran and longstanding digital assets evangelist Bill Miller’s long-running flagship fund move into the market. Paul Tudor-Jones, the macrofocused founder of Tudor Investment Corp, and former Fortress Investment Group manager Michael Novogratz, who now runs cryptocurrencyfocused asset manager Galaxy Investment Partners, are also
long-standing crypto advocates advocates, along with other highprofile industry veterans including Stanley Druckenmiller, Ray Dalio, and Anthony Scaramucci.
Exposure
Last year’s third annual ‘Global Crypto Hedge Fund Report 2021’, published jointly by PwC, Elwood Asset Management and the Alternative Investment Management Association, found roughly 150-200 active crypto hedge funds, with four out of five (81 per cent) launched between 2017 and 2020, spread across a range of discretionary longonly, discretionary long/short, multistrategy and quantitative investment strategies. One in five (21 per cent) of traditional hedge fund managers also actively invest in digital assets, according to the data, with the average percentage of their total hedge fund AUM invested standing at 3 per cent.
WHAT’S YOUR
STRATEGY? PAU L F R O ST- S M I T H , FO U N D E R A N D C E O, CORINTHIAN DIGITAL ASSET MANAGEMENT
“We are thematic long/short – that’s our core portfolio. Outside that, we trade a whole range of market neutral, derivative-type opportunities that surface from time to time. We describe ourselves as ‘quantamental’ – we have a fundamental team and then we have a quantitative team. We talked to our investors and asked them whether they wanted us to be pretty safe in crypto-land, or if they were looking to us for a real performance diversifier. They all, without exception, said they wanted us to go after a minimum of 35 per cent a year. That’s what they’re looking for. My view is that there is a risk/return threshold for investing in crypto. It’s very different from just looking at what the basis is between futures and spot and trading it for three months and coming out on the right side. Given the spreads that are charged by exchanges, given the inherent costs in the market, given the custody issues, I think you have to be making 30 per cent plus to be credible. If you’re not doing that, then investors who are putting money with you may be better off in a traditional hedge fund, probably because they don’t carry some of those fundamental risks which are inherent in the crypto markets.”
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WHAT’S YOUR
STRATEGY? S A M E D B O UAYN AYA , P O RT FO L I O M A N A G E R , A LTA N A D I G I TA L A S S E T S F U N D
“Altana Wealth launched its Digital Currency Fund in 2014, mainly investing in the top four market-cap cryptocurrencies, primarily bitcoin and Ethereum. It was actively managing the three or four major assets, taking gains and reinvesting at certain levels which proved to be more successful than simply following bitcoin. From that we have evolved, and our new strategy considers blockchain technology as a whole. Bitcoin dominance has shifted from 90 per cent to below 40 per cent, and that gives validation to an entire ecosystem of cryptocurrencies that are eating into the top market cap we had previously in 2017 and 2018. We want to be in this space in order to capture this market share shift to new Layer 1s and new protocols. Our new investment strategy is a discretionary fund that will invest in blockchain technology across six different themes using a top-down approach with a strict VC-style investment. We have due diligence that we apply to each protocol prior to investing in it, and we complement this with narrative and sentiment analysis.” We will invest in early-stage tokens and listed liquid tokens. The early stage tokens will typically be via private placements or liquidity pools, while the listed tokens will be typically blue-chip projects we believe will withstand the future bear cycles. We will also be nimble, we won’t be married to our positions and we will evolve as narratives evolve, but at the same time we will give our blue-chips enough time to realise their market adoption and their full market potential.”
Lee Robinson, founder and CIO of multi-asset class manager Altana Wealth – a prime mover in the crypto hedge fund landscape which entered the sector in 2014 with its Altana Digital Currency Fund – says several things changed in late 2020 and early 2021 which ultimately helped make the asset class respectable in the eyes of previously-reticent players. “One was the realisation among people that they needed to have an exposure to crypto – whether it was DeFi, bitcoin, VC; be it one per cent, be it two per cent, be it half a per cent. That was a big change,” says Robinson, whose firm is preparing to launch a new digital assets strategy focused on blockchain opportunities. The other was banks and other payment companies such as MasterCard and PayPal offering crypto services for their customers. “It meant a whole new swathe of institutions could come into crypto. At nearly USD3 trillion, and one per cent of global assets, it can no longer be ignored by large institutions. That’s the reality,” adds Robinson, who before launching Altana in 2010 had been CIO and co-founder of event driven specialist hedge fund Trafalgar Asset Managers and, earlier, a portfolio manager at Tudor Investments.
Volatile
Despite crypto hedge fund strategies scoring stellar returns in recent seasons – HFR’s 2021 year-end data shows digital assets managers outflanked all other hedge fund strategies – the difficulty of having a profitable strategy in such a volatile market should not be
underestimated, according to Paul Frost-Smith, founder and CEO of London-based Corinthian Digital Asset Management, a thematic, relative value digital assets hedge fund. “Unless you’ve got people who really know what they’re doing in derivatives, I think this is a very difficult market to have a strategy that can work,” Frost-Smith tells Hedgeweek. “This market moves around a lot. You have implied volatility between 80 and 120; by comparison, when I was in equity derivatives, the highest I think we ever saw for any significant length of time was 42ish.” In a market commentary last year, London-headquartered publiclytrade hedge fund giant Man Group indicated bitcoin’s volatile price movements could be seen as part of the price discovery process in a new assets, which will ultimately give way to greater stability in the currency and, crucially, more credibility in the eyes of investors. Frost-Smith says: “Correlations are highly complex in this market, much more so than in the equities or bond markets, and so you really have to have some idea of correlation and hedging ability to run a profitable strategy. Essentially you’re looking at a much more quantitative-type market than traditional markets and that provides the biggest barrier to entry to the day trader. “There are things that are hard to explain in the market – recently we saw a 9 per cent drop in bitcoin overnight. If you look at some of the altcoins, they are down 14, 18, 22 per cent. So there are inexplicable,
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underperforming aspects of the market which we are constantly looking into, constantly crunching data on – another one of our big spends is on data and having our quants crunching huge amounts of data.” Managers also point to the 24/7/365 nature of the crypto market, which offers a wealth of crossexchange arbitrage opportunities for systematic funds, but can be a tricky step-change for some investment firms used to trading traditional hedge fund strategies such as long/short equity, macro or CTAs. “It’s a different mindset,” says Lee Robinson. “You need to have that ability and that recognition that there’s no open and there’s no close. It’s a very different market, and for a lot of people, it’s very difficult to trade.”
Learning curve
Anatoly Crachilov, founding partner and CEO at London-based Nickel Digital Asset Management, also reflects on the culture gap between digital-first, crypto-native managers and those established traditional funds looking to enter the digital assets sphere. “There is a commitment and passion across this group of people who are now creating and building a new generation of hedge funds in crypto. But for traditional hedge funds, it’s a jump – they have to change many of the ways they have
been operating on the tech level and also hire a new generation of people. It’s not always an easy transition,” Crachilov tells Hedgeweek. Launched in early 2019 with its flagship Digital Asset Arbitrage Fund, Nickel Digital aims to bridge the gap between traditional finance and the cryptocurrency market, offering a diverse range of investment strategies across the hedge fund, multi-strategy and long-only spectrum. Crachilov says: “There is a cultural adoption which is required here – you need to have onboard people who are pro-crypto, if you will, who are willing to engage and put themselves on this massive learning curve, because crypto is a fast-moving animal.” Looking ahead, Lee Robinson suggests the future generation of leading hedge fund traders and algorithm programmers are those who are cutting their teeth in crypto. “We all used to hire people out of banks. But the next wave of new traders, who are currently 16 through 22 and who you want to hire when they are 25-35, you’re going to find them in this space, regardless of whether you like this space or not,” he explains. “If you’re recruiting people who you want to be programming and doing quant trading or algo trading, you’re not going to find them very easily if you ignore the crypto space. It’s where all the talent is coming through globally.”
WHAT’S YOUR
STRATEGY? KEVIN KANG, FOUNDING PR I N C I PA L , B KCO I N CA PI TA L
“It’s important for us to be able to offer investors different strategies that fit with their risk appetite profile. We’re launching a multi-strategy fund this year which is going to still have a market neutral focus, but it’s going to have a combination of directional components – momentum, mean reversion, and trend-following – overlaid with options. So not only will we be able to take advantage of all this mispricing in the market, but we’ll be able take advantage of some of the volatility that comes with the crypto space. We’re also launching a DeFi fund as well as a VC fund. We’re really pivoting ourselves to become a go-to active manager in this space, and be able to offer all different types of flavors, whether it be VC, or an actively managed market neutral strategy, or to take advantage of the opportunities that DeFi offers. We’ll be able to offer different types of strategies to different types of investors.”
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CRYPTO POSSIBILITIES PIQUE INSTITUTIONAL INVESTOR INTEREST
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espite various concerns around the asset class, a study commissioned by Nickel Digital Asset Management has revealed that, since the start of the pandemic, institutional investors and wealth managers have changed their opinion on cryptocurrency, with 43 per cent saying that they now have a much more positive outlook on the asset class, citing reasons such as strong capital growth, clearer diversification benefits, and improving custodial services. More specifically, the study revealed that 78 per cent have a positive opinion of bitcoin, with only 9 per cent saying that their perception of it is negative, and for Ethereum, 77 per cent have a positive view with only 7 per cent considering it a negative investment.
“We’ve seen investor interest increase dramatically, particularly over the past year, with total value locked in the DeFi market already reaching USD250 billion at the start of this year, from just USD18.7 billion in January 2021,” says Diana Biggs, chief strategy officer, DeFi Technologies.
Close to innovation
Investment consultant Syz Capital has also noticed an increasing interest in digital assets from investors. Sherban Tautu, head of liquid alternatives, says: “Our clients are very interested in crypto, NFTs and blockchain infrastructure. They wish to invest in digital assets as a way of being exposed to innovation assets. They’ve seen the interest from the younger generation and
wish to learn more about it.” Chris Shelby, director, private markets at Verus, also notes a high interest in bitcoin, other cryptocurrency, and related strategies. A recent study carried out by investment platform VALK showed how professional investors are also increasingly focusing on digital assets, with roughly a third – from a pool of professional investors working in eight major economies for institutions holding more than USD1 trillion AuM – recently investing in crypto assets for the first time, and 55 per cent increasing their allocations. This burgeoning interest within the investor community is also reflected in findings from a recent industry poll of more than 50
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“The long-term trends for crypto continue to be positive; institutional investors continue to invest in the space and are more willing to use these new platforms. Just like other asset classes, there will be ups and downs in the short-term, especially since crypto is a complete rewrite of the traditional financial system. While price drops may affect investor sentiment, they have never slowed down the pace of innovation in the space.”
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Until recently retail investors were at the forefront of digital asset investments. Since the pandemic, all types of investors, notably institutional investors who were somewhat initially reluctant, are steadily realising the potential of investing in cryptocurrency
George Melika, co-founder and CEO, San Francisco Open Exchange
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Have you been asked by allocators to offer a digital asset vehicle?
Yes 39%
No 61%
Source: Hedgeweek readers survey, January 2022
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hedge fund managers conducted by Hedgeweek, which suggested around 39 per cent of managers have been asked by allocators to offer a digital assets vehicle.
Fringe experiments
Whereas ESG was a concern at the forefront of the industry this time last year, the VALK study shows that 54 per cent of professional investors are now more concerned about custodial services in DeFi and 52 per cent are also concerned about security issues. Jawad Nayyar, co-founder and CVO, DAO PropTech says: “Apart from the volatility, issues of legality
and security still plague the space making it difficult to do anything other than experiment on the fringes with crypto.” Investors are calling for the regulatory environment to improve, with VALK’s research showing that 84 per cent expect regulatory improvements over the next three years, and 12 per cent predict a dramatic improvement. To combat this and still allow for some allocation, John Bowman, executive vice-president, CAIA Association, thinks investors “should be taking a diversified “venture” approach to expose and play in this very disruptive and volatile innovation petri dish.”
The burgeoning support and interest among institutional investors throughout 2021 and into 2022 suggests digital assets are now being taken more seriously by managers and are starting to be viewed as a viable asset class, due to the high returns and investment opportunities. Biggs adds: “As a relatively new alternative asset class, it naturally requires the right approach, timeframe, allocation and overall risk management, but the possibilities are definitely there for it to be a successful part of a diversified investment strategy.”
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“A MIXED BAG? ”
NAVIGATING CRYPTO’ S NASCENT REGULATORY FRAMEWORK
Regulation remains in sharp focus. Digital participants from across the financial markets spectrum are keen to dive in headfirst while others, partly due to a perceived supervisory gap, remain on the sidelines
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ith the global regulatory landscape very much in a state of flux, the US Securities and Exchange Commission has set to work on establishing a supervisory framework covering the proliferation of digital coins and assets. These potentially include treating certain cryptocurrencies and tokens as investment securities, together with further oversight of NFTs, while SEC chairman Gary Gensler indicated in September that crypto exchanges may have to register as securities markets. The SEC also greenlighted the first US bitcoin futures ETFs - ProShares, Valkyrie and VanEck - on the New York Stock Exchange in October, while the Commodity Futures Trading Commission continues to weigh up the regulation of crypto derivatives in the same way it supervises traditional futures.
their money.” The watchdog pointed to significant price volatility and product complexity in the asset class, and suggested it can be difficult to price reliably. While developed markets have inevitably taken the lead, industry participants point to the “hodgepodge mishmash” of fractured rules and requirements globally. While El Salvador, for instance, enacted legislation last summer permitting bitcoin to be used as legal tender for the payment of goods and taxes, China has maintained its tough stance against cryptocurrencies, outlawing trading services, token issuances and digital currency derivatives, and prohibiting overseas exchanges from offering services in mainland China. Concerns over the shape of regulation loom large among hedge funds.
Across the Atlantic, meanwhile, the EU’s forthcoming Markets in Crypto-Assets (MiCA) initiative sets out proposed rules covering issuance and service provision of crypto assets, with a view to strengthening market integrity and improving investor protection. The plans also look to tackle the potential financial stability and monetary policy risks posed to economies by digital assets. In December, the European Securities and Markets Authority (ESMA) added crypto asset investing to its Alternative Investment Fund Managers Directive (AIFMD) Q&A.
Co-ordination
Early last year, the UK’s Financial Conduct Authority weighed in, warning that consumers investing in crypto assets “should be prepared to lose all
What do you see as the greatest obstacle to launching a digital assets hedge fund strategy currently?
Regulation
Custody risk
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Launch cost or complexity
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“In the crypto mainstream, if you have investments in bitcoin and ether, I don’t think there’s a huge danger that regulators will change their mind on their existing guidance with respect to those assets,” Tu-Sekine noted. But moving towards the more esoteric crypto assets, Tu-Sekine believes there is “significant regulatory risk” as market authorities continue play catch-up on the fringe elements.
Revolution
Underlining the complexity of the challenge, the view that digital assets is not so much one single asset class, but part of a broader technological revolution - encompassing DeFi, Web3, the metaverse and more – is taking hold among many market participants, who see attempts at regulatory scrutiny in a financial markets context as merely scratching the surface. But while some managers and investors have cited regulatory uncertainty as one of the biggest barriers to entry in digital assets, there have been “leaps and bounds” made over the past 12 months as regulators get to grips with how crypto markets operate, according to Stephanie Ramezan, director of business development at Gemini. “It’s fantastic for the digital assets space to have somebody who is proactively having conversations,” Ramezan says of the approach taken by SEC chair Gary Gensler towards a more comprehensive regulatory environment. Ramezan acknowledges that in the UK the “psychology” towards digital assets remains somewhat behind the US in terms of institutional and retail perspective. “But I think the US has
always been far more bullish, across a variety of asset classes generally. In the UK, through the FCA, we have the FCA Crypto Asset Register, which I think is exactly the right approach for the UK to be taking.” While regulation improves and strengthens around core elements of the crypto assets ecosystem – notably custody exchanges and coins – other areas, such as decentralised finance (DeFi), remain outside the regulatory scope. And with interest in DeFi booming among hedge funds, the sprawling, labyrinthine array of assets and products could raise fresh questions surrounding oversight for both investors and regulators. “Ultimately, the very large allocators may decide they are not comfortable with the non-regulated parts of the marketplace, because it’s too much of a risk to take and so they’re just not willing to allocate big sums to a manager that’s playing in those parts of the market,” Dan Smith, president and head of US Fund Services Operations at Trident Trust, tells Hedgeweek. “I expect that managers who want allocations from those big investors will play in the neater, tidier part of the marketplace. You’ll still have the retail and individual investors, maybe even the very small funds with just high-net-worth investors who are less concerned about that who will still play in those less-regulated areas.”
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The very large allocators may decide they are not comfortable with the non-regulated parts of the market
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According to a Hedgeweek survey of 50 fund managers, more than a third of those polled identified regulation as the single greatest obstacle to launching a digital assets hedge fund strategy currently. Asked specifically about the biggest risk facing hedge fund managers in this space, “Changes in securities law covering the asset class”, “Frequent regulatory changes” and “The cost of regulation and time consumed by regulation” were among the responses given. “We need stable and well thoughtout regulation,” remarked one respondent who manages a crypto fund and is looking to launch more strategies this year. Acknowledging the complexities and challenges of supervisory oversight, Asen Kostadinov, head of strategy, Copper, says the “number one challenge” for regulators is how new and different digital assets are in comparison to other markets and asset classes. “The first thing is understanding what it is, and once they understand it, they try to liken it to something that they’ve seen before and put it into the current regulatory framework,” Kostadinov observes of the current regulatory approach. “The next thing I think they will start grappling with is the global aspect of this – co-ordination on a global level is going to be very difficult but also key.” Speaking at last year’s Hedgeweek DigitalAssetsLIVE summit, Anthony Tu-Sekine, head of blockchain and cryptocurrency group at Seward & Kissel, described the current regulatory landscape in the US as something of a “mixed bag”.
Conflict
Paul Frost-Smith, founder and CEO of Corinthian Digital Asset Management, believes there is a “fundamental conflict “at the theoretical level” between “anything that’s decentralised and particular institutions trying to regulate it.”
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R E G U LAT ION
DAN SMITH, PRESIDENT AND HEAD OF US FUND SERVICES OPERATIONS , TRIDENT TRUST
“The evolution of the regulatory landscape and the institutional money both crashing in are both forcing the direction of travel of certain aspects of this industry to accommodate the big institutional capital, which at the end of the day is what everyone in this space wants and needs. The more money in this space means there is more money to be made by everybody.”
He points to different regulations across different jurisdictions, noting there are various rules depending on whether a market participant is buyside or sell-side. “Because no specific regulations are really being targeted at crypto yet, everyone is really trying apply the existing regulatory regime that covers traditional hedge funds and traditional asset classes to crypto. But due to the nature of decentralisation, I’m not sure you can actually regulate the products themselves. I think you have to take an approach of regulating certain participants,” he adds. “You can regulate activities - like marketing, or exchanging fiat for crypto - and I think you can regulate some of the participants in the infrastructure. But because of the actual nature of the industry I don’t think it’s actually capable of being regulated easily.” Aiming to address some of the supervisory challenges surrounding DeFi, Los Angeles-based Quadrata is developing an identity and compliance element for prospective market participants in decentralised blockchains. Lisa Fridman, Quadrata’s president and co-founder, and former partner and global head of research at PAAMCO Europe, points to the sizable opportunities in blockchain technology, particularly within the realm of decentralised finance, with “huge potential” for DeFi to provide a viable alternative to traditional financial services, with potentially lower costs, faster transac-
tion speeds, and more transparency. “DeFi originated as a permissionless system, with a broad reach. But regulated institutions are not necessarily able to participate in permissionless pools where they may be commingled with potential bad actors,” Fridman tells Hedgeweek. “What we are developing at Quadrata is introducing this identity and compliance layer to decentralised finance across different blockchains. What we aim to achieve is to enable institutions and individuals to leverage their off-chain reputation to transact on-chain.” Specifically, this involves the introduction of a passport-like verification system – Quadrata Passport - where trusted entities will be able to verify and attest to data in those participants. “Initially, it will be KYC, AML-type of reviews and assessments that will be posted to the passport, and in the future we anticipate adding further fields to the passport. We can help mitigate some of the risks of being commingled with unknown participants.”
Catch-up
Ultimately, large institutional investors, banks and central banks all have a vested interest in there being more regulation of this space, according to market participants. “The regulators at the moment are scrambling to catch up, but they will catch up. They will hire enough people
and will get there in the end,” says Lee Robinson, founder and CIO of multi-asset class hedge fund manager Altana Wealth. “They can’t be seen to not be in control of a USD3 trillion market that is very volatile.” Robinson believes there is clear direction of travel in regulation of DeFi, and ensuring the owners of DeFi platforms are regulated, which will bolster trust in the eyes of institutional and retail investors. “It’s going to go that way, and people will go to platforms they trust and regulated platforms - I think it’s a really good thing for the industry.” Looking ahead, Asen Kostadinov expects a degree of supervisory ebband-flow as regulators play catch-up with a rapidly-evolving landscape. “You can’t really grapple with the pace of growth, so perhaps in the beginning it’s going to be overly restrictive,” Kostadinov observes. “It’s not easy to forecast, but the idea being is that in the short-term they feel like they need to get a very firm grasp of it and to restrict some of the activities. That what they’re doing now. “Overall, it’s positive - if you want to get more institutional flow, if you want to get broader adoption, then you need to give people basic peace of mind that what they’re dealing with has been sanctioned by somebody else. Above all, ensuring and maintaining the integrity of all financial markets is absolutely key.”
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C U S T OD Y
WH Y CO U N T E R PA RTY R I S K I S T H E K EY TO CRYPTO MARKET INSTITUTIONALISATION
A
s hedge funds and other asset managers continue to seize on the assortment of investment opportunities in cryptocurrencies and blockchain technology, many big-ticket long-term allocators pension funds, insurance companies, foundations and endowments – may be sitting on the sidelines thanks to continued concerns surrounding asset security. A recent investor survey by decentralised infrastructure technology provider VALK found that more than half – 54 per cent – of respondents are ‘very concerned’ about custodial services in DeFi. At the same time, some 52 per cent of the those polled (100 institutional investors holding USD1 trillion in assets) are ‘very concerned’ about security issues in crypto. The core issue stems from the way crypto assets are traded on exchanges - a central component to the market architecture – and how the security of hot wallets, which are used in order to trade, is managed. In recent years, a slew of digital assets custody platforms including
Copper, Fireblocks, Gemini, and Komainu have developed advanced services for trading and exchange, while Fidelity, Anchorage and BitGo are among those platforms offering buy-and-hold services.
Seeking comfort
“There are now very powerful solutions in place, but the knowledge is yet to be disseminated so that institutional investors can take comfort,” says Anatoly Crachilov, founding partner and CEO at London-based Nickel Digital Asset Management. “The reputational angle of crypto is improving, and that will help open the gate for institutional arrivals.” While the digital assets hedge fund space initially blossomed around crypto-native managers willing to accept greater risk and more operational leg-work in return for attractive investment opportunities and sizable alpha generation potential, the market will not fully develop unless larger traditional asset managers and investors come onboard, suggests Asen Kostadinov, head of strategy at London-based crypto
custody service provider Copper. “But for them, a lot of the key details - like counterparty risk, and how settlement is done - are going to be non-negotiable,” Kostadinov tells Hedgeweek. “At the beginning of any market, people actually can compromise – they want to be there and they will make do with whatever they have. However, as this market develops, the details start to matter a lot. “Fortunately we have, to some extent, a blueprint of what the infrastructure should look like, because we’ve know how traditional markets operate.” For Copper, an understanding of the traditional finance space and creating products that can provide the same safeguards traditional asset classes enjoy is vital for fostering investor confidence, and that stance forms the basis of its Walled Garden and ClearLoop products. “Ultimately, you are trying to create a market structure resembling the market structure that you see in traditional finance,” he observes. “In crypto, one of the first things
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Key details such as counterparty risk and how settlement risk is done are going to be non-negotiable for larger players
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Major advances in the way trading and custody infrastructure tackles counterparty and exchange risk in digital assets are helping to assuage investor fears and will help further drive institutionalisation of this market further down the line, industry participants say
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C U S T OD Y
“
ANTOINE LOTH, CO-FOUNDER AND CEO, VALK
DeFi is undergoing rapid growth – there were less than USD1 billion of digital assets locked into DeFi services two years ago, and today that number is over USD250 billion – so it is natural that institutional investors handling billions of assets have concerns.
you immediately notice is that the whole market is concentrated within exchanges. You need to be moving your assets to exchanges in order to trade. When you move your assets to an exchange, if you’re a fund manager, this means that you are in complete control of the assets that you manage. And of course, these are not always your own assets – you are managing these assets on behalf of investors. So one of the core responsibilities of a custodian is actually to manage that conflict between a fund manager that is managing assets on behalf of somebody else and ensuring the fund manager observes the agreements they have with their investors. “It’s important for you as a provider to be offering a solution to your clients where they can actually operate in a paradigm close to the traditional space. That’s what ClearLoop does – it allows you to trade on an exchange, but custody your assets at Copper, so that your assets never move to that venue. This puts the first building blocks towards creating a central clearing model for crypto and can open up the market to much more sophisticated operations.” Dan Smith, president and head of US Fund Services Operations at Trident Trust, notes how custody services remain “very expensive” for asset managers, adding that
smaller and emerging crypto-focused hedge funds are trying to find the right balance of taking that next step towards expansion while remaining cognisant of how they can readily afford to incur such costs. “From the investor perspective, meanwhile, it is absolutely about having assets more tightly protected where the odds of a hack, or a lost key, or a misappropriation by fund personnel are lowered.” The other challenge for managers, adds Smith, is that investors are becoming smarter about the right questions to ask.
Four pillars
“They’re asking more probing questions – ‘Who is your custodian?’; ‘How is your internal trade mechanism set up to stop misappropriation of funds?’,” he says. “Investors want exposure - but they want to ensure risks are being addressed and managers are doing things the right way.” For many, having crypto custody solutions mirror the service already firmly established within the traditional finance sector is key. “Our four pillars are security, products, licensing and compliance, and that is always how we have approached any market, any type of clients,” explains Stephanie Ramezan, director of business development at
Gemini Europe. “The challenge for any fund manager, whether it be digital assets or traditional currency, is security. As part of our Gemini Foundation, we like to talk about the attributes that differentiate us from competitors in the crypto space, but we also see that our policies and procedures very much mirror that of traditional regulated, financial institutions. “Because we have our licensing and regulation, we are already a very different type of player in both the exchange and in the custody side of things. “In terms of our custody, we have different types of offering. Anybody who trades on the Gemini exchange gets to take advantage of the custody on exchange. That’s used by people who wanted to be trading very proactively. However, if someone who wants to just buy-and-hold, people have the option of our segregated custody, which is cold storage.” She also points to Gemini’s recent acquisition of London-based startup Shard X, which has developed multiparty computation technology allowing for the security of cold storage with the accessibility of a hot wallet. Ramezan tells Hedgeweek that a perennial risk for hedge funds is client reaction and reputational risk. “If you are a crypto native hedge fund, then of course your GPs
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C U S T OD Y
and LPs are going to be far more open to investment into this space. Traditional hedge funds, aside from not necessarily having the right team in place or having the knowledge base, they also have that reputational risk and a different type of investor to answer to. I think this is where we can see the crypto-native hedge funds really pulling away very, very quickly out the starting gate. “What do fund managers have to think about? It is security, it is risk. When we onboard with new customers, we fill in – if they wish – a DDQ, just like any bank would. That comes back to the point of mirroring those regulated financial institutions. That’s the absolute core of what we do.” So as the crypto asset landscape evolves and expands, is the question of safe asset custody - a pivotal point in the road to market institutionalisation – close to being resolved? “It’s definitely very much more advanced than it was three years ago. The reason why I can’t say it’s completely resolved is because we are still very early in the development of this market,” explains Kostadinov. “I would say that in its basic form, the custody issue has been solved. There are providers you can go to get custody services and have some peace of mind. In the US, a
number of these providers are wellregulated. With regards to just basic functionality and being able to find good custodians, there has definitely been progress compared to three years ago. “It’s adequate for the time being to some extent, but it needs to develop a lot more in order to serve the market and enable the market to expand. “And, of course, it’s not just custody – there are a lot of other things that also need to develop. Take a look at exchanges - their technology in a lot of cases is now outdated; there is a lot of patching that needs to be done. The way data is shared and generated in this space; the way some of the execution services are being run.” Underlining this point, he describes the current iteration of the digital assets industry as ‘version 1.0’. “The first version of any particular niche or particular industry - it doesn’t necessarily need to be financial services - will always have the early adopters and first movers, and they can make do with inefficiencies at the start,” he says. “But ultimately, when you see the version 2.0, or v3 or v4, that market will be completely different, and the level of service that you’ll have will be completely different, to what you have today. It’s just natural evolution.”
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ESG
BALANCING ACT:
TACKLING BITCOIN’ S ENERGY CONSUMPTION Cryptocurrency investing has not always gone handin-hand with ESG. Recent analysis suggests that these two major trends, which loom large over hedge funds and asset managers, are set for a head-on clash
T
hough cryptocurrency has been criticised for its negative impact on the environment – particularly the energy-intensive bitcoin mining process – recent studies suggest institutional investors are more concerned with regulatory and security issues surrounding digital assets than their carbon footprint, with research from Fidelity Digital Assets highlighting volatility as the biggest worry, and a report commissioned by Nickel Digital Asset Management revealing crypto security as the biggest concern for allocators. But it’s also clear that ESG factors remain vitally important to firms and clients, with Federated Hermes finding that 88 per cent of institutional investors view ESG factors as more important than financial metrics when evaluating a company’s attraction. So, as the USD2 trillion-plus digital assets industry widens its appeal to institutional investors (Nickel Digital’s study reveals 43 per cent have a more positive view of cryptocurrency), how are market participants balancing this surging appetite alongside the ongoing push for green investment, just two months after the COP26 climate summit in Glasgow highlighted the
scale of the climate challenge? “It’s not the job of asset managers to be picking investments based on ESG criteria; I fundamentally disagree with it,” says Paul Frost-Smith, founder and CEO, Corinthian Digital Asset Management. Though Frost-Smith concedes that his view is “not the consensus one”, his stance is founded on the view that ‘ESG-aligned’ remains an unclear notion across the industry, and sometimes represents open and empty promises in the form of tick boxes. He also believes it slows down or prevents much needed allocations to companies and projects in emerging and developing countries which are least able to meet the criteria.
Vetting companies
“The job of your asset manager is to make you the best returns they can, within the risk parameters that are laid down. It’s not to be vetting third-party companies to see if they’re ticking boxes on a form to say that they’re going carbon neutral,” he adds. “By and large, with perhaps the exception of Algorand and Harmony, most cryptocurrency requires proof-
of-work, and yes that undoubtedly consumes a large amount of power, a lot of which doesn’t come from renewable sources.” Anatoly Crachilov, founding partner and CEO, Nickel Digital Asset Management, takes a different view, suggesting that the industry’s shift towards proof-of-stake, which is much more energy efficient, and away from proof-of-work, is evidence that ESG and cryptocurrency can work conjointly. While acknowledging that it’s unlikely for bitcoin to switch to proofof-stake due to resistance from the community, Crachilov argues that bitcoin drives the cost of renewables down. “It can be energy intensive, but most of the mining today comes from renewables, not from burning fossil fuels,” he says. Market participants note that as bitcoin miners moved beyond China – a significantly coal-based economy – to countries such as the US and Kazakhstan, they took the opportunity to switch to greener forms of energy, particularly solar energy, with crypto mining emerging as a major buyer of solar panels.
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ESG
Views on Cyptocurrency Reason for developing a more positive view of cryptocurrencies since the Coronavirus crisis started
Percentage of institutional investors and wealth managers who cited this factor as one of their three main reasons for developing a more positive view of cryptocurrencies
Strong capital growth of many mainstream cryptocurrencies
58%
Clearer diversi cation bene ts
53%
Improving custodial services
47%
Improving market cap and its impact on liquidity
41%
Improving regulatory environment
31%
More crypto/digital investment strategies to choose from
28%
Growth of decentralised nance (DeFi)
10%
Source: Nickel Digital Asset Management, November 2021
The Bitcoin Mining Council survey found that bitcoin mining’s electrical mix increased to 58.5 per cent renewable in Q4 2021. However, the data around the asset class can often be unreliable and contradictory, making it difficult to assess exactly how much damage is being caused through higher carbon emissions for example. Ultimately, “until the world and protocols move towards proof-ofstake across the asset class as a whole, this is going to continue to be an issue”, Frost-Smith notes of the energy consumption question, “although things have improved since the Chinese mining ban.” He believes that while the main concerns are often centred around energy consumption and pollution, on the social and governance side, it
remains difficult for crypto assets to meet the criteria. “Crypto can’t really tick the ESG box; you go into crypto for the higher returns and the diversification benefits. If you’re investing in hedge funds, you want returns and we’re all measured on our monthly performance. You just have to trade your way and at the end of the month, do your carbon offset, but at the end of the day hedge funds are for producing returns, not saving the environment or improving social norms,” he adds.
Social equality
While the environmental aspect in ESG is often the central focus when it comes to cryptocurrency, a recent study by Stanford University points to how crypto may serve as a powerful tool for social equality.
Digital assets evangelists have also hailed crypto as a non-discriminatory asset class which allows those with less traditional forms of investment and banking to access these opportunities. Citing the Stanford University findings, Melbourne-based crypto investment firm Apollo Capital, which invests on behalf of family offices and institutional investors mainly in Australia, noted in an analysis paper how the asset class is open and inclusive to unbanked sections of the population, particularly women, offering access to finance and markets where they previously may have been deprived. While this time last year many might have assumed that ESG alignment and crypto would only ever collide in investment portfolios, there is perhaps a possibility for them to complement one another to a certain point after all. Made with
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D IR E C T ORY
www.copper.co Copper is transforming how institutional investors engage with digital assets, providing market-leading infrastructure in addition to custody, trading and prime brokerage solutions. Our award-winning custody application leverages the genius of multi-party computation (MPC) encryption and can be configured to support cold, warm, and hot wallet solutions. Asset managers are further protected by our pioneering ClearLoop network, which enables off-exchange trading and settlement at tier-1 digital asset exchanges. An offering enhanced by the availability of uncollateralised lending. Copper’s secure wallet architecture is available as a standalone application, a mobile app, and a browser extension for smart contract signing.
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IN S IG H T R E P ORT
HEDGEWEEK
CONTRIBUTORS: Hugh Leask Editor hugh.leask@globalfundmedia.com Fiona McNally Reporter fiona.mcnally@globalfundmedia.com Scott Newman Art Director scott.newman@globalfundmedia.com Colin Leopold Head of Research & Insight colin.leopold@globalfundmedia.com FOR SPONSORSHIP & COMMERCIAL ENQUIRIES: Jo Cole Commercial Director jo.cole@globalfundmedia.com
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