Since the market crash in March 2020, hedge funds have flocked to the world of cryptocurrencies in search of profits.
Currently, firms such as Galaxy Capital, Grayscale and Pantera dominate the cryptocurrency hedge fund market. Together, these funds have about $60 billion in discretionary capital. Their clients want exposure to the world of bitcoin and ethereum without having to buy and hold bitcoin themselves.
This seems unsurprising given that the price of bitcoin has doubled in the last 12 months, but it is interesting to note that the actions of this group of investors are changing the cryptocurrency landscape. While many early cryptocurrency investors saw buying cryptocurrencies as a way to support their favorite ecosystem and benefit from the rising prices. But hedge funds clearly don’t have that kind of loyalty when it comes to profits.
According to Eurekahedge data, crypto hedge funds have returned 116.8% so far in the first quarter of 2021, outpacing bitcoin’s 104.2% return. How is this done? By betting that, in some cases, they drive the price of bitcoin down and profit from the price movement. As hedge funds have grown in size, so has their ability to influence relatively small markets in terms of circulating supply.
What is a cryptocurrency hedge fund?
While most short term traders bet their money on being able to predict the price of bitcoin, hedge funds are different. Hedge funds are essentially money managers for ultra-high net worth individuals and institutional investors. To put money into a hedge fund, the threshold then requires having a net worth of $1 million (not including a house) and an annual income of about $300,000 – an amount that varies depending on the investor’s location.
Thereafter, these fund managers have complete autonomy in choosing who to invest in. Perhaps the most famous example is Michael Burry, the well-known hedge fund manager who was the prototype for the movie “the Big Short” (the Big Short), played by Christian Bale.
Burry had complete control over his investors’ money, having bet $1 billion on the collapse of the real estate market. In this instance, of course, he was right. But his investors weren’t happy because they had little power to stop him from doing so.
However, if Burry had run a mutual fund, he would have been regulated by the SEC, his investment strategy would have been limited, and he would have had to comply with regulations when reporting his actions. Instead, he is free to dabble in unrestricted trading. And characters like Burry are running a growing number of 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 own brokerage accounts. It has 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 a high-risk, high-return investment vehicle and therefore not for the faint of heart.
As more hedge fund managers jump on the digital currency bandwagon, early simple long bets on assets such as bitcoin, ethereum or ripple are making way for more complex asset-linked strategies, including swaps, futures and options indexed to cryptocurrencies, as well as bets on income generated by the underlying technology, Lyxor Asset Management said.
With this increased complexity, the cryptocurrency landscape has changed a bit.
Different types of investors
The composition of hedge funds is important because it highlights their purpose and approach when entering the market. According to a report published by PricewaterhouseCoopers (PwC), the composition of these cryptocurrency hedge funds is
- quantitative (48%) – funds that use “automated” trading rules rather than being identified and evaluated by the fund’s staff.
- Discretionary long (19%) – long-term investments that believe asset prices will rise.
- Discretionary long/short (17%) – a switching strategy that allows hedge funds to go both short and long depending on market conditions.
- Multi-Strategy Investing (17%) – A combination of the above.
Of these funds, the vast majority trade Bitcoin (97%), followed by ETH (67%), XRP (38%), LTC (38%), BCH (31%), and EOS (25%).
Of these, about half of cryptocurrency hedge funds are engaged in derivatives trading (56%) or are active short sellers (48%). Derivatives trading is used by traders to guess the future price movement of the underlying asset without having to buy the actual asset itself, with a view to making a profit. Short sellers, meanwhile, are funds that 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 a measure of how volatile an asset’s price is. for most of 2020, Bitcoin’s price volatility has hovered around 2.5%. However, since the bull market, the index has started to climb, peaking at 6% in March and April of this year.
Raoul Pal, a former Goldman Sachs hedge fund manager, says, “You can’t have 230% compound annual returns without that volatility. On this occasion, volatility is your friend.”
That’s what makes cryptocurrencies so attractive to risk-hungry hedge funds, who feed on market volatility.
It is well known that the demand for bitcoin is speculative and emotional, and not necessarily based on fundamentals such as adopting virtual currency as a daily payment method. And, supply can be artificially squeezed, not just limited to algorithms.
This is why hedge funds are flocking to the market. One of Europe’s largest hedge funds, Brevan Howard Asset Management, announced last month that it would set aside a percentage of its $5.6 billion fund to buy bitcoin. It has since been joined by companies such as Galaxy Digital and Tudor Investment Corp, which have quietly bought hundreds of millions of dollars of bitcoin, effectively squeezing supply.
Research firm Chainalysis estimates that 60 percent of the bitcoin supply is being hoarded, while 20 percent is “lost” or unattended.
Glassnode reports that this squeeze is further exacerbated as more hedge funds enter the market. The tighter the supply, the easier it is for prices to fluctuate. Hedge funds, for their part, know this all too well.
Dan Morehead, CEO of Pantera Capital, the first U.S. bitcoin hedge fund, has written in an investor note, “Cryptocurrencies are starting to trade independently of other assets. While most asset classes are falling, cryptocurrencies are rising …… Would you rather put your savings in Lehman Brothers in 2020, or in a token you control?”
Because of this volatility, hedge funds have been able to use their positions to create new income opportunities. The most significant of these is to act as market makers themselves. How do they work?
Hedge funds look for the difference between the spot price, the current price of an asset like bitcoin, and the value of a derivative contract that expires in a few months. This is often referred to as an underlying trade. For example, at the time of this writing, the price of Bitcoin is about $55,000.
But there are also futures contracts, such as those from the CME Group, who predict that the price of bitcoin will reach about $60,000 in July.
A hedge fund buys bitcoin at the spot price and then sells futures for July, meaning the derivative contract will increase in value if bitcoin falls. By doing this, a so-called “spread” is created between today’s price and tomorrow’s bet. As these gaps widen over time, they can generate significant returns.
This kind of trading is also starting to permeate Ether, sending its price to new highs this month thanks to a 700% return for investors using a similar strategy.
As mentioned before, hedge funds are risky, and the risk of this market-making game becomes very real if one of the market makers experiences a margin call.
This happened once in the fiat currency market when Archegos, an investment firm run by hedge fund manager Bill Hwang, went bankrupt after a margin call, subsequently dragging down several large banks. When the dust settled, one of the world’s largest banks, Credit Suisse, suffered losses of more than $5 billion.
As Bitcoin becomes more volatile, time will tell if cryptocurrencies can sustain the risk appetite of hedge funds.
Posted by:CoinYuppie，Reprinted with attribution to:https://coinyuppie.com/how-hedge-funds-are-changing-the-cryptocurrency-landscape-as-billions-pour-in/
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