The Inner Workings of Cryptocurrency Hedge Funds
Hedge funds have the advantage of being able to invest in almost anything. From traditional asset classes like equity, fixed income, commodity, and currency to derivatives and various forms of leverage, almost nothing is off-limits. With the enormous profits generated by cryptocurrencies, it was only a matter of time before they looked into it to generate the yields they needed to keep their investors happy. Hedge funds that cater to accredited or institutional investors are exempt from the stricter rules that apply to other financial market players because they are not guaranteed the same level of protection as retail clients, allowing hedge funds to pursue riskier strategies. You could say it’s a match made in heaven. The cryptocurrency sector, which is largely unregulated and offers opportunities unlike any other asset class at the moment, is the ideal playing field for return-hungry, risk-averse hedge fund managers, according to Autonomous NEXT, a research firm.
How They Operate
What are Cryptocurrency Hedge Funds, and how do they work? Some do what they do in other asset classes, such as FX, and buy and sell cryptocurrencies like Bitcoin based on their models to profit from the trading activity. They either invest exclusively in cryptocurrencies or include them as a new asset class in their portfolio.
Others invest in Pre-ICOs like venture capital funds. If you didn’t know, a pre-ICO is a period in which selected investors can purchase tokens before the official crowd sale, often at a significant discount. Naturally, access is not always easy to come by. It necessitates a thorough understanding of an opportunity, both in locating it and determining whether it is worthwhile to invest in. Investments in companies running an ICO, where hedge funds take an actual equity stake, are heading in the same direction.
Hedge funds that use the ICO model to raise funds to invest in cryptocurrencies in one of the ways described above are slightly different and technically not a separate business model.
Investment Methodologies
Hedge funds that invest in cryptocurrency are usually divided into four categories:
Discretionary Long Only Funds are long-only funds with a longer investment horizon for their investors. These funds are more likely to invest in early-stage token/coin projects and purchase and hold more liquid cryptocurrencies. Investors in these funds typically have the most prolonged lock-up periods.
Long/Short Discretionary Funds cover a wide range of strategies, including long/short, relative value, event-driven, technical analysis, and some crypto-specific strategies, such as mining. Hybrid strategies, such as investing in early-stage projects, are common in discretionary funds. They have a lock-up period that is similar to the Discretionary long-only group.
Quantitative Funds are those that take a quantitative approach to the market, either directional or market neutral. Market making, arbitrage, and low latency trading are examples of indicator strategies. These strategies rely on liquidity, so these funds can only trade more liquid cryptocurrencies. As a result, investors in these funds typically have the shortest lock-up periods.
Multi-Strategy Funds use a combination of the strategies mentioned above. Traders can, for example, manage discretionary long/short and quantitative sub-accounts within limits outlined in a fund’s prospectus.
Where the cash comes from
The investor base is skewed towards wealthy individuals, unlike traditional hedge funds. Polychain Capital, a $250 million blockchain asset hedge fund backed by Sequoia Capital, Founders Fund, Union Square Ventures, and Andreessen Horowitz, is one of the few exceptions that attract institutional investors.
How to Get in
However, getting in is easier said than done. It takes a lot of money to be an accredited investor or a high-net-worth individual, as the terms suggest. To be considered an accredited investor in the United States, an individual must have a net worth of at least $1 million at the time of purchase, or assets under management of at least $1 million, or income of at least $200,000 in each of the two most recent years, according to SEC Rule 501 of Regulation D. (to understand the threshold for your joint patrimony with your wife, check the rules). While hedge funds — crypto or not — rarely discuss their financials, they should be in the same ballpark. Cryptocurrency Fund LP, for example, requires a minimum investment of $100,000, while Metastable requires a minimum investment of $1 million. Crypto Asset Fund, like Cryptocurrency Fund LP, requires a minimum investment of $100,000 and offers a feeder fund for non-US investors that starts at $25,000 and managed portfolios for those willing to invest $50,000.
Bitwise Asset Management, for example, aims to make it easier to access cryptocurrency markets. A $10,000 minimum investment is required for the HOLD 10 Index, a basket of the largest coins. While current investors must be accredited and based in the United States, it hopes to expand its services to include non-accredited investors in the form of ETFs or mutual funds.
Regulatory Adherence
But what about the legal aspect? In general, it’s the same regulation that applies to all hedge funds, and it’s determined by the fund’s jurisdiction of origin and location. In other words, given the nature of the underlying asset, investments in cryptocurrency hedge funds are likely to be riskier than traditional hedge funds.
Another consideration is for those who fund their investments through an initial coin offering (ICO). ICOs are, of course, subject to the relevant rules, which vary significantly from jurisdiction to jurisdiction and are currently being scrutinized by regulators all over the world. While investor protection in that context is likely to improve in the future, any losses are unlikely to be compensated, so make sure you understand what you’re getting into before investing your hard-earned cash.
