Bitcoin’s inefficiencies are creating arbitrage trades for crypto hedge funds

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As more hedge funds pile into cryptocurrencies, market inefficiencies and price dispersion are bringing fresh arbitrage opportunities for managers.

Bitcoin’s sustained rally over the past year saw the cryptocurrency roar to a record high of more than USD41,000 in early 2021, with many investors increasingly using it as a hedge against falling real yields and inflation risks stemming from central bank quantitative easing.

But as more hedge fund managers join the digital asset arena, running a range of discretionary and quantitative strategies, the potential for alpha generation “will likely moderate” in the coming months and years, said senior Lyxor Asset Management strategists Jean-Baptiste Berthon and Philippe Ferreira, and hedge fund analyst Pierre Carreyn.

There are now more than 800 active blockchain and cryptoasset-focused funds, 150 of which manage more than USD50 million in assets. Bitcoin’s charge helped bring stratospheric gains to crypto-focused hedge funds last year, with HFR’s Blockchain Composite Index soaring to a 190.1 per cent return in 2020.

But the market remains “highly inefficient”, Lyxor Asset Management strategists said in a note this week, and “significant digital asset price dispersion” offers scope for arbitrage opportunities.

Earlier this month, bitcoin’s dizzying momentum was abruptly halted – with the currency diving more than 20 per cent – and Lyxor believes institutional investors’ appetite will now likely cool off for the time being.

“Several key risks warrant high volatility,” Lyxor strategists said, pointing to the potential structural risk of tougher regulation, as well as speculation risk, which may be amplified by leverage and systematic trading, and the absence of a central authority to step in during crises.

“Valuation indicators keep on flashing red, in particular our macro and market relative models. A normalisation in momentum forces could also keep selling pressures. Yet, liquidity metrics have not deteriorated in an exaggerated manner thus far.

“We expect the latest cold shower to moderate institutionals’ enthusiasm in the short-term, providing time to prepare for a third run later, and supported by tools better suited for institutionals, including initiatives from central banks and commercial banks to offer more robust digital asset exposure.”

Lyxor noted that the early days of simple long positions on cryptocurrencies such as bitcoin, Ethereum, or Ripple have since given way to more sophisticated digital assets-linked strategies, which can employ swaps, futures and options indexed on cryptocurrencies, as well as bets on income generated by the underlying technology.

London-listed hedge fund giant Man Group said recently that bitcoin’s volatility could be seen as “price discovery” in a new asset class, which will ultimately give way to greater stability in the currency, and more credibility among investors.