Arbitrage strategies boost crypto hedge funds, but regulatory headaches remain

Cryptocurrency

Digital assets’ disruptive potential could herald a seismic shift in markets, with crypto hedge funds bringing bumper returns uncorrelated to other asset classes – but investors remain wary of the patchwork of ad-hoc rules and regulations covering the sector.

Attendees at Hedgeweek’s recent DigitalAssetsLIVE event heard how regulatory uncertainty remains a major hurdle for managers and investors alike, along with client aversion and reputational risk.

Moderating a regulatory-focused panel session during the one-day event, James Delaney, director, government affairs at the Association Investment Management Association, pointed to recent industry research suggesting that the removal or easing of such barriers would help persuade cautious market participants to become more actively involved in the crypto sector.

Data shows that roughly a fifth of hedge funds are currently investing in digital assets, with an average of 3 per cent of total hedge fund AUM invested. Some 90 per cent of hedge funds who are currently investing in digital assets intend to deploy more capital into the asset class by the end of the year, and around a quarter of hedge fund managers not yet investing are at least in the late-stage planning to invest or looking to invest, Delaney noted.

The discussion examined the contrasting regulatory approaches across regions, with Anthony Tu-Sekine, head of blockchain and cryptocurrency group at Seward & Kissel, describing the current regulatory landscape in the US as something of a “mixed bag”.

“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 the 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. He added that under the Biden administration, there is evidence that regulatory response remains “somewhat in flux.”

Similarly, Guenther Dobrauz, partner at PwC, drew a contrast between the EU, which has attempted to create a unified coded regulation for cryptocurrencies, and non-EU countries like Switzerland, which has evolved towards a more open, principles-based framework.

Panelists also probed hedge funds’ and asset managers’ response to the evolving regulatory environment.  Steven D'Mello, partner at Albourne Partners, believes that firms with the capabilities to perform deep-dive due diligence during the investment decision-making process could be at an advantage when weighing up risks in acquiring assets.

“We think it’s important for managers to be equipped to assess that regulatory uncertainty,” D’Mello told the panel, adding that a key emerging challenge surrounds whether or not a fund or fund manager is investing in assets that may be deemed unregistered securities offerings. He also flagged up challenges surrounding exchange risks.

“In our view managers should be proactively sweeping assets off-exchange, to protect against some of that regulatory risk that exchanges face,” D’Mello added. “Managers that have to self-custody assets where perhaps there’s no custody solution available should be aware of the SEC custody rule in the requirements, and what it means to potentially not meet them.”

Later, attendees also heard how hedge funds and other alternative assets managers have sought to capitalise on the sector’s ongoing price volatility.

Speaking on the concluding panel which explored trading and investment strategies, Peter Habermacher, CEO of Aaro Capital, said both digital ledger technology and crypto assets offer an attractive long-term growth opportunity for investors. He added crypto’s surge comes at a time when there is increased uncertainty among other asset classes which are becoming increasingly detached from economic fundamentals.

“From a technology perspective, there is the potential to disrupt virtually every industry and has application throughout many different value chains,” Habermacher said.

Kevin Kang, founding principal of BKCoin Capital, a multi-strategy, market neutral digital asset hedge fund, said the aim is to deliver uncorrelated returns for investors, adding that bitcoin’s correlation to the market remains low over a long-term horizon. “Our goal is to give institutional investors exposure to this asset class, as well as institutional-grade risk and compliance,” Kang added.

Ian Morley, a founder of AIMA who today runs YRD Capital, a single family office allocating exclusively to quant crypto hedge funds, drew attention to some of the “naïve” and “volatile” elements of the sector.

“Investors going in and trying to pick the times they are going to buy bitcoin or ethereum or any other coin is a dangerous place to be,” Morley observed. “Whereas fund managers are mostly taking advantage of the arbitrages and inefficiencies that are available. It strikes me that you need to be going in with a fund, or a fund-of-fund.”