This article first appeared in the February 2023 Digial Assets Insights Report
It’s been a little over three months since the collapse of FTX Trading and its cryptocurrency exchange. For fund managers, that’s a lifetime.
In a 12-month period featuring multiple high-profile failures and challenges, FTX remains at the forefront of digital asset hedge fund managers’ minds.
Yes, the crash of stablecoin Terra Luna in the spring resulted in a bigger hit for crypto hedge fund performance – with a drop of 15.7% in May versus 13.2% in November when FTX collapsed (see Figure 1.1) – and the value of bitcoin (see Figure 1.2), but the fall of FTX Trading and its centralized exchange will likely have the more enduring impact on the crypto ecosystem – for better, many fund managers say.
The consensus: the FTX event was different because of who was affected. While the Terra Luna crash was, in many ways, a retail event, FTX managed one of the largest exchanges for crypto investments. It was a so-called ‘safe haven’ for larger entities, investors at the more risk averse end of the digital asset investment spectrum. Some large fund managers had significant capital with FTX – losing hundreds of millions of dollars in some cases – but many institutional allocators were also affected as part of their initial forays into the asset class.
One year on
The shift in mood among digital asset hedge fund managers since the spring, and culminating in the FTX collapse, has been palpable. If the start of 2022 saw managers (and headlines) preoccupied with the potential for dramatic outperformance, 2023 has begun with conversations around improved processes, due diligence, and risk assessment – and the tone is being set from the top down.
Mike Novogratz, CEO of Galaxy Digital, perhaps the crypto hedge fund industry’s best-known manager, has said “rebuilding trust” will the digital asset investment industry’s key theme for 2023.
“Last year was a setback,” Novogratz states, during a Hedgeweek research interview. “Our industry proved to be immature, with various players lacking proper governance and risk controls. That ended up causing a breakdown in trust within and across the industry.” This will be repaired by fund managers “stepping up and deepening due diligence practices”, he adds.
Novogratz is not alone in saying hard work – and time – is now required. Some commentators have said the FTX failure could set the cryptocurrency investment market back five years or more.
But the fund managers Hedgeweek spoke to for this report expect the industry to make that time count. Though the events of last year caused huge upheaval, they have also created an opportunity for an ‘immature’ yet rapidly growing industry to rewind and rebuild on stronger foundations.
“Many of the players running big crypto companies were only there because they were early in a bull market,” says Emil Van Essen, co-founder of quantitative hedge fund specialist and crypto investor Katonah EvE. “These early successes were reckless and irresponsible, and we needed a big shakeout to get rid of these weak players to clear the way to more growth.”
Samed Bouaynaya, portfolio manager for Altana Wealth’s digital assets fund, suggests 2022 will be remembered as “very productive” for the future of digital assets, not the “year to forget” that some investors have ascribed it.
Plans delayed, strengthened
Product development, at least, is ongoing. During a survey of hedge fund managers in January and early February 2023, Hedgeweek found a greater proportion of respondents saying the events of 2022 had ‘strengthened’ their plans for a digital assets product or service than had weakened it, albeit from a low base (see figure 1.3). This was true for both digital asset hedge fund managers and other hedge fund managers. Indeed, news broke in mid-November – just two weeks after the FTX collapse – that Man Group was pushing ahead with plans to launch a dedicated cryptocurrency hedge fund.
“Speculative bubble implosions pave the way for creation, progress, and maturity,” Bouaynaya wrote in Hedgeweek’s Global Outlook 2023 report in January, articulating an approach to last year’s events that many in the crypto industry have adopted. Looking back, he notes that, had it not been for investment in the DotCom bubble and its subsequent implosion, we wouldn’t have unleashed the power of today’s internet.
The comparison to the DotCom bubble – as well as 2008 – is reasonably made and, perhaps unsurprisingly, commonplace during Hedgeweek’s research interviews.
“The biggest risk now is not market risk – it’s counterparty risk,” says Arianna Luna, COO of digital assets fund manager Campsor Capital, pointing to the technological advances in the crypto trading infrastructure – from finetuning option products and the proliferation of OTC options desk, to decentralised finance – as reasons for fund managers to be optimistic. “The opportunities are still available, but it’s paramount, now more than ever, to balance potential returns and expected risks, especially counterparty risk.”
How, then, to better address these risks? According to Novogratz, the events of 2022 should prompt fund managers to reassess the financial health of their counterparties and push for regular dialogue. “When evaluating exchange risk,” he says, “due diligence should include a close look at the firm’s financials and if they are audited, whether the exchange provides proof of reserves, and more details on governance and controls, including whether the firm employs a chief risk officer or utilises an independent board of directors.”
Roland Roventa, Bouaynaya’s co-portfolio manager at Altana Wealth’s digital assets fund, sees signs of progress through exchanges releasing the proof of assets Novogratz mentions, and “custodians launching off-exchange settlement solutions”.
The rise of DeFi?
Roventa – and other interviewees – also point to the increased trading volumes at decentralised finance (DeFi) exchanges following the FTX collapse as a welcome shift away from centralised finance (CeFi) and towards the DeFi ecosystem. DeFi’s proponents – easy to find, with decentralisation being at the core of the entire crypto ethos – argue that this is a positive step for the industry. Traditional investors will need convincing.
In November, trading volumes at DeFi exchanges hit $107bn, up from $57bn in October. Those trading volumes, though, have since normalised.
“While DeFi exchanges and liquidity providers have been discussed as a potentially attractive alternative to CeFi, operational, legal and regulatory considerations have inhibited material migration to these platforms to date,” explains Travis Williamson, head of Hedge Fund Investment Due Diligence at Albourne Partners, co-writing for Hedgeweek with Steven D’Mello, a partner within Albourne’s Operational Due Diligence team. “Until some of these considerations are resolved, usage of centralised counterparties will likely continue, and we expect to see fund managers continue to push for greater transparency from counterparties.”
There could be a shift towards centralised exchanges that offer more transparency, Williamson and D’Mello add, but proof of reserves may lack granularity on the liabilities side of the balance sheet.
Ultimately, though, the pair believe that the impact of the FTX collapse on the industry, in crypto terms, “has been relatively muted compared to other events of this nature” (see boxout).
Of course, managers are just three months out from FTX – and nine from Terra Luna. There is much still to process and more consequences to come: not least the lingering impact on investor appetite for cryptocurrencies, the top-rated obstacle to launching a digital assets fund according to hedge fund managers surveyed by Hedgeweek (see Figure 1.5) and the focus of this report’s second chapter.
“Failure to understand counterparty risk, custodial management, operational security, along with the lack of ability to audit code means that we will likely see some fund managers make crucial mistakes and lose much of their LP’s money,” warns Ray Ng, CIO at emerging crypto fund Alt-Tab Capital.
“2022 should have been the wake-up call needed for the industry,” Ng adds. “But, while I see some additional short-term vigilance, the hard lessons will be learnt through individual experience.”