Hedge funds that want to be active in the crypto space are immediately faced with the difficulty of how to execute on their trading strategies. Other asset classes, like equities or commodities, don’t present this problem in such a heightened way because those markets have well-defined, regulatory-compliant ways to act on trade ideas.
This article argues that over-the-counter derivatives (for brevity, swaps) can help mitigate regulatory and operational difficulties that hedge funds face when executing on crypto trading strategies. The article focuses on US hedge funds and US regulations because the US generally presents the greatest difficulties for hedge funds looking to execute on crypto trading strategies.
Why use swaps to access crypto?
Swaps provide more regulatory clarity and comfort for hedge funds. They also solve specific regulatory issues. They: –
- Help hedge funds comply with the SEC Qualified Custody Rule;
- Allow hedge funds to access the economics of hard-to-access instruments
- Serve needs when hedge funds face exchange position and accountability limits
Swaps help hedge funds comply with the SEC Qualified Custody Rule
The SEC Qualified Custody Rule says, in essence, that (i) hedge funds managed by a Registered Investment Adviser (RIA) have to hold assets with a Qualified Custodian, which is defined as a bank, broker-dealer, futures commission merchant, or foreign financial institution, and (ii) the Qualified Custodian has to hold those assets in a separate account on behalf of the fund. Moreover, the SEC recently proposed a new Custody Rule (now called the Segregation Rule) that expands the reach of the rule and imposes new requirements on how RIA-managed hedge funds custody assets.
If a hedge fund managed by an RIA wants to invest in crypto directly, it has to ensure that the crypto is being held by a Qualified Custodian that complies with the rule, and there is considerable doubt about whether any of the leading crypto custodians actually meets the requirements of the rule notwithstanding that they say they do. SEC Chair Gensler has stated, “Crypto companies may claim they can take proper custody of your assets . . . [but] even if a crypto company claims that they custody your assets, it’s not the same as qualified custody.” Commissioner Hester Peirce also asked SEC staff about the proposed Segregation Rule, “If the rules were to go into effect as written today . . . would there be any Qualified Custodians in the crypto space?”
Swaps give hedge funds more certainty that they are complying with the SEC Qualified Custody Rule.
Swaps help hedge funds get the economics of hard-to-access instruments
Although limited exchange-traded crypto derivatives markets exist in the US (the CME, for example, offers Bitcoin futures), markets for some products that hedge funds want, like options on Bitcoin, simply do not exist in the US. Markets for these products have developed outside the US – like Deribit – but those markets are not US-registered trading venues and are not allowed to accept US customers. Swaps allow US hedge funds to enter into trades, like options on Bitcoin, that essentially mirror the economics of the instruments found on non-US trading venues.
Swaps serve needs when hedge funds face exchange position and accountability limits
Swaps also can help hedge funds execute on their crypto trading strategies when they face position and accountability limits in exchange-traded futures. This is not a trivial or theoretical problem because those limits generally apply at the commodity pool operator (CPO) level to all funds managed by that commodity pool operator, so a CPO with several funds that invest in crypto futures can quickly hit limits. Position limits are hard limits that a CPO faces when investing in futures, and accountability limits subject a CPO to heightened scrutiny by an exchange that can lead to a CPO having to cut back on its positions. Hedge funds can get greater certainty that they can execute on their crypto trading strategies and not be forced to cut back on positions by entering into swaps.
Swaps also solve operational problems for hedge funds. They: –
- Allow hedge funds to make trades that are difficult or impossible to make
- Provide leverage to hedge funds
Swaps allow hedge funds to make trades that are difficult or impossible to make
Some trades that US hedge funds may want to enter into, like shorting anything other than Bitcoin or ETH, are difficult or impossible to execute. For example, last year, many funds in the crypto space wanted to short Tether (“USDT”). In theory, they could have borrowed USDT and sold it short, but it is both difficult to find a party willing to lend USDT and difficult operationally for many funds to manage physically borrowing USDT. The problem becomes even more complicated for a hedge fund that wants to short a basket of alternative crypto assets. Entering into a swap outsources all of those problems to the swap dealer and makes this a simple trade for a hedge fund.
Swaps can provide leverage to hedge funds
Swaps can be a more capital-efficient way of accessing crypto because they can provide leverage to hedge funds. Direct investment in crypto is obviously capital-intensive, but exchange-traded crypto futures also are more capital-intensive than their non-crypto futures cousins. CME Bitcoin Futures, for example, require 38% of the notional amount to be posted as initial margin. Hedge funds may be able to enter into Bitcoin swaps with less initial collateral.
Considerations when entering into crypto swaps
Crypto swaps present similar issues to swaps on other underlying assets. Hedge funds should make sure that a swap dealer is either registered or exempt under SEC and CFTC rules because they fall under the de minimis amounts – $400 million for SEC registration and $8 billion in aggregate gross notional amount in the past 12 months for CFTC registration. They should also make sure that the swap dealer will properly report trades as per CFTC rules, which some non-US swap dealers do not do. Finally, since swaps involve future payments, funds should consider the creditworthiness of their counterparties. Credit concerns, however, can be mitigated by using triparty or control accounts to hold collateral.
Solving regulatory and operational issues
Crypto swaps solve regulatory and operational problems for hedge funds. From giving funds regulatory certainty with respect to SEC and CFTC rules, to allowing funds to execute on trade ideas like shorting altcoins that are difficult to impossible to execute, funds that are active in the crypto space should consider executing on those trade ideas by entering into swaps.
