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November 3, 2022

3 Key Considerations for Crypto Hedge Funds

As institutional investors steadily come around to cryptocurrency investing, hedge funds pursuing a crypto strategy face exciting opportunities alongside a growing need for partners to help them service the strategy.

 

Nadia Cobalovic, Co-Chief Operating Officer, Northern Trust Hedge Fund Services
Greg Clay, Senior Vice President – Relationship Management, Northern Trust Hedge Fund Services
Pete Connor, Senior Vice President – Middle Office Asset Servicing, Northern Trust Hedge Fund Services  

For years, cryptocurrency investing was seen as a fringe strategy reserved for bold individual investors happy to stomach wildly volatile markets. But as top cryptocurrencies like Bitcoin and Ethereum have gained relevance and proved their place in the investment industry, institutional investors have begun to recognize crypto’s long-term value and potential as a hedge against inflation.1 

Their emerging interest is one reason cryptocurrency values are skyrocketing. To give context to their explosive growth, consider that a decade ago, Bitcoin’s market cap sat around $1.5 million at the beginning of 2011, while in 2021 it started the year off around $536 billion and, over the course of the first quarter, has at times crossed over into $1 trillion.2

With the market-moving influence of institutional investors entering the crypto world, hedge fund managers are naturally eyeing crypto strategies as a strong opportunity. Hedge funds setting out to pursue a crypto strategy will have to select administrative partners that have the knowledge, expertise and infrastructure to help them as the market rushes to scale up to this emerging strategy.

Growing opportunity for crypto hedge fund strategies

According to Fidelity, one-third of institutional investors now hold digital assets such as Bitcoin,3 and 47% see digital assets as having a place in their portfolios.4 Given this data, it’s clear that their acceptance of cryptocurrency has come a long way in the last decade. As they embrace the idea of investing in cryptocurrency, pure-play crypto hedge funds and hedge funds who offer crypto funds are sure to see greater demand – and potentially already have.

The total AuM of global crypto hedge funds roughly doubled from 2018 to 2019.5 Family offices are leading the way in this movement, making up 48% of crypto hedge fund investors, while high net worth individuals make up 42%, indicating untapped opportunity to bring other classes of institutional investors – such as pension plans and foundations and endowments – into the fold.

There are encouraging signs that institutional investors are ready to embrace crypto hedge fund strategies, but these sophisticated investors won’t sign on to invest with a manager who they feel isn’t addressing the elements of risk and unfamiliarity that accompany a crypto strategy.

One River Asset Management, a Connecticut-based investment manager that offers Bitcoin and Ethereum strategies, knows this to be true from experience. “We’ve been successful in launching our crypto funds, and service providers like Northern Trust have played a key role in that success,” said Will Wallin, Chief Compliance Officer at One River. “We field many questions from current and prospective investors about the service providers we engage with and whether they have the ability and resources to service complex and emerging approaches like our digital asset strategies. From both an operational and investor relations perspective, it is essential to trust in a service provider’s reputation and to gain an intricate understanding of their capabilities and processes before setting out.”

Managers should consider a few key points when selecting service providers to support a crypto hedge fund strategy.

  • Previous experience in servicing crypto strategies – According to PwC and Elwood Asset Management, 86% of crypto hedge funds use an independent fund administrator, only slightly lower than the estimated percentage of general hedge funds who do so.5,6 But hedge fund managers should ensure they’re vetting their administrator’s preparedness and processes for servicing the back office operations of a crypto strategy fund – particularly for hybrid managers who default to their existing administrator once they launch a new crypto strategy. The logistics of valuing a crypto fund are challenging compared to those of a more traditional fund. Crypto markets operate at all times, unlike traditional stock markets which have daily open and close times, making quantitative strategies particularly difficult when it comes to establishing a structure and process for striking a NAV. To instill confidence in their investors and to reduce the risk of a rocky onboarding, crypto hedge funds should seek out a fund administrator with established processes and expertise in managing crypto hedge fund back office operations.
  • Assistance with investor transparency – As institutional investors are newer to the crypto investment space, they’ll likely desire a deeper sense of transparency and understanding of its performance, risk and liquidity. They may not be satisfied with the typical monthly or quarterly statements and want an interactive, on-demand experience of digesting the fund’s performance. Partnering with a fund administrator with a built-in digital platform specifically designed for investor use can help crypto hedge funds quickly build a foundation for investor trust and transparency.
  • Risk-averse custody options – Handling custody internally can be precarious for crypto hedge fund managers from a technology and knowledge standpoint, so going to a licensed third-party custodian with the needed infrastructure and expertise is a wise approach. Industry standard and expectation is quickly shifting to require managers to custody digital assets with a crypto-capable custodian rather than self-custody, and 81% of crypto hedge funds now use third-party custodians.5 As the need for established crypto custody solutions grows, new options are arriving on the market. In December 2020 Northern Trust announced it entered into an agreement, which is currently pending regulatory approval, with Standard Chartered Bank to launch Zodia Custody Limited, an institutional-grade custody solution for cryptocurrencies.

As institutional investors begin to embrace cryptocurrency investing and capital flows to the asset class increase, hedge funds already engaged in crypto strategies or interested in pursuing a crypto strategy face a promising landscape. But before they make the leap, finding the right partners to support their crypto operations is a critical step to finding success.

 

1 CoinDesk, “Crypto Long & Short: Bitcoin Is More Than a Hedge Against Inflation – It’s a Hedge Against ‘Crazy’”, December 20, 2020.
2 BitInfoCharts, “Bitcoin Market Capitalization historical chart.”
3 Fidelity, “Growing Number of Institutional Investors Believe That Digital Assets Should Be a Part of Their Investment Portfolios, According to New Research from Fidelity Digital Assets℠”, June 9 2020.
4 Fidelity, “New Research from Fidelity® Finds Institutional Investments in Digital Assets Are Likely to Increase over the Next Five Years”, May 2 2019.
5 PwC and Elwood, “2020 Crypto Hedge Fund Report”, May 2020.
6 PwC, “Alternative Administration Survey”, 2014.

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