The Rise of the Crypto Hedge Fund: Opportunities and Challenges

The extraordinary returns generated by cryptocurrencies have led to a frenzy of investment activity and interest from investors. Several new crypto hedge funds have emerged, and cryptocurrency is fast establishing itself as a mainstream asset class.

However, numerous operational and regulatory concerns remain. While regulators are increasing oversight, established players and startups are moving to address the current gaps in infrastructure, control and compliance.

According to Autonomous Next, there are currently 370 crypto funds, with USD 8-10 billion in assets under management.

One of the heavyweights in this space is blockchain investment company Pantera Capital, which recently launched its third crypto fund with over USD 71 million already committed. Pantera has recorded a 10,000 percent return over the last 5 years from its stakes in various crypto projects, including crypto exchanges such as Bitstamp, Korbit and Shapeshift, as well as payments startups such as Circle and Ripple.

There is also increasing interest in developing asset-backed tokens that derive their value from a tangible or intangible object with economic value, effectively creating tokenised funds for greater liquidity and fundraising potential.

Silicon Valley venture capital firm 500 Startups’ new 22X Fund permits accredited investors who purchase 22X tokens to own up to 10 percent equity in the 22nd batch of its portfolio companies. Proceeds from the fund are distributed pro rata to participating companies, with token holders able to trade tokens after a year and receive proceeds from liquidity events.

The rise of tokenised funds is revolutionising the way in which private equity and venture capital fund managers raise capital, and bringing greater democratisation and transparency to the fund management space.

Despite this explosive growth, challenges remain in these largely unregulated trading markets. Varying regulatory requirements across jurisdictions, fears over market manipulation, and operational issues around valuation, liquidity and custody all contribute to a difficult environment for hedge fund operators and investors.

Amorphous and varying regulatory requirements

Regulatory analysis on whether a digital token constitutes a regulated product varies from country to country. There are particular complexities for asset-backed tokens, which are amorphous and can involve many different business models.

A vehicle whose primary purpose is to invest money provided by its investors in cryptocurrencies or cryptocurrency products may be considered to be a “collective investment scheme”, or its equivalent in many jurisdictions. In these cases, a fund company would need to consider various licensing implications, including whether the fund manager needs to be licensed, and if the fund documentation needs to be registered or approved by the relevant regulators.

There may also be reporting requirements for existing regulated entities that decide to extend the scope of their fund management business to include crypto funds.

In Hong Kong, the SFC (Securities and Futures Commission) issued a circular on 1 June 2018 reminding intermediaries that they are expected to notify the SFC if they intend to provide trading and asset management services involving crypto-assets.

Other regulators, such as the Canadian Securities Administrators, may also impose additional conditions on existing or new registrations of fund managers as a consequence of their cryptocurrency-related activities.

Market manipulation

Allegations of market manipulation continue to plague the crypto markets, casting a shadow of doubt on projected trading volumes and profits in the market.

The US SEC (Securities and Exchange Commission) recently rejected a second attempt by Cameron and Tyler Winklevoss, founders of crypto exchange Gemini, to list shares of a bitcoin exchange traded fund (ETF).

The SEC said it did not support the Winklevoss’ argument that bitcoin markets were “uniquely resistant to manipulation”, and raised concerns about fraud and manipulation, particularly since trading takes place in a largely unregulated offshore market. Three other ETF proposals by Proshares, Direxion and GraniteShares were also recently rejected on 22 August for similar reasons.

According to Forbes, many crypto funds have fostered close relationships with crypto exchanges, and have recommended ICOs (initial coin offerings) to those exchanges. Some crypto funds may have a stronger influence over exchanges, particularly where they act as market makers and can direct trading to exchanges as incentives.

The price of a digital token usually rises when it is listed on an exchange, as new liquidity is perceived as an endorsement. Such price increases would benefit the crypto fund, hence creating a conflict in its role as introducer, but such arrangements are usually not disclosed to investors.

US regulators, in strengthening their oversight over cryptocurrencies, are increasingly looking into whether manipulation might be compromising prices in virtual currency markets. The CFTC (Commodity Futures Trading Commission) has reportedly demanded extensive trading data from several cryptocurrency exchanges and is looking into whether manipulative trading could have distorted the value of bitcoin futures.

Even so, Kraken CEO Jesse Powell has famously stated that market manipulation, or protecting consumers from making risky investments, “doesn’t matter” to most crypto traders. In Asia, there have also been allegations that various exchanges have engaged in wash trades to drive up trading volumes, or engaged in front-running activities.

There are also concerns that the lack of regulation over social media forums and media campaigns means that ICO issuers have free rein to pay bloggers or website operators for positive reviews and analysis of tokens, as reflected in a Wall Street Journal study. This creates a propensity for ‘pump and dump’ strategies, whereby crypto funds get in and out of investments quickly soon after the token launch.

Valuation

Valuation plays an important role, as it impacts how fund performance and investor fees are reflected.

Given concerns about possible manipulation of crypto prices, there are challenges for funds to obtain the information necessary to adequately value and determine the settlement prices of cryptocurrencies and cryptocurrency products.

Crypto fund policies would also need to consider how to deal with blockchain “forks”, which could result in differing crypto prices.

Fragmented liquidity

The lack of liquidity remains one of the most significant barriers to institutional cryptocurrency adoption. The distributed nature of cryptocurrency has given rise to numerous exchanges around the world, creating a fragmented market and limited liquidity.

However, solutions are rapidly being developed in this space. SFOX, a crypto prime dealer for high-volume traders and institutional investors, recently announced that it had raised USD 22.7 million in Series A funding. The company has seen its client base grow 12-fold since the beginning of 2018 alone. SFOX enables institutions to trade high volumes without impacting prices, by providing a global integrated order book which connects them to a vast network of global crypto liquidity venues.

An increasing number of major market players are planning to offer OTC crypto services in Asia, including Chicago trading firm DRW, one of the largest principal trading firms in the financial sector.

Crypto funds will need to consider how they will address regulators’ and investors’ concerns about the volatility and liquidity of fund portfolios and their impact on redemptions.

Custody and supporting infrastructure

Crypto hedge funds that trade security tokens may be mandated by law to store their digital assets with licensed custodians. Custody arrangements may require segregation of client monies and other associated security requirements.

To address the gap, financial institutions and emerging startups are developing custody infrastructure based on existing systems utilised in traditional markets to support and further legitimise the crypto asset ecosystem.

According to Bloomberg, Goldman Sachs, one of the first Wall Street firms to clear bitcoin futures, is considering a plan to offer custody for crypto funds. A formal product from an institution like Goldman Sachs would provide a credible backing for crypto funds and could pave the way for more investors to bet on the asset class.

In May, Nomura Holdings joined other firms to create a custody consortium called Komainu. Meanwhile, three giant Wall Street global custodians – BNY Mellon, JP Morgan Chase and Northern Trust – are reportedly working on or exploring options for crypto-custody services.

Meanwhile, Libra, a provider of middle and back office technology and data services for the crypto asset ecosystem, also recently announced that it closed a USD 15 million Series B round to build out its core product. The Libra Crypto Office platform provides critical reporting infrastructure utilised in traditional markets by managers and investors to the crypto world.

Conclusion

Cryptocurrency remains a highly speculative and high risk asset class. There are unique operational and technological risks associated with custody of crypto assets. Crypto funds may need to make additional disclosures and focus more on internal controls to safeguard client property internally.

Given the complex regulatory and operational issues involved, it is important for firms to review their cryptocurrency projects carefully. At a bare minimum, they should determine if any existing regulations apply and engage with regulators early to avoid costly regulatory surprises and delays.

Herbert Smith Freehills provides legal services to fintech sector participants including incumbent banks, growing fintech businesses, asset managers, payment firms and technology services providers, including in practice areas such as corporate law, technology, cyber security, data protection and financial services regulation.

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