Hedge funds wary of regulatory uncertainty in crypto market

24 August 2022 Consultancy.uk 4 min. read
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Even amid the volatility of the sector, the potential to accumulate large amounts of wealth mean a growing number of traditional hedge funds are braving the risks to invest in cryptocurrency and digital assets. Around four-in-ten funds have already done so, while more than a quarter would “definitely” accelerate investment in the sector if certain regulatory changes were made.

A hedge fund is a pooled investment fund that trades in relatively liquid assets and is able to make extensive use of more complex trading, portfolio-construction, and risk management techniques in an attempt to improve performance, such as short selling, leverage, and derivatives. Hedge funds make money as part of a fee structure paid by fund investors based on assets under management (AUM). Funds typically receive a flat fee plus a percentage of positive returns that exceed some benchmark or hurdle rate.

The sector is not unknown to take large financial risks – and some experts claim that the hedge fund industry was, in part, to blame for the crisis, as it had pushed risky investments like mortgage-backed securities which led to the 2008 financial collapse. Even now, some believe hedge funds, or subsets of hedge funds, may still generate systemic risk that imposes externalities on the financial system.

2022: Investments in Digital Assets + Plans for Gaining Exposure

One trend which might give economists cause for concern on this basis, is the increasing push of hedge funds into the crypto-economy. A new study from PwC – in collaboration with the Alternative Investment Management Association (AIMA) and Elwood Asset Management (now part of CoinShares) – found that a growing number of specialist crypto funds are being created, as the digital asset class gains acceptance.

By the end of 2021, some 38% of traditional hedge funds surveyed told researchers that they were currently investing in digital assets. That’s close to double the 21% seen the year before. Meanwhile, the global number of specialist crypto hedge funds is estimated to now top 300, with the pace of new funds being created accelerating in the past two years. Meanwhile, the total assets under management of crypto hedge funds surveyed rose 8% to $4.1 billion.

Speaking on the phenomenon, PwC’s Global Asset and Wealth Management Leader, Olwyn Alexander, commented, “Increasing appetite and demand from investors has spurred interest in crypto as an asset class, spanning retail to institutional. In addition to the numerous hedge funds investing in crypto, many larger “traditional” asset managers have been exploring the crypto space, working on pilots, and are now starting to launch product. This will help to accelerate the institutionalisation of the crypto markets and, as they mature, regulation and infrastructure will continue to improve. Given recent market developments, we are hearing greater demand for transparency and trust from investors.”

Main regulatory concern + If main obstacles are removed

The ‘wild west’ reputation of cryptocurrency may be putting off hedge funds from investing more heavily, though. At present, most of the traditional hedge funds getting into digital assets are still just dipping their toes – 57% have less than 1% of total AuM in digital assets. The market’s infamous volatility is seeing returns slow significantly – with the median crypto fund in 2021 returning +63.4%, in stark contrast to the +127.55% median return of 2020 – and the attitude among hedge funds seems to be that without more regulatory assurances, they would be reluctant to invest further.

Whether or not they are currently invested in digital assets, hedge funds stated that regulatory uncertainty in the market was a key issue for them. In particular, the lack of regulatory and tax regime clarity was cited as a top challenge by 89% of hedge fund managers, who currently invest in digital assets. At the same time, 83% of managers not currently investing in crypto echoed that sentiment. A further 36% specified that their top concern around cryptocurrency regulation was that it was so globally fragmented, and 20% added that they wanted more clear guidance when it came to rulemaking and enforcement.

Should these main obstacles be removed, many hedge funds seem notably more upbeat on crypto. Around 27% confirmed they would definitely “accelerate investment” with more certainty on the assets, while 29% suggested that would potentially see them become more involved.