Published: May 14th, 2021
Hedge funds are flooding into the crypto marketplace, changing the supply-demand dynamic and handing institutional investors a more significant role in determining BTC price movements.
That growing market dominance is concentrated in three of the world’s biggest funds, Grayscale, Pantera and Galaxy Capital, which combined hold or manage around USD 60 billion, either for themselves or on behalf of wealthy clients who want exposure to crypto without the risk and technical hassles related to crypto custody.
It’s probably no surprise when you consider that Bitcoin’s price has doubled and then some in the last year. The fascinating thing about this group, however, is how their behaviour is altering the crypto landscape. While many early crypto investors took to acquiring cryptocurrency to support emerging ecosystems that showed promise, hedge funds tend to be less altruistic with their investments.
Across 2021, YoY crypto hedge fund gains are up 117 per cent for Q1, beating even Bitcoin’s 104 per cent return. Fund managers have got there by betting both up down on BTC, arguably mitigating some speculative upward price movements while maintaining their own profits either way.
As hedge funds build up their crypto holdings, however, their ability to exert influence in what is still a relatively small investment market is expanding, especially when it comes to circulating supply.
Traditional hedge funds act as money managers for institutional investors and the ultra-rich.
In fact, they won’t even consider you as an investor unless you have a net worth of at least USD 1 million and earn about USD 300,000 annually.
While traditional hedge funds are focused on traditional assets, crypto hedge fund managers are different. Take Grayscale’s Bitcoin Trust as one example. The investment firm created a crypto investment product to enable individual investors to use their brokerage accounts to buy and sell digital currencies. It's fully ‘legit’ in the old school finance sense, registered with the SEC and subject to all the standard rules around financial and risk reporting.
Traditional hedge funds aren't held back by as much regulatory red tape. They’re known to be high-risk, high-reward type investments and only for sophisticated investors.
As more funds jump on the digital currency bandwagon, those innocent days of simply making long bets on Bitcoin, ripple or ether giving way to more complex asset-backed strategies, including futures, options, and swaps indexed against a longer list of coins, plus a few hail-Mary bets on income driven by the underlying technology.
With growing sophistication, the crypto investment landscape is being re-shaped.
Numbers from CyptoQuant show that the vast majority of crypto hedge funds focus on Bitcoin (97 per cent), followed by Ethereum (66 per cent), XRP (37.5 per cent), Bitcoin Cash (38 per cent), Litecoin (31 per cent) and EOS (24 per cent).
A bit more than half of funds trade in derivatives, while the rest tend to be active short sellers. Derivatives are traded to bet on future price movements of an underlying digital currency asset without needing to buy the actual asset itself.
Short sellers purposefully speculate that the price of a cryptocurrency will drop. It’s important to understand that strategic 50/50 split in the crypto hedge fund market, as it sheds light on the methodology each group takes when entering a market.
Bitcoin’s sometimes dizzying price volatility hovered around 2.5 per cent of most of 2020. This year, however, it's leapt to as much as 6 per cent.
Analysts at Goldman Sachs told Bloomberg last week that you won’t get the compounded annual returns of 225 per cent without volatility. If you have the means and confidence to take risky bets, volatility is your friend.’
For risk-hungry hedge fund managers making their money on market swings, that’s what’s made crypto so suddenly irresistible.
Demand for crypto can be both speculative and emotional, sometimes based as much on belief and faith as market savvy. And its limited supply can be manipulated artificially.
Those risks are why hedge funds have jumped in headfirst. One of Europe's largest hedge funds, Brevan Howard, said last month it would now devote a rolling percentage of its USD 5.7 billion fund to purchasing. That puts it on the same footing as names like Galaxy Digital, Paul Tudor Jones's Tudor Investments, which have both gobbled up hundreds of millions worth of BTC, effectively reducing the supply available to individual traders and retail buyers.
Numbers from Chainalysis suggest that as much as 60 per cent of BTC is being hoarded by hedge fund whales, while another 20 per cent has been lost or sits untouched in cold wallets.
With a growing number of hedge funds moving into the market, expect the squeeze to get tighter. With less volume in play, it’s easier to move the price. Hedge funds rely on this to extend their gains, and they've been able to leverage their positions in periods of volatility to create new money-making opportunities. Most importantly, the situation enables them to become market makers for themselves.
Hedge funds look for mismatches between the current price of an asset and the value of a futures contract set to mature in a couple of months.
For example, at the time of writing, BTC stands at around USD 58,000. But there are crypto futures contracts expiring in July where the price of bitcoin is predicted to exceed USD 63,000.
A hedge fund might buy bitcoin at today’s spot price and sell it at the July future target, meaning the futures contract would grow in value if BTC’s price were to drop back. That spread between today’s price and tomorrow’s bet can generate sizeable returns when compounded over time.