Shivraj D
- Apr 18, 2022
- 19 min read

Crypto Hedge Can be Important for Interview in upcoming Time(Hedge Fund & Privat Equity)

Updated: May 17, 2022

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Crypto Hedge :-

Crypto Funds it means since 2014 most of the Funds they are actively investing into Crypto coins like Bitcoin, Ethereum , Polkadot and Block chain technology so, the Funds setup and accounting structure for Crypto funds work like Side Pocket investment fund , to create separate accounting books and maintain the same like side Pocket investment funds maintain so, see the below in details discussion on Crypto hedge And enhance your knowledge .

Introduction to Crypto Hedge Fund Blog

Key Takeaways

Survey Data

Investment Data

Strategy Insights

Market Analysis

Assets Under Management (AuM)

Fund performance

Fees

Cryptocurrencies

Derivatives and Leverage

Custody and Counterparty Risk

Governance

Valuation and Fund Administration

Liquidity and Lock-ups

Legal and Regulatory

Tax

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In this Blog we provide an overview of the global crypto hedge fund landscape and offer insights into both quantitative elements (such as liquidity terms, trading of cryptocurrencies and performance) and qualitative aspects, such as best practice with respect to custody and governance Functions etc. By sharing these insights with the broader Audience, our goal is to encourage you to make aware about the market participants and ecosystem structure so that will help you to develop your career in crypto hedge fund also.

The data contained in this blog comes from research that was conducted in Q1 2020 across the largest global crypto hedge funds by assets under management (AuM). This blogs specifically focuses on crypto hedge funds and excludes data from crypto index/tracking/passive funds and crypto venture capital funds which would be more important for the Interview perspective in upcoming time.

Key Takeaways:

Size of the Market and AuM:

• We estimate that the total AuM of crypto hedge funds globally increased to over US$2 billion in 2019 from US$1 billion the previous year.

The percentage of crypto hedge funds with an AuM of over US$20 million increased in 2019 from 19% to 35%.

Investor Type and Average Ticket Size:

The vast majority of investors in crypto hedge funds (90%) are either family offices (48%) or high-net worth individuals (42%).
The median ticket size is US$0.3 million, while the average ticket size is US$3.1 million.
Almost two thirds of crypto hedge funds have average ticket sizes below US$0.5 million.
Crypto hedge funds have a median of 28 investors.

( Average 28 Investors are investing into one Fund)

Performance and Fees:

The median crypto hedge fund returned +30% in 2019 (vs - 46% in 2018)
The median of the best performing by strategy in 2019 was discretionary long only (+40%) follow ed by discretionary long-short (+33%), quantitative (+30%) and multi-strategy (+15%)
Median management and performance fees remained unchanged at 2% and 20% respectively, although the average management fee increased from 1.7% to 2.3% and the performance fee decreased from 23.5% to 21.1%
65% of crypto hedge funds have either a hard or soft lock and 63% have either an investor level or fund level gate.

( Gate it means entry or Exist Cost or Fees you can say that usually every funds charge so, same here Crypto Funds also Charge fees to the Investors )

Fund Strategies, Activities and Trading:

The most common crypto hedge fund strategy is quantitative (48% of funds), follow ed by discretionary long only (19%), discretionary long/short (17%), and multi-strategy (17%)
Most crypto hedge funds trade Bitcoin (97%) follow ed by Ethereum (67%), XRP (38%), Litecoin (38%), Bitcoin Cash (31%) and EOS (25%)
About half of crypto hedge funds trade derivatives (56%) or are active short sellers (48%)
Crypto hedge funds are also involved in cryptocurrency staking (42%), lending (38%) and borrowing (27%)

( There is no big change in the Investment strategies like Long , Short and ICO etc. )

Governance:

The percentage of crypto hedge funds using an independent custodian increased in 2019 from 52% to 81%.
The percentage with at least one independent director on their board increased from 25% to 43% in 2019.
The percentage of crypto hedge funds using third party research increased from 7% to 38% in 2019.
86% w ere using an independent fund administration 2019

( Most of the Funds has its Custodian and Fund Administrations entities like we have Apex , Northen Trust etc, so in short Fund admin and Custodian Jobs will be Impacted due to the Crypto Funds)

After go through the Above data what you understood ?

Crytpo Fund are similar Nature like Side Pocket Investment Funds.
Crypto Funds has its own Fund Admin and Custodian to store their Keys .
Fees structure is remain unchanged like - 2 % - Management Fees and 20% as Performance Fees.
Investment Strategies are also same like Longs and Shorts .

Location

Funds tend to be domiciled in the same jurisdictions as traditional hedge funds, with the top three being the Cayman Islands (42%), the United States (38%) and the British Virgin Islands (BVI) (8%).

Over half of crypto hedge fund managers are based in the United States (52%), follow ed by the United Kingdom (15%)

( Latest count will be Published on the same Blog so just Subscribe it for Further Updates)

As shown by the graph above, the launch of actively managed crypto funds is highly correlated with the price of Bitcoin (BTC) . The Bitcoin price spike in 2018 appears to have been a catalyst for further crypto funds to launch. We can also see a material decline in new fund launches as crypto markets trended downward at the end of 2019.

Most common strategies of crypto hedge funds

Taking our dataset as being representative of the total crypto fund universe, we can see that quant funds are the most prevalent and make up almost half of crypto hedge funds in the market today. The remaining strategies - discretionary long-only (19%), discretionary long/short (17%) and multi-strategy (17%) - are significantly smaller by comparison and together make up the other 50% of the crypto hedge fund market.

Market Analysis

This year we asked funds to categories their investor base. Below we can see that the most common investor types (almost 90% of all investors) are either family offices (48%) or high-net worth individuals (42%). In fact, none of our respondents cited pensions funds and only a handful had foundations or endowments as investors. Somewhat surprisingly, we see that the share of investors that are Venture Capital (VC) funds and Fund of Funds (FoFs) is small by comparison.

Most common investors in crypto hedge funds

The median number of investors in funds is 27.5 and the average is 58.5, while the median ticket size is US$0.3 million and the average is US$3.1 million. The graph below shows the distribution of the average ticket size and suggests that almost two thirds of funds have tickets below US$0.5 million.

Investor ticket size - distribution of average

The graph below shows the distribution of AuM held by individual crypto hedge funds. This is similar to the distribution for traditional hedge funds, where a few large funds manage the majority of assets, with a long tail of smaller funds.

The above graph shows us that the percentage of crypto hedge funds with an AuM of over US$20 million increased in 2019 from 19% to 35%. This is not surprising: funds with a larger AuM tend to attract not only new investors but larger ticket sizes, a s many investors are restricted from representing more than 10% of AuM due to concentration risk.

Fund Performance

The table above shows a breakdown of the performance by investment strategy. The reported median 2019 year-end performance for the multi-strategy approach appears to be substantially lower (15%) than quantitative (30%), discretionary long / short (33%) and discretionary long only (40%).

Please note that multi-strategy performance is excluded from the table above as this strategy was not covered separately in 2019.

An interesting take-away from our survey is that there is significant survivorship bias. For example, the median crypto hedge fund performance was -46% in 2018. However, the median 2019 year-end performance of the funds that are included in this year’s report is 74%. This provides very clear evidence that funds that significantly underperformed during the previous year had to shut down. This is particularly relevant when we consider the small AuM of crypto hedge funds: their average management fees (discussed further below in this report) are not enough for them to break even. This can only be achieved with strong performance fees.

In the chart above, we compare performance by strategy rather than by fund to mitigate the survivorship bias caused by the funds that closed during 2018 and 2019. It is clear that Bitcoin (+92%) outperformed all hedge fund strategies in 2019. While these strategies were able to mitigate the effects of the 2018 crypto bear market, they did not succeed in replicating the upward trend of 2019. In summary, they acted as volatility-reducing tools rather than performance-enhancing catalysts.

Fees

Crypto hedge fund management and performance fees

Median fees were the same as in 2019: a 2% management fee with a 20% performance fee. However, we find that the average management fee increased (from 1.7% to 2.3%) but the average performance fee decreased (from 23.5% to 21.1%). We believe that most managers increased their management fees to help them cover their running costs, which have increased materially in recent years.

As crypto hedge funds seek to attract more institutional investors and other market participants, such as third-party custodians, they have become more regulated. The costs associated with complying to these stricter regulatory standards have also increased. We would expect these fees to gradually decrease over the coming years. As the industry matures it will become more competitive, offering more options for investors as institutional grade players enter the market.

Despite the slight increase in management fees, crypto funds will still find it challenging to break even, unless they are able to attract enough investors, keeping in mind that the median crypto hedge fund in 2019 had US$8.2 million in AuM.

To illustrate this point, if the median crypto fund manages US$8.2 million and charges a 2% management fee, then they have US$164,000 in annual revenue. This is unlikely to be sufficient to sustain a business operation, especially considering that the median fund has a payroll with six employees. As a result, some funds are exploring ways to increase their income in order to cover costs. For example, we have seen quant funds diversify their approach and start market making, and early-stage focused funds take on advisory roles for new projects, while other funds seek to raise additional capital by selling stakes in their General Partner (GP). Some funds remain focused on their core strategy and hope to cover costs via the performance fee. While this approach can be seen as a positive, the downside is that managers may be inclined to take additional risks, especially towards year-end if they are still under their high water mark. The reality is that, at such low median AuMs, we expect a large number of existing crypto funds to shut down unless they are able to generate exceptionally high returns.

Investing in Cryptocurrencies

In this year’s report, given the multifaceted nature of

cryptocurrencies, we asked crypto funds how they are using Bitcoin and other cryptocurrencies other than for investment purposes.

The activities listed below were highlighted by the funds.

.Percentage of crypto hedge funds involved in staking, lending and borrowing.

Staking and lending, in particular, highlight how funds have increased their knowledge of specific crypto-related technologies in order to diversify their revenue streams.

• Staking, baking, delegating and running master-nodes are yield-based strategies, but also contribute to the

overall stability and robustness of the network. This is an important differentiation between crypto markets and capital markets. Moreover, running Proof-of-Stake (PoS) nodes requires engineers to setup and maintain a cloud

and/or hardware configuration. Depending on their specific software requirements, different cryptocurrency projects may require very different configurations.

• Granting and monitoring a loan of crypto assets also require specific technologies and skills. Multiple managers may be required to authorize the transfer, and the flow of funds may be tracked on the public ledger.

Again, engineers may be required to design and develop very specific tools to monitor all the individual steps involved in the loan process and to create interfaces between the firm’s proprietary software and exchanges or other market participants.

The examples above explain why inputs from tech-savvy investment professionals are fundamental and why the Chief Technology Officer (CTO) is often actively involved.

When it comes to the percentage of a fund’s daily trading activity attributed to BTC, almost half of all funds in our survey (49%) reported that at least half of their daily cryptocurrency trading volume is BTC, while only 5% of funds are pure Bitcoin funds and trade only BTC.

We also asked funds to name their top traded altcoins by daily volume (stablecoins were excluded) and we found that the top five altcoins traded the most by funds were: Ethereum (ETH, 67%), XRP (38%), Litecoin (LTC, 38%), Bitcoin Cash (BCH, 31%) and EOS (25%).

Although we did not ask funds to rank their top traded altcoins by market capitalization, it is interesting to note that Litecoin was mentioned by funds as one of their top traded altcoins despite its market cap being relatively smaller than the other mentioned altcoins. This also applies to ZCash and Ethereum Classic but to a lesser extent.

Derivatives and Leverage

Derivatives can either be used as hedging or alpha - generating instruments. Over the past year, we have seen further developments in the crypto lending market. For instance, many centralized and decentralized crypto exchange platforms are now providing lending and margin trading features to their customers. Therefore, flash loans and interest rate arbitrage are becoming more common.

These developments are also enabling funds to take short positions more easily as the derivatives market has become more diverse and more liquid. This means that crypto funds are more easily able to offer complex investment strategies such as market-neutral, as they have a more advanced toolkit at their disposal. It also means that we are seeing a closer correlation between investment strategies at crypto hedge funds and traditional hedge funds.

Our 2019 data supports this view, as almost half of the funds short crypto (48%) and over fifty percent (56%) actively use derivatives. Looking into the options and futures markets, about one third of funds use futures (either cash or physically settled) and options. The presence of regulated futures offerings should contribute to an increase of usage of such instruments over the coming years .

A different trend can be observed on the use of leverage. In the 2019 report, only 36% of the funds surveyed were allowed to use leverage. This year the figure has gone up to 56%, although only 19% of funds actively use it.

Whilst we believe that more crypto hedge funds will be allowed to use leverage in their PPM, it still not clear that we should see a material increase in the coming years due to difficulties in obtaining debt financing by brokers (e.g. high

collateral requirements, inherent risks) and the fact that many are able to get leveraged exposure by using derivatives.

Custody and Counterparty Risk

In the traditional fund management space, it is expected that funds use an independent third-party custodian. There are a large number of established players, from licensed custodians through to prime brokers, who can take custody of fund assets. This is not as straightforward in the crypto space, given the realities of public and private keys — which is why half of the crypto fund managers in our 2019 report said they used multi-signature wallets, hot/cold wallet set-ups or other innovative ways to hold the private keys of the fund’s crypto assets. For funds using such a self-custody approach, having the in-house technology and expertise to design and monitor the self-custody set-up is also very important.

However, the crypto ecosystem has changed substantially and there are now a large number of crypto custodians that can service the industry.

So it should not be a surprise that, while our 2018 data showed that just over half the funds used an independent custodian, there was a significant increase this year. Over 80% of funds now use one or more independent custodians (either third party or exchange custodians).

This is not only due to institutional investor pressure and the continuous implementation of industry best practices, but also as fund managers are becoming increasingly regulated. These new regulations not only require funds to be stored in a safe environment (including with an independent custodian) but many jurisdictions also forbid a regulated fund manager from directly holding client assets.

It is important to remember that almost half of the crypto hedge funds surveyed are quant funds. These traditionally leave their assets directly with the various exchanges as they trade continuously. Given the fact that 80% of funds report using an independent custodian, this implies that a large number of quant funds also use an independent custodian. However, for these quant funds, having a well - defined and enforced risk management policy is likely to be more important than having a custodian or not. Conducting regular counterparty risk assessments on these exchanges is also becoming important, as institutional investors will likely focus on this area as part of their operational due diligence. Demonstrating how the fund manager reacted to some of the big market events (e.g. the 12 March 2020 market crash) will also be key.

Given the relevance of these developments, it is interesting to take a look at the overall crypto custody landscape. From the chart below, we can see that there is no ‘market leader’ and that the industry is fragmented. Our data shows that the most frequently named custodian serves only 15% of the crypto hedge fund universe in our report. While this data weighs each fund equally (not factoring in AuM), we still consider it relevant as it shows how fragmented the custodian ecosystem is.

Some of the larger hedge funds will have more than one custodian. There are many reasons for this. Some do it for counterparty risk management reasons, especially considering the existing hacking risks in the industry. Others need a second custodian as their primary custodian may not custody all the assets they trade or may trade. Unfortunately, onboarding a second custodian is not always possible for smaller funds due to the minimum monthly fees that are added to the fund expenses, which could impact their net performance.

We also note that the vast majority of custodians used by funds are regulated or licensed in some form. This is a positive development for the industry and indicates the further institutionalization of the space. In addition, a handful of custodians also have System and Organization Controls (SOC) reports (or their ISAE 3402 equivalent), which are different from financial audits. These reports provide a level of transparency around financial reporting (SOC 1/ISAE 3402) and operational controls (SOC 2) and help to build customer trust in their risk management framework. We expect to see an increase in the number of custodians that obtain such public assurance reports. This should give comfort not only to investors in funds which use these custodians but also to the funds’ service providers.

Governance

Percentage of crypto hedge funds with an independent director

Having independent directors on a fund board is critical, especially when decisions that may have an impact on investors need to be made, such as whether a side pocket needs to be set up to hold certain assets or whether restrictions need to be imposed on investor redemptions. In the crypto space, critical decisions are exacerbated by volatility issues and illiquid assets.

In the 2019 report, only 25% of funds had an independent director on their board. This year, our data shows that 43% of funds have one. Part of the reason is the general institutionalization of the industry and the de facto requirement by institutional investors to have independent directors on the boards of the funds they invest in. There is also a wider availability of board directors with relevant expertise and knowledge of the space. In the early years these were a rare commodity. But now, as the industry

matures, there are more candidates to choose from. This trend is likely to have a positive impact on funds’ ability to

attract institutional investors and is another development that demonstrates how the industry is becoming more institutionalized.

Valuation and Fund Administration

Percentage of crypto hedge funds using an independent fund administrator.

Last year we mentioned that an independently verified NAV is a crucial piece of information for fund auditors as well as investors, and that we expected to see more developments in this area. We are happy to see that over 86% of the crypto hedge funds in our report use an independent fund administrator.

It is very unlikely that institutional investors will select any fund without an independent administrator. While this was acceptable in the early days of the industry, there is no valid reason for a crypto hedge fund to calculate its own Net Asset Value (NAV) each month. We expect only a very restricted number of funds, such as those with small AuMs or who hold niche crypto assets, to be able to value part of their portfolio themselves.

Regardless of the choice of fund administrator, the valuation policy needs particular focus. Most funds will have their valuation methodologies and frameworks set out in the PPM. It is important for any fund to ensure that it complies with what is set out in its documentation. Management fees are determined based on NAV and performance fees are typically charged on NAV appreciation over a set period (e.g. Above a ‘high water mark’).

Investors expect a monthly NAV to be available and verified by an independent, reputable fund administrator. Cryptocurrency exchanges can provide independent price quotes for certain crypto assets. But for those portfolios made up of less liquid crypto assets, managers may have to source a valuation from an independent third-party which satisfies the requirements set out in the PPM.

However, being able to accurately value a crypto fund remains challenging. This is particularly true for funds that hold illiquid tokens or crypto investments via SAFTs. There are also details that are important for funds trading some of the more liquid crypto assets, such as: the cut-off time for valuation (crypto markets operate 24 hours a day) or how many and which price sources to use (the same crypto asset may be priced differently at different exchanges globally).

PwC’s is going to be published the report on accounting considerations for crypto assets .

Liquidity and Lock-ups

Not surprisingly, the liquidity and lock-up terms of the crypto hedge fund universe is largely similar to the other Hedge Funds. Quant funds provide the most liquid fund. Quant funds that generally trade very liquid exchange-listed crypto assets can easily provide better liquidity to investors than a fundamental investor targeting early-stage projects or a multi-strategy, where the fund manager needs to consider the various strategies and instruments in its portfolio. One surprising takeaway is that we are seeing hard locks (where an investor is not allowed to redeem until the end of the lock-up period) and soft locks (where an investor is allowed to redeem early by paying a penalty) being used across the various fund strategies, with the majority of funds (65%) having one or the other.

Although hard locks are commonly used in situations where liquidity could be an issue, many liquid quant funds have similar terms. We believe that this is due mainly to the negotiating power of quant funds. Also, it may be that some funds were able to negotiate fee reductions via side letters in exchange for locking up their capital. As the industry matures and becomes more competitive, it will be interesting to see whether new crypto hedge fund vintages result in a change in the mix of fund terms that we see below.

We do not discuss fund liquidity overall, as each strategy is different and has its own liquidity constraints. We believe that such an analysis could be more interesting for gates.

Gates are a useful mechanism that allow fund directors to put in place restrictions in very limited circumstances, which limit the speed at which investors can redeem. The main purpose of a gate is not to protect the fund manager, but rather the remaining shareholders in the fund, so as to ensure that assets do not need to be liquidated in a fire sale solely to meet the large number of redemption requests.

There are two main types of gates:

• Fund-level gates Triggered only when redemptions are over a certain threshold of the fund (e.g. when over 25% of fund NAV or of total number of shares in issue at a particular redemption day).

Investors generally receive their redemptions on a pro-rata basis depending on the number of investors redeeming, but the total redemption amount is capped (e.g. at 25% of the NAV or total number of shares).
As there is no priority, the scaled-down redemption request will be treated on the next redemption day on a pro-rata basis with any new redemption requests.

• Investor-level gates

Always applied when an investor chooses to redeem (e.g. investors can only redeem 25% of their investment each redemption day regardless of whether other investors are redeeming at the same day)

Our data shows that the majority of crypto hedge funds have some sort of gate mechanism in place. Whether the industry will move towards investor level or fund level gates over the coming years is still unclear.

Fund-level gates may be seen as fairer, as they can only be triggered if a certain threshold of redemption requests on a particular redemption day is crossed. For example, if there is only one investor redeeming, with limited impact on the fund, then there is no reason for a gate to be imposed in the first place. The downside for an investor is that they cannot know whether their redemption request will be fulfilled, which may cause some cash management issues if the investor has their own liquidity requirements. Fund-level gates also put more pressure on the fund’s board of directors, as they are responsible for deciding when to enact the gates.

Investor-level gates can be seen as somewhat favoring the fund manager at first glance, as the investor will never be able to redeem his capital in one go, but rather over a set number of months, during which time the fund manager will continue to collect fees. However, some investors prefer investor-level gates. Although they cannot redeem their full investment in one go, there is certainty as to what amount they will receive, which helps their cash flow management. Generally speaking, investors are now comfortable with both gate mechanisms. In practice, the final decision as to which one to put in place is often made after consulting with the lead or Day 1 investor on their preference.

We will continue to track this data over the coming years.

Percentage of crypto hedge funds with redemption gates

Tax

A crypto hedge fund and its manager need to consider many of the same multi-jurisdictional tax issues that a regular hedge fund and fund manager would face. These include:

• Choice of fund structure and ensuring that the fund/feeder(s) are set up to be attractive to investors with different tax attributes;

• Assessment of whether the fund is trading or investing for tax purposes;

• Understanding the capital gains and withholding tax implications of different trades (if any);

• Structuring the performance fees/carry structure used to incentivise key staff of the manager;

• Dealing with transfer pricing between any connected entities responsible for managing the fund; and

• Managing investor tax reporting as well as CRS/FATCA.

However, there are a number of areas where crypto funds have unique tax issues. These include.

• Treatment of cryptocurrency investments – The characterisation of the income/gains derived from the

fund’s crypto investments could depend on whether the investments are treated as securities, commodities, or other property for tax purposes.

• Different and unique sources of income / gains - As highlighted in this Blogs, crypto hedge funds can have a variety of sources of income that may require special consideration from a tax perspective (e.g. staking income from running proof of stake nodes, mining income, token

rewards, coin-lending and tokens received from hard forks or airdrops). These sources of income / gains can often have unintended tax consequences. For example, if income from staking/rewards is treated as services

income the activities giving rise to the income may constitute a trade or business or permanent establishment of the fund.

For example, if such activities took place in the US, then non-US investors in the fund may be subject to US tax and the fund may have withholding obligations. The fund will also likely lose its ability to be considered for electing investment partnership status.

• Do loss limitation regimes apply to crypto fund trades? - For example, the wash sale or straddle rules in the United States. Wash sale rules applies to a sale or other disposition of "shares of stock or securities" while

straddle rules apply to losses with respect to offsetting positions with respect to "personal property that is actively traded". Each crypto asset should be analysed separately.

• Are mark-to-market elections available (such as the mark-to-market regime in the United States which means that all gain or losses are ordinary in character)? In general, a trader in securities or commodities may make a mark to market election with respect to "securities" or "commodities" held in connection with its trade or

business of trading. Again each crypto asset should be analysed separately.

• Availability of fund tax safe-harbors - If the fund is established in a different jurisdiction to the fund manager, then detailed consideration will need to be given as to whether the activities of the investment team could result

in tax obligations arising for the fund. Many jurisdictions have safe harbors in place to prevent funds from suffering tax in the location of the investment team. In many cases, these exemptions were written into law prior to the

advent of digital assets and therefore there is significant uncertainty as to whether many safe-harbor regimes or fund exemptions can be relied upon for crypto funds. For example, regimes such as the UK's investment manager

exemption, Hong Kong's unified fund exemption and Singapore's offshore fund exemption include lists of qualifying investments. Many crypto assets (particularly payment tokens and utility tokens) do not qualify.

Because of these uncertainties, extra caution is needed, and there may be more uncertainty in many of the tax positions that crypto funds take on. As the market develops and becomes more institutional, managers should expect increased investor scrutiny on this topic.