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Digital assets and hedge funds

22nd Sep 2022
Notwithstanding the recent volatility, hedge fund appetite for digital assets, such as crypto-currencies, has increased year-on-year.

According to a recent Alternative Investment Management Association (AIMA) survey, one in three hedge funds is currently investing into digital assets, up from one in five in 2021. The AIMA survey continues that the average hedge fund allocation to digital assets is around 4%. [1]

A panel of experts examined some of the main issues facing the digital asset market at a roundtable hosted by JTC Group. So what were the main talking points?

 

Regulatory consensus on digital assets remains elusive

Although interest in crypto has been steadily rising, panellists acknowledged that the lack of regulatory clarity or consensus around the asset class is highly problematic, especially for larger, more risk conscious institutions. “The biggest challenge is regulatory,” says Jack Inglis, CEO at AIMA.

In particular, different markets are likely to take a fragmented approach towards supervising digital assets, in what could lead to regulatory arbitrage. Bill Prew, Director of INDOS, notes that whereas the UK and EU are both trying to position themselves as being crypto-friendly jurisdictions, the US Securities and Exchange Commission (SEC) is adopting a much tougher line.

For example, the SEC has publicly said that a number of digital assets have securities-like features, something which could result in these instruments and the providers supporting them being subjected to tougher regulatory oversight.

This absence of standardised regulations, however, will make it harder for asset managers when trading these instruments across multiple jurisdictions.

 

Digital asset service providers – not many options to choose from

While regulatory uncertainty is frustrating, there are concerns, especially among institutional investors, about the limited supply of quality providers capable of servicing digital assets.

“There is not really the infrastructure of service providers out there to support digital assets,” comments Prew. “We have spoken to a couple of macro funds which run crypto strategies. However, these managers cannot operate crypto strategies within their existing funds as their service providers have told them that their professional indemnity insurance will not cover them if crypto comprises more than 1% of the net asset value,” he adds.

More worryingly, there appear to be very few protections to prevent fraud from occurring in this nascent market, according to Jon Masters, Head of Business Development at INDOS. “Administrators servicing crypto-assets will need to look into private wallets to verify the assets exist within those wallets particularly those represented by tokens and to also confirm ownership rights of the tokens. This verification requirement could also be performed by other independent parties such as depositaries. There is not really much to stop a corrupt actor from using the same wallet across multiple. If the service providers do not speak to each other and corroborate this, then there could be a problem,” says Masters.

The relative lack of maturity and persistent open questions facing digital asset service providers is forcing institutions to rethink how they conduct due diligence on these providers.  Just as AIMA led the way on educating the wider industry about hedge fund investing two decades ago, it is being equally proactive around crypto, having published several guides tackling custody, audit and due diligence in the crypto ecosystem.

“AIMA and crypto due diligence experts like ourselves are applying an institutional lens onto the crypto world. This involves identifying what areas need to be improved around things like risk management and asset segregation, and bringing about change. However, there are some risks which are particular to crypto, and these need to be considered too,” says James Newman, Co-Head of Perform Due Diligence Services Limited, a JTC Group company.

 

Overcoming the impediments – Is it doable?

Right now, the crypto market is immature, having been populated overwhelmingly by retail investors, crypto-enthusiasts and very small institutions (e.g. family offices). As the investors in this emerging market become increasingly sophisticated, change will need to happen. At the most basic level, there has to be better regulation of the asset class and its service providers.

At the same time, investors ought to re-think their traditional due diligence processes so that they can oversee crypto-assets properly moving forward.

 

 

[1] AIMA – 4th Annual Global Crypto Hedge Fund Report 2022

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