Hedge funds reconsider crypto amid US regulatory concerns

The past year hasn’t been easy for the cryptocurrency industry, given market volatility and business failures including the high-profile collapse of the FTX exchange.

However, hedge funds are clear that digital assets are a viable and important part of their investment mix and are not intending to pull back from cryptos in the near term.

A new report from PwC, the Alternative Investment Management Association and CoinShares reveals a decline in the percentage of traditional hedge funds globally that are investing in crypto assets from 37% last year to 29% in 2023.

But respondents still intend to maintain or increase their exposure to cryptos even as market volatility and the regulatory landscape — particularly in the United States — make them more cautious.

Exposure to cryptos remains in single figures, but average allocations have increased from just 4% last year to 7% in 2023, and 93% of poll participants are expecting the market cap of these assets to be higher at the end of 2023.

“Traditional hedge funds, committed to the market in the longer term, are not only increasing their crypto-assets under management, but also maintaining — if not increasing — the amount of capital deployed in the ecosystem,” said John Garvey, global financial services leader for PwC United States.

Half of respondents said recent market volatility had no impact on their crypto investing decision and 27% feel positive about the current market — likely as a result of greater investment opportunities as a result of a broad decline in crypto-asset valuations.

“General diversification” or “long-term outperformance” are the most-cited reasons for investing in cryptos by those funds that already do so.

Bitcoin and Ethereum are easily the most invested-in digital assets, while no respondents said they hold non-fungible tokens (NFTs) compared to 1 in 5 who did in 2022.

REGULATORY CONCERNS

One of the biggest concerns of traditional hedge fund managers is the regulatory environment.

Those that already invest in cryptos want greater transparency and regulatory requirements, especially following crypto business collapses, to shore up trust in crypto assets and provide better protection for investors.

Respondents would like to see:

• mandatory segregation of assets (highlighted by 75% of all survey respondents)
• mandatory financial audits (62%)
• an independent statement of reserve assets (60%).

Liquidity is now seen as important as platform security and more than half of crypto-investing hedge funds polled have upgraded their counterparty risk management processes.

The regulatory environment in the U.S. means that almost a quarter of poll participants are reconsidering the viability of their crypto assets, and 54% of those fund managers who do not currently invest in cryptos would consider doing so under a more certain regulatory and industry landscape.

“It’s clear that regulatory uncertainty and barriers increasingly weigh on investment decisions of many funds, with more than half of those surveyed noting they would likely invest/invest more in digital assets once greater transparency, regulatory certainty and risk management is in place,” added Garvey.

BARRIERS TO INVESTING

For those hedge funds that are not currently investing in crypto assets, the top reasons cited in the 2023 Global Crypto Hedge Fund Report are:

• client reaction or reputation risk.
• lack of regulatory and tax clarity.
• insufficient or unreliable third-party data.
• outside the scope of current investment mandate.

On the positive side, tokenization of crypto assets and securities is seen as an opportunity thanks to faster transactions and lower costs, with 31% of traditional hedge funds surveyed noting tokenization as the biggest growth opportunity in the crypto-asset space in the coming year.

“The digital assets space has had to reckon with short-comings in its fundamental operations, including risk management, as well as allegations of corporate malfeasance,” said Jack Inglis, CEO of AIMA. “Some observable resilience in investor interest in the space, especially in newer areas like tokenization, will provide a foundation for industry participants to rebuild confidence among institutional investors and traditional hedge funds seeking to allocate to this asset class.”