Hedge Fund Portfolio Strategies in Crypto
Mostly pseudo-analysis and rant about backdoor deals and opaqueness.
I sometimes like to joke (mostly with myself) that hedge funds are anything-goes boxes for rich people’s money. They employ complex trading strategies and weirdly opaque portfolio construction to make obscene returns.
This wasn’t always true. The word hedge is, of course, a metaphor for risk mitigation, since the original hedge funds aimed to trade in a market-neutral way, i.e. make money regardless of market going up or down.
In the good old days of finance (when Warren Buffet was still a young gent), this meant that a fund that was good at analyzing companies, would short some stock that it didn’t like and buy another stock that it thought was underpriced relative to the first one.
This is a long-short equity strategy. The expectation is that the market will eventually correct the inefficiency (bad stock down, good stock up), while if some large market drop were to happen, the worse (shorted) stock would fall more earning the fund money to offset losses on the better stock.
But like all good things, they never last, and finance has this strange tendency that over time, it gets more opaque, layered and inherently risky. Bigger finance and more competition required hedge funds to either invent new forms of complexity (statistical arbitrage, ghost patterns and quant funds)*, or do a lot more crazy stuff.
Crazy stuff like going on a public campaign shorting a stock pitching to the world why company X is a Ponzi scheme, or making a very outsized long bet on a stock, pushing its price up through derivatives that no one except for the banks that manufactured them knows of.
This category of crazy hedge fund stuff is, by and large, based on backroom deals, good relationships and one’s belonging to social structures. You could say that it depends on getting to the best information first, exchanging favors (getting on the TV to pitch the short thesis to the world or making bankers to NOT margin call you on that large derivative they manufactured for you when the market turns red for a bit) and then taking enormous risks (kudos to them!).
Yes, Institutional Money.
The narrative of the 2020–21 crypto bubble was the proverbial inflow of institutional money. That family offices, hedge funds and larger institutional investors were increasing their allocations to crypto, became a widely accepted mantra that emboldened small investors.
The post-mortem review of the 2022 crypto implosion, beginning with Terra-Luna and spreading to Three Arrows Capital and the wider crypto market reveals that this was true — hedge funds were very much there — but also that they recreated the opaque backroom deals on top of crypto.
Nothing of the 2022 crypto crash has anything to do with crypto. (Also see Dominoes Falling.) The essence of free cryptography as a technology superior to the centuries old counterparty trust system still stands. DeFi worked great throughout the crash. Of course it did! It literally consists of people entering bilateral agreements that are encoded and overcollateralized.
What failed were the quasi-bank startups building lending businesses on top of crypto, using customers’ money in secret deals with hedge funds**.
The New Old Playbook.
If you were to make a broad definition of what hedge funds did in crypto in the past 2 years, you would say that they used the conventional old world methods of making traditional paper-agreement-style bets with counterparties in more exciting asset classes.
1.
A good example could be the short selling of Tether. Western hedge funds are reportedly borrowing Tether from Chinese counterparties in exchange for bitcoin put up as collateral. They then sell the borrowed Tether in expectation of its debacle in another Terra-Luna stablecoin catastrophe moment.
Or the hedge fund buys a put option on Tether, which just means that someone (like Genesis Global Trading Inc.) sells it (writes a put option) the right to sell Tether back to them at a certain price. If Tether de-pegs and begins falling in some cataclysmic event, the hedge fund can sell it back at a fixed price. That is, as long as the counterparty survives it and can honor its obligation. (Also maybe see Plastic Surgeons Are the Best Bankers.)
2.
The other well known trade was a sort of arbitrage using Grayscale Bitcoin Trust. GBTC was and still is one of the only ways to bet on bitcoin without actually having to own the coin. (Reasons why are also in Kill Your Neighbor.) For a long time GBTC traded at a premium to the value of bitcoin it held. Essentially, investors were paying extra for the privilege of owning bitcoin in the clothes of traditional financial system.
The basic trade was that hedge funds would borrow real bitcoin and deposit it to GBTC in exchange for shares that were more valuable than the coins, then pocket that profit by selling the shares in market. The trick was that there was a six-month lockup period on GBTC shares, so they had to wait. Earlier this year, both due to the change of sentiment on bitcoin and its volatility, GBTC shares began trading at a discount to the value of bitcoins held. Damn!
3.
Combine these directional bets with the old good Ponzi dynamics. Tokens of projects paying interest in the form of newly issued tokens diluting everyone in a world where no one cared because fresh capital kept flowing in and the new money paid for the old. Hedge funds (as well as the quasi-banks) were happy to park their capital in the Ponzi-like black boxes.
One such project was the Anchor protocol, which was manufacturing the interest for Terra-Luna holders. Ethereum is undergoing a change to proof of stake consensus later this year. The fundamental difference is that PoS works in such a way that it rewards investors who commit (stake) their tokens to support the verification of transactions. If you stake ETH, you earn what is essentially an interest.
A lot of the manufacturing came from the use of protocols that allowed people to stake ETH and get another token which was liquid and could be re-used in other DeFi protocols. A borrower could put up a staked ETH to borrow from Anchor at ˜10%. But the depositors on Anchor earned more because they received both the ˜10% and additional return from staking through clever smart contract that passed the staking earnings on.
In addition, the borrowers were incentivized to come to Anchor because they also received some newly minted native token (ANC or something like that). Manufactured high rates that kept the money sucked in. But the 20% rate promised by Anchor was unsustainable, and one quick moment of a mad bank run brought it down. When Terra-Luna imploded, it started dragging down the rest of the crypto universe. For a moment, everything looked like a Ponzi exposed.
4.
Add to this leverage. Lots and lots of leverage that turbocharged returns of hedge funds on these directional bets and high-risk trades. The now defamed Three Arrows Capital borrowed tens to hundreds of millions of dollars mainly from the then-booming-now-failing quasi-banks and wealthy investors.
But then the trades “got super marked down, super fast.” — Zhu Su, founder 3AC.
The End.
The conclusion is not that hedge funds brought the crypto market down, but that the crypto is in its early phase, essentially playing an exciting largely misunderstood asset class with little practical use on top of which layers and layers of traditional financial opaqueness could be built.
What failed was not crypto, but human inexperience and error. Although for now it seems that most of the failures of the likes of 3AC have been well internalized by the market, one should stay vigilant of the other shoe to drop in the form of fund redemptions.
Hedge funds usually require investors to submit redemption requests weeks or months ahead. Coming to the Q3, the full effect of the crypto (and general macro) crash has been felt by the investors, and we may well see one more bank run.
Then again, with markets destroyed or in the very least down to the pre-pandemic levels, now is the time to buy. Common logic is that hedge funds manage money of affluent financially sophisticated investors.
Still, many of the crypto hedge funds will be crushed. PwC report*** reveals just how small and early-stage (understandably) some of the (pure) crypto hedge funds are.
To demonstrate, according to PwC, median crypto hedge fund in 2020 had US$15 million in AuM, which at 2% management fee amounted to US$300,000 in annual revenue, barely enough to sustain even a few hedge fund employees. On the basis of those numbers, few of them will make it (indeed will be willing to make it) through the crypto winter.
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*primarily the discovery of irrational patterns in the markets in the 1980s and the subsequent establishment of specialized trading units in banks (Morgan Stanley) and standalone hedge funds (Renaissance Technologies)
**yes, ok. not only hedge funds
***although it is a 2021 report, please note this is outdated on the basis that the survey was performed in 2020
