With the rapid development of cryptocurrencies and blockchain, crypto hedge funds are becoming increasingly popular. Learn about Hedge Fund in this article.
What is Hedge Fund?
Hedge Funds in the Crypto Market
A hedge fund is an investment fund that utilizes flexible and complex financial strategies to optimize returns for investors while mitigating risks in uncertain market conditions. Hedge funds typically restrict their investor base to institutional investors or high-net-worth individuals.
In the crypto market, hedge funds operate similarly to those in traditional financial markets but focus on investing in digital assets such as:
- Cryptocurrencies (Bitcoin, Ethereum, Solana, etc.)
- DeFi tokens
- NFTs (Non-Fungible Tokens)
- Crypto derivatives
Investment strategies of Crypto Hedge Fund
Hedge Fund Strategies
Hedge funds employ a variety of strategies to maximize returns and minimize risks. Here are some common investment strategies that hedge funds utilize:
Long/Short Trading
This is the most popular strategy in hedge funds.
- Long: Buying a crypto asset with the expectation that its price will increase.
- Short: Selling a crypto asset short to profit when the price decreases.
This strategy allows the fund to profit regardless of whether the market goes up or down.
Read more: What is Long/Short? Benefits and Risks of Long/Short Trading.
Case Study: The Collapse of Three Arrows Capital (3AC)
Three Arrows Capital (3AC), once one of the largest crypto hedge funds with approximately $18 billion in assets under management, collapsed in 2022.
The main causes stemmed from:
- Heavy investment in LUNA and Terra: 3AC held a large position in LUNA and Terra assets, valued at up to $560 million at its peak. When the Terra ecosystem collapsed, the fund suffered severe losses.
- Significant borrowing to execute directional trades: 3AC employed a long/short strategy with assets like GBTC, LUNA, and stETH. However, they made bets on market direction and suffered losses when the market moved against their predictions.
- Impact of high leverage: 3AC borrowed from over 20 financial institutions, including Genesis (the largest creditor, lending $2.3 billion). When the fund could not repay its debts, a domino effect spread throughout the crypto market.
- Disappearance of the founders: After the fund’s collapse, founders Zhu Su and Kyle Davies disappeared, complicating the legal proceedings.
As a result, the collapse of 3AC not only caused losses for themselves but also had a widespread impact on other financial institutions and funds in the crypto ecosystem.
Arbitrage (Price Difference Trading)
Crypto hedge funds capitalize on price discrepancies between different exchanges or markets to generate profits. For example, they might buy Bitcoin at a lower price on one exchange and sell it at a higher price on another.
Alameda Research, before the FTX collapse incident, employed this strategy to exploit price differences between international and domestic exchanges, particularly in the Asian region. This was one of the core strategies that helped Alameda emerge as a leading crypto hedge fund before facing its crisis.
Alameda exploited price differences between exchanges in different regions. For example:
- Taking advantage of the Kimchi Premium: Alameda capitalized on price disparities between exchanges in different regions, such as the Bitcoin price difference in South Korea or Japan (Kimchi Premium), where Bitcoin prices are typically higher than in the international market.
- Arbitrage across multiple exchanges: The fragmentation of the crypto market in its early stages (2017-2020) created opportunities for Alameda to exploit price differences between international and domestic exchanges.
During the years 2018-2020, this strategy generated millions of dollars in profit, especially when global price differences peaked.
In addition, Alameda also took advantage of arbitrage between:
- Intra-exchange arbitrage: Alameda conducted arbitrage trades within the same exchange between different asset pairs. For example, they capitalized on temporary price differences between Bitcoin and stablecoins (USDT, USDC) during periods of high market volatility.
- Derivatives trading arbitrage: Alameda used futures contracts and options to exploit price differences between the spot market and the derivatives market.
- For example, when the price of Bitcoin in the futures market was higher than the spot price, Alameda could sell futures contracts and buy Bitcoin on the spot market to lock in profits.
To achieve this, it’s important to acknowledge that Alameda had several asymmetric advantages:
- High-Frequency Trading (HFT): Alameda used automated algorithms to quickly detect price discrepancies and execute trades in the shortest possible time.
- Large Capital Management: With billions of dollars in assets under management, Alameda had the capacity to execute large trades without significantly impacting the market.
- Strategic Relationships: Alameda had close relationships with major exchanges like FTX, giving them easy access to liquidity and low transaction costs
Furthermore, Alameda Research was founded by Sam Bankman-Fried and a team with backgrounds in mathematics and quantitative finance, enabling the company to optimize its investment strategies. At its peak, Sam had a net worth of $26.5 billion, ranking 60th on the global billionaire list in 2022.
The arbitrage strategy helped Alameda Research generate consistent profits for many years, capitalizing on the fragmented nature of the crypto market. However, the risks from over-reliance on leverage and the relationship with FTX contributed to Alameda’s downfall, highlighting the need for better risk management even in seemingly “safe” strategies
Read more: Risks of Arbitrage Trading in Crypto.
Staking and Yield Farming
Staking and Yield Farming strategies focus on using crypto assets to earn passive income through decentralized finance (DeFi) protocols.
Hedge funds, such as Pantera Capital or Framework Ventures, can directly stake crypto assets in Proof-of-Stake (PoS) protocols like Ethereum 2.0, Solana, or Polkadot to earn staking rewards.
Similarly, they can also participate in yield farming by providing liquidity on DeFi platforms like Uniswap, Aave, or Curve to earn profits from token rewards and trading fees.
Some hedge funds do not directly engage in staking or yield farming but instead invest in protocols or platforms that support these activities. This is the case with Polychain Capital, where the fund does not directly profit from staking but invests in projects that provide services or build DeFi infrastructure.
Although not the most common hedge fund strategy, yield farming and staking are still considered an important part of optimizing asset portfolios and increasing capital value in the DeFi space.
Market Neutral
The Market Neutral strategy focuses on maintaining a balance between long and short positions to minimize risk from overall market price fluctuations. Instead of betting on the market’s upward or downward trend, this strategy aims to profit from price differences between assets or discrepancies in their performance.
Specifically:
- Long: Buying an asset with the expectation of a future price increase.
- Short: Short selling another asset that has an inverse or weaker correlation with the purchased asset.
Hedge funds can implement a Market Neutral strategy by investing in cryptocurrency pairs with low correlation, such as Bitcoin and stablecoins, or different tokens within the same DeFi ecosystem.
They can also take advantage of performance differences between similar assets to protect their portfolio from market volatility.
Token Early-Stage Investment Strategy
Some crypto hedge funds invest in blockchain projects or tokens in their early stages, before they are publicly listed on exchanges. This is a stage where projects often need capital to develop products, expand their ecosystem, or enhance marketing activities. In return, the investment fund receives tokens or equity at a discounted price, with the potential for growth if the project develops favorably.
Paradigm, one of the leading venture capital firms in the crypto space, is an example of this strategy. Paradigm focuses on Web3, NFT, and DeFi projects from their early stages.
Some notable projects in Paradigm’s portfolio have achieved significant success:
- Uniswap: As one of the leading decentralized exchanges on Ethereum, Uniswap has seen strong growth in trading volume and users.
- Optimism: A Layer-2 solution for Ethereum aimed at improving speed and reducing transaction costs, it has attracted significant interest from the community and developers.
- Arbitrum: Also a Layer-2 solution for Ethereum, Arbitrum has achieved several milestones in scaling and improving performance for decentralized applications.
Conclusion
Hedge fund investment strategies in the crypto market are diverse. The performance of each fund depends on how these strategies are applied and the overall market volatility.
Who is the Crypto Hedge Fund for?
Crypto Hedge Funds: Not for the Faint of Heart
Crypto hedge funds are not for the average retail investor. They are designed for institutional investors or individuals with significant assets and a high-risk tolerance. Specifically:
- High-Net-Worth Individuals (HNWIs): These are individuals with a high net worth, typically $1 million or more, who can access hedge funds.
- Institutional Investors: Institutions such as pension funds, insurance companies, and sovereign wealth funds often invest in hedge funds to diversify their portfolios.
- Accredited Investors: In some countries, investors must meet certain legal criteria, such as having an annual income of $200,000 or more (or $300,000 with a spouse) or a net worth of $1 million excluding the value of their primary residence, to be considered accredited investors and participate in hedge funds.
How much money does it take to invest in a hedge fund?
High Minimum Investment Requirements
Hedge funds often require a very high minimum investment compared to traditional investment funds. This is to ensure that only investors with the financial capacity and understanding to accept the risks involved can participate. Specifically:
Implementation of complex investment strategies and the need to cover large transaction costs in the crypto market.
Minimum investment:
Typically ranges from 100,000 USD to several million USD, depending on the fund.
Some exclusive funds have minimums of 10 million USD or more.
Reasons for high capital requirements:
Focus on wealthy investors with a high-risk tolerance.
Why do Venture Capital need to establish a Hedge Fund?
Venture capital (VC) firms establish hedge funds not only to diversify their investment strategies but also to maximize returns and protect their portfolios against risk. In the volatile landscape of finance and cryptocurrency markets, expanding into investment branches like hedge funds is essential to ensure flexibility and adaptability.
Traditional VC funds typically focus on long-term investments in startups or early-stage projects, expecting significant returns over many years. However, this strategy comes with high risk due to the illiquidity and instability of nascent projects. Therefore, establishing a hedge fund provides VCs with an additional tool to cope with market uncertainties by generating a steady cash flow through short-term strategies such as arbitrage, staking, or derivatives trading.
Learn: The importance of AUM in Crypto.
By incorporating hedge funds, VCs can also enhance their risk management capabilities. Hedge funds not only generate profits in bull markets but can also mitigate losses during downturns. Through strategies like market neutral, hedge funds maintain a balance between long and short positions, protecting the portfolio from significant fluctuations. This creates a robust layer of defense for the VC fund’s long-term investments.
Expanding into branches like hedge funds also allows VCs to increase their investment flexibility, capitalizing on short-term opportunities that traditional VC funds find difficult to access.
For example, in the crypto market, hedge funds can participate in trading liquid tokens on the secondary market, while VC investments primarily focus on unlisted projects. This flexibility not only helps funds maximize profits but also balances risk in a rapidly changing market environment.
Building Reputation and Influence
Furthermore, successfully managing a hedge fund brings significant prestige to VCs. This helps the fund attract more investors, thereby expanding its fundraising capabilities and increasing its influence in the financial industry.
Major firms like Andreessen Horowitz (a16z Crypto) and Pantera Capital have demonstrated that the combination of long-term VC investing and short-term hedge fund strategies is an effective model, ensuring both sustainable returns and risk mitigation in a highly competitive and volatile market like cryptocurrency.
Conclusion
Ultimately, combining models like VC and hedge funds not only optimizes profits but also ensures effective risk management. This has become a crucial part of modern asset management strategies, especially in the crypto market, where the line between success and failure depends heavily on flexibility and adaptability.
