Blockchain technology for investment and hedge fund managers

As with each new technology, there has been much discussion about how blockchain can help hedge funds, whether hedge fund managers are willing to embrace it, and if it will be able to deliver on expectations.

In a similar vein, the future of cryptocurrency hedge funds remains uncertain. Despite the market’s reported volatility in the news, more and more traditional hedge funds are investing in crypto.

This article seeks to explore the current state of both technologies within the hedge fund industry, collating expert comments and insights on the topic.

What is blockchain technology?

Blockchain technology serves as a distributed database or ledger, shared amongst the nodes of a computer network. It allows data, often transaction records, to be recorded securely in a completely digital format.

The reason why blockchain is considered to be such a market-disrupting technology is because it guarantees the complete security of the data from the second it is entered, creating instant trust between those involved and eliminating the need for a third party to instil trust.

Blockchain is known by many for its role in cryptocurrency systems such as Bitcoin, and for hedge funds, the two are linked intrinsically.

With blockchain, data is stored in limited-capacity blocks. Once a block reaches its storage capacity, it is closed, timestamped, and attached to the block before it. A new block is then created, ready to be filled with data and attached to the chain.

Each block is fixed and immutable, meaning that none of the data can be changed once the block is closed.

Blockchain asset management

For hedge funds, blockchain has the potential to support processes and solve business challenges when applied correctly.

Looking first at middle and back-office functions, blockchain can be utilised internally to track investors' capital and manage the ownership of complex assets or investment vehicles.

In this application, blockchain could also eradicate the masses of paperwork associated with these types of tasks, which may help fund managers edge closer towards ESG objectives, depending on their specific goals.

Another potential use case for blockchain in hedge funds is as a widespread client solution, allowing investors to view their holdings and investment allocations whenever they want. This would save hedge fund managers immeasurable hours of time spent putting together complex statements and sophisticated performance reports.

In a report titled ‘Blockchain for Investment Managers: Are we there yet?’ Deloitte states that “While its speed of adoption is slower than some expected, blockchain’s disruptive application is undeniable.”

The report goes on to explain that “For investors looking for increased transparency beyond what their Financial Advisors/custodians/consultants can provide, blockchain could offer real time (eventually to the minute) visibility into positions to better analyse portfolio exposure/performance.”

Traditional hedge fund investment in cryptocurrencies

According to the PwC Global Crypto Hedge Fund Report 2022 , more than a third of traditional hedge funds (38%) are now investing in digital assets, which is nearly double the amount reported to be doing so in 2021 (21%).

However, many of the traditional hedge funds exploring digital assets are doing so tentatively, with 57% of those surveyed for the report having less than 1% of total AuM in digital assets. One of the main causes for uncertainty amongst traditional hedge funds is the lack of regulatory and tax regime clarity associated with digital asset investment.

For digital asset adoption traditional hedge fund managers have also identified a need for infrastructure improvements within the areas of audit and accounting, risk management and compliance, ability to use digital assets as collateral, and fund administration.

In the course of the next year, we can expect to see greater investment into digital assets, with 67% of funds reportedly intending to deploy more capital into the asset class by the end of 2022.

In an article for The Street , Michael J. Torosian, a partner with Baker Botts L.L.P. "Investors see cryptocurrencies as non-correlative to traditional asset classes and a good diversification tool and a hedge against certain risks such as inflation."

This could indicate strong investor buy-in and might suggest positive investor attitudes to traditional hedge funds exploring crypto, despite the above average risk compared with other asset classes.

Specialist crypto hedge funds

Looking at specialist crypto hedge funds specifically, PwC reports the accelerated market growth seen over the past two years to have now resulted in more than 300 specialist crypto hedge funds across the world. Not only has the number of crypto hedge funds grown, but their total AuM had also risen by 8% in 2021 compared with the previous year.

According to the same report, 86% of crypto hedge funds trade Bitcoin (BTC). Other popular currencies include Ethereum ‘ETH’ (81%), Solana ‘SOL’ (56%), and Polkadot ‘DOT’ (53%).

The recent collapse of multibillion-dollar stablecoin Terra, which has been likened to the 2008 Lehman Brothers collapse by Institutional Investor, demonstrates that the market is still experiencing high levels of volatility in its relative infancy.

This collapse, and any others like it that could potentially follow, can have a catastrophic impact on investors and put strain on their relationships with crypto hedge fund managers.

What do crypto prime brokers do?

Crypto prime brokers offer a wide variety of services to help specialist crypto hedge funds increase their chances of success and give them a competitive edge ahead of other firms in the market.

In summary, a crypto prime broker’s key function is to secure the peace of mind of hedge fund managers and their investors.

Crypto prime brokers have a responsibility to simplify the often-complex processes associated with trading crypto. Once employed by a firm, crypto prime brokers are tasked with ensuring the safety of the hedge fund’s assets, prioritising operational transparency, and achieving optimal regulatory clarity.

Aside from these key areas, many crypto brokers are updating their service offerings to add additional value to crypto hedge fund managers, these might include:

• Offering regulatory advice and guidance around the increasingly sophisticated stipulations set out by the market’s governing bodies and lawmakers.
• Collating market data and providing valuable insights to facilitate in-depth trend analysis across futures, options, decentralised finance and various other core market themes.
• Providing clients with an API-enabled trading platform to help them optimise and streamline their processes.