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Family offices are among the biggest investors in crypto hedge funds…what a mistake that turned out to be

Crypto hedge funds face challenging times following a collapse in digital currencies triggered by rising inflation and interest rates.

The sector saw a fall of -37.2% in the year to May, similar to bitcoin, according to Eurekahedge. According to investors, their fall has continued, as market participants hit unexpected problems.

The value of the cryptocurrency market has fallen to $960 billion, down 60% against its $2.4 trillion at the start of 2022, according to CoinGecko. Bitcoin has fallen 29% in a week.

Whatever the price of bitcoin, blockchain is still capable of disrupting financial transactions by doing away with expensive intermediaries. It is starting to create an alternative 3D reality via the metaverse. Institutional interest is growing, despite everything

Speaking at a recent Piper Sandler conference, Mike Novogratz of Galaxy Digital Holdings warned that two-thirds of crypto hedge funds could fail.

By chance, Novogratz was an investor in Terra, founded by Do Kwon who has denied wrongdoing but been summoned for a hearing by the South Korean government.

Terra created a stablecoin linked to the dollar, and a related alternative fast crypto called Luna which collapsed in May due to liquidity issues. Around 45% of crypto hedge funds backed Luna, according to a newly-published PwC survey.

Other newly-minted fast currencies, like Solana and Avalanche, were backed by cyber hedge funds as their use of bitcoin fell. This led to a dramatic rise in the price of fast currencies last year which boosted their returns. Now we are seeing the reversal.

Family offices are keen supporters of crypto hedge funds, because they produced an average 300% a year over the last decade, amid wild performance swings. 

In 2021, they generated 142%. This partly came from investing in non-fungible tokens whose price has also fallen.

Family offices invest in 66% of crypto hedge funds, according to PwC. 

The broader high net-worth community invests in 86% of the sector and has a majority position in 53% of it. Institutions are less involved, preferring derivative trades.

Crypto hedge funds have thrived in a market yet to be swamped by traders using sophisticated algorithms. 

Volatility provided predictable opportunities. Buying bitcoin on the dip has been a particularly rewarding strategy, due to devout faith in the coin professed by its supporters.

Optimism has, in fact, been the greatest asset for crypto hedge funds, as speculative money wary of overpriced mainstream assets has headed into the sector.

Despite gathering storm clouds, crypto hedge funds have been massively bullish. In the PwC survey they were predicting a bitcoin price of $75,000 at the end of 2022, ahead of its recent plunge to $21,400. 

As recently as May, billionaire hedge fund manager Paul Tudor Jones told CNBC: “It’s hard not to want to be long crypto.” Skybridge Capital’s Anthony Scaramucci said in January: “Bitcoin is here and bitcoin is the winner.” 

Michael Saylor’s MicroStrategy is another big supporter, despite losing $1 billion on its bitcoin stash. Back in May 2021 Saylor was urging investors to take out mortgages to buy the coin. Nayib Bukele, president of El Salvador, made bitcoin his country’s legal tender. 

Optimists continue to argue that market conditions will be a disaster for fiat currencies but not crypto.

This may be the case. But fund outflows saddle crypto with a solvency problem which does not apply to fiat, backed by government tax payers.

Crypto hedge funds have also taken the risk of assuming the permanent nature of crypto structures like Terra. This cannot be guaranteed in a sector relying on speculative cash inflows, as opposed to structured finance.

Crypto also developed its reputational problem in 2021. Data provider Chainalysis has calculated $7.7 billion was lost to crypto scams in 2021, up 81% compared to 2020. Time and again, promoters created new currencies and pumped up their price to suck in other investors, only to pull the rug under them later on.

The market is now littered with 13,400 semi-dormant coin issues, priced at fractions of a cent. Darker stories circulate over crypto’s involvement in money laundering. 

Bill Gates has been a critic of digital assets “based on a greater fool theory”. In December, Nassim Nicholas Taleb said: “It is an awkward, clunky and already obsolete product of low-interest rates. It should collapse with inflation.” 

In December, Family Capital warned exuberance in digital assets recalled events building up to the dotcom crash of 2000

Decisions by CoinBase and FTX to spend their cash on Super Bowl adverts harks back to 2000 when Pets.com invested its surplus the same way.

Suddenly the sector has to deal with a shortage of capital, not a surfeit. Coinbase is laying off 18% of its workforce. Gemini Trust, run by the Winklevoss twins, is cutting 10%, blaming a “crypto winter.” 

Celsius, a crypto lender has paused withdrawals, citing market conditions, leading to fears of margin calls. Trading platform Binance confirmed a technical glitch in bitcoin trading, upsetting the market more than you might expect.

Tron and Tether stablecoins have occasionally lost their peg to the dollar, in trading conditions which remain challenging following Terra’s demise.

All that said, crypto hedge funds will recall that the dotcom crash of 2000 was ultimately followed by a digital revolution, fuelled by technology during the dotcom boom.

Whatever the price of bitcoin, blockchain is still capable of disrupting financial transactions by doing away with expensive intermediaries. It is starting to create an alternative 3D reality via the metaverse. Institutional interest is growing, despite everything.

All this could benefit crypto, over time. JP Morgan has even argued that the crash in crypto prices means they could offer better value than real estate and private equity, whose worth is yet to reflect their reality.

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