Hedge funds structures don’t work in crypto

Disclosure: The views and opinions expressed here are solely those of the author and do not necessarily represent the views and opinions of crypto.news editorial.

Earlier this year in January, 11 of the world’s largest asset managers entered the crypto space, mostly through Bitcoin (BTC) exchange-traded funds. This has brought in billions of dollars of new money from institutional investors who were previously hesitant to invest. When many of these asset managers entered the crypto space, they found that their tried and true methods developed in traditional markets did not work well in this market.

How do hedge funds work?

Hedge funds, with their regulated offshore structures and established audit procedures, operate for traditional assets. They provide an advanced and secure framework for investors to generate alpha (above-market return) through a variety of strategies. However, when applied to crypto markets, several fundamental problems arise.

First of all, offshore structures do not comply with crypto’s regulatory environment. Traditional hedge funds are often based offshore, where regulatory scrutiny is less intense and allows for greater flexibility in investment strategies. However, assets bought and sold through these funds in the crypto market must be sent to unregulated exchanges. This is a significant risk because funds are moved to environments where there is no oversight, such as traditional markets. In other words, hedge fund packaging in crypto is more cosmetic than functional; it’s just a thin layer of security.

Another problem with hedge funds is that they do not report on a timely basis. Most hedge funds provide performance data only after monthly or quarterly audits are completed, i.e. 45 days after the event. This is unacceptable in fast-paced crypto markets where prices can move 10% within hours.

By the time investors receive the results of a transaction, the market conditions that caused those results may have completely changed. To put it in perspective, applying this delay to traditional markets like Nasdaq would be like waiting five months for performance results. This is impossible in a volatile market.

Hedge funds are also moving more slowly; Unlike traditional markets with specific trading hours, the crypto market is open 24/7. This requires constant monitoring and rapid decision-making. Hedge funds, with their slower pace and periodic reporting structures, are not designed for this environment. Crypto native traders who are accustomed to this can quickly adapt to market changes. Traditional hedge fund managers are unable to keep up with the more volatile and faster-moving crypto market.

SMA solution: specific, clear and timely

Separately managed accounts, or SMAs, may be a more suitable alternative to hedge funds for crypto investments. Unlike hedge funds, SMAs offer users direct ownership of assets, real-time reporting, and a proprietary approach to investment management that is more aligned with the functioning of the crypto market.

One of the main benefits of SMAs is that you own the underlying assets directly, unlike hedge funds where assets are pooled and combined. There is no mixing of funds in SMAs; Each account is treated as a separate entity, so you can see exactly where your money is and how it’s performing at any given time. This level of transparency is especially important in the crypto market, where fraud and mismanagement are always a concern.

Additionally, SMAs offer real-time reporting. Since each account is managed separately, investors can receive minute-by-minute data on the performance of their portfolios. This is a big advantage over hedge funds, where performance reports are often weeks or months behind actual market activity.

The ability to use bespoke investment strategies is another advantage of SMAs. Unlike hedge funds’ one-size-fits-all approach, SMAs allow investment managers to customize strategies based on each client’s specific needs and risk tolerance. This is especially important in the volatile and ever-changing crypto market, where the ability to quickly adjust strategies can mean the difference between profit and loss.

Institutional investors benefit most from the flexibility of SMAs. For example, SMAs allow for tax optimization strategies such as tax loss harvesting, which can be especially useful given the volatility of crypto assets. SMAs also allow for asset diversification in the crypto space, so investors can create tailored portfolios that suit their overall financial goals.

The fact that you can trade whenever you want and keep your assets safe without leaving them in the hands of third parties also provides a strong reason for using SMAs. SMAs are well-suited for crypto trading and provide institutional investors with the flexibility and speed they need to navigate this constant trading environment. This is a big difference from traditional financial hedge funds, which are limited by market hours and delays with quarterly audits and reports.

Off-exchange settlements are another reason to love SMAs in crypto. Eighteen months ago, non-exchange settlements did not exist. Now companies like BitGo, Zodia, Fireblocks and Copper.co are filling this gap. Copper.co was the first company to offer a secure off-exchange exchange service that allows institutions to trade without exposing their assets to unregulated exchanges. These services add an extra layer of security, ensuring that assets remain in cold storage in controlled custodians.

Interestingly, each of these companies does things differently. Copper.co’s goal is trust in their platform; Zodia is a trust-based custody service that allows all assets to be held in trust on behalf of the customer and significantly reduces counterparty risk. Fireblocks has been criticized for pooling customer funds into a single account, so you can’t track individual assets. However, the rise of over-the-counter payments demonstrates the importance of transparency and security in crypto, two of the core tenets of the SMA model.

SMAs are the future of institutional crypto investing

Regulation is also moving in favor of SMAs over hedge funds. For example, the Monetary Authority of Singapore introduced new rules requiring crypto exchanges to hold customer funds in an escrow to protect assets and investors following the FTX collapse. MAS also prohibits staking and lending for retail investors and allows institutional investors. This move towards greater regulation and investor protection is in line with the SMA model, which is all about transparency, security and individualized management.

Additionally, investors around the world had to scramble when FTX crashed in 2022, but in Japan the story was a little different. Unlike other regions, FTX Japan’s users get their funds back. From where? Because Japan insisted on a special regulation requiring crypto exchanges to keep customer assets in separate accounts; This is a kind of security measure that is exactly in line with how SMAs work.

In Japan, exchanges had to separate customer deposits and store them in a third-party bank or trust. This prevented the mixing of customer and business funds, a problem that largely contributed to FTX’s collapse elsewhere. The idea behind SMAs is the same; investors retain direct ownership of their own assets, and those assets aren’t pooled with everyone else’s, making it much harder for anything suspicious or careless to happen.

So while FTX’s global clients are still struggling to get their investments back, Japanese investors are already starting to see their funds returned. This is not just a coincidence; It’s a clear example of how the right regulations, similar to the principles in SMAs, can offer a great layer of protection. If more places adopted this approach, we could avoid another FTX-style meltdown in the future.

Hedge fund structures may have worked for traditional assets, but they are increasingly incompatible with crypto. Delayed reporting, offshore structures, and 24/7 trading make hedge funds a poor choice for crypto. SMAs offer modern institutional investors a tailored, transparent and timely solution. SMAs will soon become the investment tool of choice for institutions looking to acquire digital assets. Direct ownership, real-time reporting and custom strategies.

Stephen Wundke

Stephen Wundke is director of strategy and revenue at Algoz Technologies. He joined Algoz in late 2022 and pioneered the unique SMA structure for an over-the-counter payment product called Quant Pro, using Zodia Custody and Bitfinex.