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Insights |02.11.2022

Crypto funds: key drivers of digital assets investments

(Article updated on 10 November 2022)

 

Investors have been looking at the crypto market with a great deal of doubt until the market capitalization hit the three trillion dollar mark in November 2021 and saw a series of bull runs. Large adoption pushes through the DeFi summer of 2020 and NFT summer of 2021 then further convinced an increasing number of former crypto skeptics to invest their money in this new asset class. This has led to a growing number and variety of funds as these investors sought trusted and expert-managed vehicles to invest in crypto, rather than investing their money directly through wallet providers like Coinbase. Over the last 3 years, the number of such funds reached over 300. [1] 


Then a hard hit came - the crash of crypto, some stablecoins, in particular, macroeconomic conditions, and regulatory debates made investors re-evaluate the risk in their strategies and pause investments in the crypto market. Six months forward we are not out of the woods yet but already see initial signs that markets adapted to the new macro conditions and are ready to recover. It’s time to recap the crypto landscape to get an idea of its main drivers, how the recent shakeout changed its growth trajectory, and what are crypto investment prospects.  
 

More than a currency 

Assets under Management (AuM) of Crypto Hedge Funds and Digital Asset acceptance among Traditional Hedge Funds continued to grow. 59% of the crypto hedge funds reached a threshold of US$20 million in AuM in 2021, which is considered a “critical mass” in the traditional hedge fund world. [1] The market is now distinguished by developing trading strategies and a greater grasp of the cryptocurrency sector. 

Several years of crypto market development and increasing complexity have finally led to a paradigm shift: Crypto is no longer seen just as a currency, but as a promising general-purpose technology with broad application promise that is worth investing in. Blockchain has become a buzzword among investors, attracting billions of dollars into companies revolutionizing our understanding of the internet and data privacy. The enormous growth in the number of NFT transactions and funding for crypto exchanges made headlines; notably, Coinbase has been publicly listed and FTX raised nearly $1.57 billion in deal value last year. [2] 

The investment allocations of crypto funds reflect this paradigm change. According to PWC Crypto Hedge Fund research, the biggest investment flow in 2021 went to the sector represented by Store of Value-based cryptocurrencies, such as Bitcoin, which are used to allocate value owing to their durability and scarcity and protect the investment from the devaluing effect of inflation. However, Decentralized Finance (DeFI) and Infrastructure have also been swiftly adopted by crypto funds, with 78% and 74% of crypto funds investing in them, respectively. No surprise, given that, despite previous volatility and bullish market conditions, those categories have shown tremendous growth. 

The estimated total value locked (TVL) of the DeFi industry has increased 13 times from the end of 2020, from US$18 billion to US$235 billion in December 2021.[13] The rapid development of DeFi is notable, particularly the fact that it has surpassed general blockchain infrastructure allocations. Overall, the median Assets Under Management (AuM) across all investment sectors has tripled in 2021, (US$24.5 million) compared to the previous year (US$8.5 million). [2]  

Venture capital has also been soaring - despite the uncertainty and hesitation from a general investor pool, successive venture funds dedicated to crypto have continuously increased in size. Cryptocurrency startups raised $25.2 billion in 2021, as compared to $3.1 billion in the previous year which is a staggering 713 percent gain. And this trend has no indication of dying out in the wake of market conditions. Andreessen Horowitz, one of the largest investors in the crypto world, announced a new $4.5 billion fund for backing crypto and blockchain companies in May. Web3 and crypto-focused venture capital firm CoinFund launched a new $300 million fund, emphasizing its bullish belief that Web3 will “continue to progress through all market cycles.” [3] 

 

Positive outlook toward regulation 

Cryptocurrency's volatile nature is well known. The global capitalization of digital assets was $3 trillion in November 2021; it is currently just below $1 trillion. [8] This volatility, combined with frauds that still define the crypto ecosystem, is calling regulators to the scene. The stablecoin collapse in May was mentioned by The White House as an example of how cryptocurrency may lead to "disruptive runs if not paired with appropriate regulation." [7] While the volatility does not only pose dangers but also opportunities to investors, customers, and developers, the rising number of fraud cases weighs heavily as a downside risk. The White House Statement claims that recorded financial losses from digital asset frauds increased by around 600% in 2021 compared to the previous year. [9] Designing a smart regulatory intervention to counter these frauds is thorny, given the nature of Blockchain as a decentralized technology, and therefore will take time.   

The majority of crypto fund managers (83 percent) cite much more concrete and resolvable regulatory and tax uncertainties as the biggest obstacle to investing in digital assets, which can be broken down into issues such as AML and KYC problems. Although there is still a lot to be done, there have been significant regulatory advancements in 2022. The two main regulatory initiatives announced were a Framework for International Engagement on Digital Assets in the US and Markets in Crypto-Assets (MiCA) provisional agreement in the EU. Both frameworks aim to provide legislative certainty and boundaries for industry players to conduct their business safely and ensure "responsible development" of digital assets. US Treasury Department has already released the first framework resulting from a presidential order, indicating the direction it will take in the future. The EU has already determined how to regulate crypto assets in June 2022. [14] It will go into effect as early as 2023, allowing crypto firms time to adjust.  

 

  AMLKYC issues.png (536 KB)  
  Graph 1: Main regulatory concern [1]  

 

As the investment environment becomes more secure, the investment strategy may shift from a pure guess to a longer-term approach if regulation protects the investor, which would result in less speculative behavior. PWC reported that 29% of investors would potentially change their approach to digital assets and become more involved in general if there would be some sort of assurance in the market. [1]

 

Institutionalization of digital assets 

Market maturity and the first steps towards regulation are significant signals to the big conventional and institutional companies about the future of cryptocurrency and its investment potential. Before the stablecoin crush of 2022, EY anticipated that until 2023, over a quarter of alternative fund managers globally would increase their exposure to assets related to cryptocurrencies. Already in 2021, institutional inflows into crypto markets reached a record USD 9.3 billion – a 36% increase from 2020, thanks to several reputable institutions stepping into the space. Goldman Sachs, for example, recently announced that it was offering its first-ever Bitcoin-backed loan in a significant expansion of its crypto offering. [12]  

As interest from institutional investors ramps up, it consequently drives up the demand for a new investment opportunity through a safe and trusted environment. This is where crypto funds play a big role, as a more comprehensible means of investing in the cryptocurrency ecosystem. Crypto funds direction of development also indicates that if there is an interest the expertise and right people would follow. The average total team investment management experience of such funds increased from 24 to 60 over the course of 2018 to 2020, indicating that experts from the conventional market have shifted to the developing one. [15] 

We can see that institutional adoption of digital assets is growing, but there are still certain factors that impede institutions from entering the market. According to PWC, the largest issue is still the absence of custodial services; although the market for digital asset custody has grown over the past year, it still does not meet the whole industry's demand. [1] In fact, it is believed that institutional customers' need for operational due diligence will determine how custodian usage develops in the future. A clear and strict risk management policy will always be necessary for funds. The fact that the great majority of custodians in the market are regulated or licensed in some way, and many of them are employing conventionally recognized reporting techniques, is a trend that favors the institutionalization of the digital asset custody business now.  

On the other hand, other uncertainties persist, which draw a countertrend to the positive developments.  This refers to the still fragile crypto trading infrastructure, as a recent example shows. For example, on Nov. 09, 2022, the prices of various cryptocurrencies took a dive after Binance announced that it would not pursue the purchase of crypto exchange FTX after conducting due diligence. It said reports of "mishandled customer funds and alleged investigations by U.S. authorities" had influenced its decision. FTX had been struggling with a wave of withdrawals that caused a "liquidity shortage" and was one of the exchanges used primarily by institutional investors. The move will now deter institutional investors again for now, especially as the U.S. Securities and Exchange Commission (SEC) takes a closer look at FTX and its handling of customer funds.

The Merge  

In mid-September, Ethereum switched to the Proof of Stake (POS) consensus mechanism. In proof-of-work, the previous mechanism, miners proved they have capital at risk by expending energy, while proof-of-stake makes validators explicitly stake capital in the form of ETH as collateral. While the merge is a technological change, it is a crucial event for the whole crypto asset space including investors. Ethereum supports almost 3000 DApps, Decentralized applications providing services like insurance, finance, governance, etc on-chain, which is 74% of all the DApps across all blockchains. [5] Many of those projects that became a part of the investment products of crypto funds are either built on Ethereum or aim to reduce the speed or transaction costs on the Ethereum blockchain. 

After the so-called “merge”, the network energy consumption is expected to drop by more than 99%. As a comparison: the entire PayPal payment system consumes approximately 25 times more energy per year. [4] Before the merge, the ESG criteria would restrict some of the investors from investing in such projects despite their technological potential. A dramatic reduction in energy consumption lifts a lot of these sustainability concerns. On top of that, the merge laid the foundation for future updates to speed, fees, and ecosystem development that might eventually lead to more users and a higher value of Ether. Crypto Finance, a Swiss-based crypto service provider, states that the merge, combined with a moderate rate hike decision by the FED could potentially initiate more bullish sentiment amongst investors.  

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“Digital Assets are becoming an important element of many hedge fund portfolios in a sophisticated and interconnected financial system while developing its own Digital asset control and operational environment to enable continued engagement and long-term growth.”[1] The interplay of crypto own advancements, market sophistication across all sectors, regulation, and a positive market outlook generated an intriguing scenario for the crypto industry in 2022. During the early-year slump, the perception of cryptocurrencies significantly deteriorated, with confidence virtually reaching zero; however, it is now beginning to improve. [16] The sector is forging on with long-term plans such as the Merge and slowly gaining the trust of the public back. We have yet to see how the complicated landscape will affect the bullish beliefs of crypto funds, which are a vital connection between the digital asset market and traditional investors. 

 

[1] 4th Annual Global Crypto Hedge Fund Report 2022 PWC 
[2] Pymnts 
[3] CoinTelegraph 
[4] stateofthedapps.com 
[5] Crypto Finance 
[6] Blockchain Council 
[7] Bankless Newsletter 
[8] The Time 
[9] White House 
[10] EY 
[11] Binance 
[12] Bloomberg 
[13] The Block Crypto 
[14] Cointelegraph 
[15] 3rd Annual Global Crypto Hedge Fund Report 2021 PWC 
[16] Augmento - Predictive Sentiment Data