The concept of crypto hedge funds can be difficult to grasp. But in this detailed guide, we’ll provide an expert insight into what a crypto hedge fund is, what benefits it offers, hedge crypto risks, and how to start one yourself.
But that’s just the introductory part of our guide. Once you’re more familiar with the essentials, we’ll delve deeper into crypto hedge funds to provide you with a more comprehensive overview.
By the end, you’ll have gained a deeper understanding of the current crypto hedge fund environment. We’ll explore key quantitative elements (e.g. cryptocurrency trading, liquidity terms) as well as qualitative elements.
By detailing these aspects of cryptocurrency hedge funds, we aim to encourage anyone participating in this market to adopt sound practices as it continues to mature.
- What Are Crypto Hedge Funds?
- How To Start Your Own Crypto Hedge Fund?
- How Can You Hedge Crypto Risks?
- The Growth of Crypto Hedge Funds Worldwide
- Understanding Assets Under Management
- Analyzing the Performance of Funds
- Understanding Crypto Hedge Fund Fees
- How Funds are Using Cryptocurrencies
- Crypto Hedge Funds Derivatives and Leverage
- Who Makes up the Crypto Hedge Fund Teams?
- How Much Experience with Cryptocurrencies and Blockchains Do Funds Have?
- Crypto Funds, Custodians, and Risks
- How Crypto Hedge Funds are Governed
- How Many Crypto Funds Use Independent Fund Administrators?
- Assessing Liquidity, Lock-ups, and Gates
- Crypto Hedge Fund Locations and Jurisdictions
- How Crypto Hedge Funds are Taxed
- Top Crypto Hedge Funds
What are crypto hedge funds?
At its most basic, a crypto hedge fund is a trading platform for cryptocurrencies that enables you to pay another user to handle the trades on your behalf. They’re similar to conventional hedge funds in this regard — though this is where the similarities stop.
Cryptos, such as Litecoin and Bitcoin, are classified as commodities rather than securities by regulatory agencies. That means hedge funds dealing with cryptocurrencies aren’t subject to securities regulations. While there is some conflict about such classifications, legal agencies have struggled to piece a viable reclassification case together so far.
As a result of this lack of regulatory guidance, crypto hedge funds are required to establish their own best practices to ensure investors and the industry remain protected. Still, no regulation means a bigger danger of fraud in the cryptocurrency world than in conventional hedge fund investments. Investors can lose much more due to speculative coins (which are unregulated too), which may vanish because of fraud or theft.
Hedge funds are known better for leverage than hedging (i.e. limiting trading risks): leverage multiplies trading risk on an exponential basis, to (hopefully) generate bigger gains. That means it can lead to high profits, though there is potential for significant losses too.
Another key factor of hedge funds is that time isn’t always on their side. When a trade goes wrong for a specific fund, it’s not just a case of waiting for an upturn to come along — fast, substantial losses usually lead to liquidation. Sad, but true.
Still, the potential for negative outcomes hasn’t dampened investors’ commitment to switch to crypto hedge funds. There are around 150 crypto hedge funds, with the average assets under management estimated to be around $44.4m and the average median to be approximately $8.2m.
Since 2018, the amount under management has doubled, and cryptocurrency funds have been prompted to increase higher fixed fees or try to focus attention away from pure investment.
Crypto hedge fund management fees, for example, are 2.3 percent now on average, with a 2.0 percent median. The most common cryptocurrency traded by crypto hedge funds are Bitcoin, Ripple, Ether, Bitcoin Cash, EOS, and Litecoin.
How can you start your own crypto hedge fund?
Anyone can start a crypto hedge fund due to the cryptocurrency world’s lack of regulation. There’s no need to buy or rent an office. There’s no need to source technical expertise. There’s no need to hire skilled workers. You only need to find people who trust you enough to invest in you.
You can choose from a wealth of hedge fund platforms that manage the back-end tech, empowering you with the freedom to concentrate on trade and marketing instead.
Follow these brief steps to put your own straightforward crypto hedge fund together:
Establish a strategy
You can trade in various ways, but with hedge funds, a clear strategy is usually necessary. You don’t just need to put a successful plan together: you should also be capable of describing said plan to potential investors in terms they understand.
Build a brand
You need a credible name to gain your investors’ trust, as well as a good record for trading in an unregulated space.
Pick your platform carefully
The crypto hedge fund platform you pick will enable you to buy the cryptocurrency you’re looking for. You’re able to collect funds via any medium available as there’s no regulation, which may include your own credit card. That’s not recommended, though!
Essentially, provided you hold an account with a platform for making the trades you’re looking for, you can go ahead and make them. Just remember that platforms could be subject to different regulations and charge different fees for transactions.
Set up accounts at exchanges
Exchanges that are unregulated bring a risk of losses even if you make a solid investment: you’ll lose if you put money into an exchange that ends up going down. That’s why you should mitigate the risk by spreading funds across multiple exchanges. If one goes down, you don’t need to worry about losing everything your investors put in.
Explore varied fund types
Different cryptos are set up for funding different industries, and a good hedge fund manager typically knows a lot about specific industries. The types of funds you go for communicate the investment types you expect to make.
Investing to boost portfolio value
Once you have analyzed your choice of investments, you’ll use the exchanges you’ve picked to enhance the value of your portfolio.
How can you hedge crypto risks?
Your hedge fund manager should be incredibly effective at risk management, and know various strategies to apply. Here are a few of the most common strategies to consider:
Contract for differences
Otherwise known as CFDs, contract for differences enable you to open positions in a specific crypto coin even if you don’t actually own said coin. You don’t need to deal with a new exchange or wallet, which may charge you for transactions. With CFDs, you can short sell without having to borrow.
As you may or may not know, the whole crypto market has a tendency to move in the direction of the original cryptocurrency: Bitcoin. Short selling this is an easy method of mitigating long exposure.
Some hedge fund managers prefer to borrow this crypto to short sell it, keeping all investor funds available in core position.
Beginning in 2017, both the CBOE (Chicago Board of Options Exchange) and the CME (Chicago Mercantile Exchange) offered Bitcoin futures. But the Chicago Board of Options Exchange doesn’t offer this any longer, though the Chicago Mercantile Exchange still does.
You can use Futures to sell Bitcoin for a preset amount in the future, no matter its price on the open market.
The growth of crypto hedge funds worldwide
Today, around two-thirds of the 150 crypto hedge funds active were started in 2018 or ‘19.
There’s a fascinating correlation between the launch of these funds and Bitcoin’s price: BTC surged beyond the $15,000 point in 2018, and the number of funds launched around this time spiked too.
However, as crypto markets experienced a downward trend towards the close of 2019, the number of new crypto hedge funds being launched decreased too.
In 2020, we have classified hedge funds based on four strategies:
Discretionary Long Only
This applies to funds that are long only, and investors whose investment horizon reaches further. In the case of these funds, investments tend to be made in token/coin projects in their early stages. They will also often buy or/and hold a greater amount of liquid cryptos too. Discretionary long only funds typically give investors longer lock-up periods.
These are funds covering a wide variety of strategies, such as relative value, technical analysis, event driven, as well as crypto-centric ones e.g. mining. Discretionary funds can involve hybridized strategies, such as investments in projects at their early stage.
These adopt a quantitative market approach in a market neutral or directional way. Such strategies include arbitrage, low-latency trading, and market-making. In these strategies, liquidity is essential, and limits these funds to trading more liquid cryptos only.
In this case, these funds utilize a mix of the strategies covered above. For example, traders could manage discretionary long/short accounts and quantitative sub-accounts, while operating within the boundaries established for a specific fund.
Which of these strategies are most common? Quantitative funds are known to be the most widely-used, accounting for around 50 percent of today’s crypto hedge funds. Almost 20 percent are discretionary-long strategies, slightly more than discretionary long/short and multi-strategy (both at 17 percent).
On average, the number of crypto hedge fund investors is 58.5, while the median stands at 27.5. The average ticket size is $3.1m and the median is $0.3m, with around two-thirds of tickets falling below $0.5m.
Understanding Assets under Management
Assets under Management (AuM) have increased significantly between 2018 and 2019. In 2018, the average year-end Assets under Management was $21.9m and the median was $8.2m. But in 2019, year-end Assets under Management were $44.4m on average and $8.2m median.
Assets under Management levels at launch were typically $18.9m on average (median of $2m).
Between 2018 and 2019, the percentage of crypto hedge funds with Assets under Management exceeding $20m grew from 19 to 35 percent. That’s because funds with a bigger AuM typically appeal to both new investors and attract larger ticket sizes. Plenty of investors are prevented from representing in excess of 10 percent of Assets under Management because of concentration risk.
Analyzing the Performance of Funds
How do crypto hedge funds with different strategies perform over time?
The 2019 year-end performance for quantitative strategy is higher than funds adopting the multi-strategy method, with median growth of 30 percent versus 15 percent growth. The median growth of funds with a discretionary long/short strategy was 33 percent, and discretionary long only was 40 percent.
It’s clear that substantial survivorship bias exists. For instance, median cryptocurrency hedge fund performance in 2018 was -46 percent, while the median year-end performance for 2019 rose to 74 percent.
This shows that funds performing badly in 2018 needed to close down, an outcome which is especially important when considering crypto hedge funds’ small Assets under Management. Average management fees aren’t enough to make them break even — strong performance fees are necessary for that.
When comparing performance by strategy instead of by fund, it’s obvious that Bitcoin achieved better results than other strategies by the end of 2019, with 92 percent growth. Discretionary long/short, discretionary long only, and quantitative strategies managed to mitigate 2018’s crypto bear market but failed to replicate 2019’s skyward trend.
In essence, these served as tools to reduce volatility instead of catalysts to boost performance.
Understanding Crypto Hedge Fund Fees
The median of crypto hedge fund fees remained the same in 2019 as in 2018: a 2 percent fee for management with a 20 percent performance fee. Yet the average management fee grew to 2.3 percent from 1.7 percent, while the average performance fee dropped to 21.1 percent from 23.5 percent.
The majority of managers had boosted their fees to enable them to cover operating costs, which have grown across the past few years. That’s a reasonable move, in most cases.
With crypto hedge funds looking to appeal to a higher number of institutional investors and other participants in the market (e.g. third-party custodians), they have started to get increasingly regulated.
Complying with said tougher regulations costs more money, so it’s likely that these fees will start to drop gradually in the years ahead. The industry will get more competitive as it matures, and will provide investors with more options as institutional-grade participants join the market.
However, even with management fees’ moderate increase, crypto funds may find breaking even a challenge without attracting enough investors. Remember: median crypto hedge funds had more than $8m Assets under Management in 2019.
So, if this median fund were to charge a management fee of 2 percent, it will have more than $1640,000 yearly revenue. This may not be enough to keep a business operating, particularly if a median fund has six workers on its payroll. This means a number of funds are looking for options to grow their income to make sure they can cover their costs adequately.
That’s why it’s more common to see quantitative funds shake-up their approach and try market making. Funds focused on early-stage projects have also embraced advisory roles in emerging projects. Meanwhile, other funds have tried to raise extra capital through selling General Partner stakes.
Some funds, though, have stayed focused on the strategy driving them and aim to cover their costs through performance fees. This method could be viewed as a positive; the negative is that managers could be prompted to take more risks — particularly if they’re still short of their high water mark as they get closer to their year-end point.
With median Assets under Management so low, it’s likely that many existing funds will shut down if they can’t generate a huge number of returns.
How Funds are Using Cryptocurrencies
How are crypto hedge funds utilizing cryptocurrencies (including Bitcoin) outside of simply investing?
For 42 percent of crypto hedge funds, cryptocurrencies are used for staking, while 38 percent use them for lending and 27 percent for borrowing.
In the case of staking lending, it’s clear that funds have grown their knowledge of various technologies related to cryptocurrencies to keep revenue streams more diverse.
The likes of staking, delegating, and operating master-nodes are all yield-based approaches. However, they also contribute to the network’s general strength and stability. It’s important to differentiate between cryptocurrency and capital markets.
Furthermore, operating PoS (Proof of Stake) nodes demands that engineers can set up and maintain a configuration of cloud and/or hardware. Certain crypto projects could need vastly different configurations according to their individual software requirements.
It’s clear that the approval and monitoring of crypto asset loans demands certain skills and tech. A number of managers could need to provide authorization for a transfer, while the funds’ flow would be tracked via the public ledger.
In this case, engineers could need to design and develop tools for the monitoring of all steps throughout the loan process. This may include establishing interfaces between the proprietary software and exchanges or additional participants in the market.
We can see why input from investment professionals with knowledge of technologies is a major advantage, and why CTOs (Chief Technology Officers) usually take an active role.
In terms of funds’ daily BTC-attributed trade activities, Bitcoin accounts for around 50 percent of daily crypto trading volumes. Just 5 percent of funds use and trade Bitcoin exclusively.
It’s also crucial to note the most-traded altcoins. The five most-traded altcoins are ETH at 67 percent, XRP and LTC at 38 percent, BCH at 31 percent, and EOS at 25 percent. It’s fascinating that LTC was classed as a top-traded altcoin regardless of its market cap, which is somewhat smaller than the caps on the other four altcoins.
Crypto Hedge Funds Derivatives and Leverage
Derivatives may be utilized as hedging or alpha-generating instruments, and considerable developments have occurred in the cryptocurrency lending market throughout 2019 - 20. For example, a number of centralized and decentralized cryptocurrency exchange platforms have started to offer their customers features for lending and margin trading.
As a result, it’s more common to see interest rate arbitrage and flash loans take place. Funds can now take short positions with more ease, as the derivatives market is increasingly diversified and more liquid. As crypto hedge funds have more cutting-edge tools to hand, they can provide more complicated strategies for investments (including market-neutral).
There’s also a closer link between the investment strategies utilized by both crypto hedge funds and conventional hedge funds overall. Just under 50 percent of crypto hedge funds short crypto and 56 percent utilize derivatives actively.
For options and futures, around a third of hedge funds leverage futures (29 percent physically settled, 38 percent cash settled). It’s likely that regulated futures offerings will help to spark a rise in usage of these instruments over time.
With regards to leverage, just 36 percent of crypto hedge funds were allowed to use this in 2019, though this has increased to 56 percent in 2020. Still, less than 20 percent actively use leverage despite growth.
More cryptocurrency hedge funds will allow the use of leverage, though it’s hard to say that there will be a material increase anytime soon for two reasons. First, because of how difficult it can be to obtain debt financing by brokers (for example, inherent dangers, requirements for high collateral). Secondly, because so many can attain leveraged exposure through the use of derivatives.
Who Makes up the Crypto Hedge Fund Teams?
Investment teams’ size have grown marginally, increasing from 7.5 to 8.7 individuals. However, the years of experience in investment management has jumped from 24 to 50 on average. This means a larger amount of professionals with experience in investments are getting into the cryptocurrency space, empowering fund teams to make more financially-smart decisions.
Still, survivor bias can be an issue, and it’s possible that funds closing throughout the past year employed a higher number of junior workers. That would explain the greater experience in fund teams (on average) compared to 2019.
It’s possible that finance professionals with valuable hands-on experience will continue to step into the cryptocurrency space as the industry matures. Investment teams with “traditional” experience in asset management will probably provide investors and regulators with more comfort, as they’ll know the fund is in the hands of professionals.
Individuals who have experience outside of investments are also a vital addition to fund teams, to ensure a smooth operation. For example, a Head of Compliance or Chief Operating Officer with vast experience in the world of traditional asset management would have an in-depth knowledge of regulations and rules. They would also know about protecting investors, which is crucial. A CTO with years of experience in technologies, of various types, is vital too.
How Much Experience with Cryptocurrencies and Blockchains Do Funds Have?
On average, crypto fund teams have 16 years of cumulative experience of working with blockchains and cryptocurrencies. The median is 14.5 years.
It’s probable that this will increase as people spend more time operating in this field (which is still niche) and funds start to hire workers with relevant experience, filling such roles as consultants and engineers. This could provide funds with a competitive edge and help them understand this fast-moving market better.
Another important element of successful crypto hedge funds is research. In 2018, just 7 percent of funds employed third-party research, with most depending on their proprietary models of valuation. The market also lacked many providers of crypto-specific research.
But in 2019, 38 percent of funds used third-party research, which is a massive jump from 2018’s figure. Numerous factors may be behind this growth, including the expansion of the cryptocurrency asset market, which means in-house teams may struggle to cover it all themselves.
But with the proliferation of targeted crypto-research providers, managers can outsource aspects of their due diligence system with greater efficiency. This leaves them with more time to focus on those areas in which they have an edge.
Crypto Funds, Custodians, and Risks
Independent third-party custodians are par for the course in traditional fund management practices. Many licensed custodians and prime brokers are available to assume custody of assets.
But this isn’t so simple with crypto funds — this is down to private and public keys. In 2018, around 50 percent of cryptocurrency fund managers rely on hot/cold wallet setups, multi-signature wallets, or other cutting-edge solutions for securing the assets’ private keys. For those funds that adopt a self-custody method, it’s crucial to invest in technology and expertise for the design and monitoring of the set-up.
But in 2019, 81 percent of crypto hedge funds used independent custodians. More custodians specializing in cryptocurrencies are available, including third-party and exchange custodians.
This increase is caused by pressure from investors, the ongoing implementation of best practices across the industry, and fund managers facing more regulations. These stipulate that funds be secured in a safe environment, and in some cases, regulated managers are unable to hold clients’ assets directly.
It’s vital to remember that around 50 percent of crypto hedge funds surveyed are quantitative funds, which usually leave assets with various exchanges due to their continuous trading. As more than 80 percent of funds rely on independent custodians, a significant number of quantitative funds will use them too. But these funds will probably place greater emphasis on clear risk management policies than employing a custodian.
Undertaking counterparty risk assessments on exchanges frequently is also getting more important than it used to be. Institutional investors will be more likely to focus on this aspect dwhen performing operational due diligence, and demonstrating how fund managers react to large events in the market is essential too.
Overall, the custodian ecosystem is fairly fragmented, with some of the bigger crypto hedge funds using more than one. The most popular custodian is known to serve just 15 percent of the crypto hedge funds, indicating that there’s no clear market leader.
This reliance on multiple custodians may be due to counterparty risk management, which is unsurprising given the industry’s risk of hacks. In other cases, multiple custodians may be used if their main one cannot handle all of the assets being traded.
However, bringing a second custodian on board can be unfeasible for funds on a smaller scale, as the monthly fees added to fund expenses may affect their overall performance. Crucially, most custodians that funds use are licensed or regulated in one way or another. This is a major benefit for the industry, demonstrating that the space is becoming more institutionalized.
Furthermore, a small number of custodians hold SOC (System and Organization Controls) reports, which differ to financial audits. They offer valuable transparency surrounding financial reporting and operational controls, helping to encourage trust in their risk management. It’s likely that more custodians will start to acquire these reports, providing investors and funds’ service providers with peace of mind.
How Crypto Hedge Funds are Governed
Independent directors are a vital addition to fund boards, particularly when decisions have to be made that could affect investors (e.g. setting up side pockets for holding specific assets, imposing investor redemption restrictions). Volatility issues and illiquid assets exacerbate crucial decisions in the cryptocurrency space.
Between 2018 - 19, the number of crypto funds with independent directors on their boards grew from 25 to 43 percent. A key driver for this is the industry’s overall institutionalization and institutional investors’ need for funds they invest in to have independent directors. It’s also easier to find board directors with valuable knowledge of the crypto space: they were rare in the market’s early days, but as it continues to mature, they’re more abundant.
This could help funds to appeal to institutional investors, and shows the industry’s ongoing institutionalization.
How Many Crypto Funds Use Independent Fund Administrators?
A NetAsset Value (NAV) which has been independently verified is essential for both investors and fund auditors. It’s exciting to see that more than 86 percent of crypto hedge funds now use independent fund administrators, as institutional investors are highly unlikely to choose funds without one. There’s also no good reason for a hedge fund to calculate its own NAV month to month, unless they have very small Assets under Management or hold niche assets.
No matter what their fund administrator of choice is, it’s critical that the valuation policy is a specific focus. The majority of funds will outline their method and framework for valuation in the PPM — and it’s essential for funds to comply with these accurately. Management fees will be finalized according to NAV, and performance fees tend to be based on NAV appreciation across a fixed period.
Investors want access to a month-by-month NAV, and for it to be verified by a trustworthy fund administrator. Exchanges may offer independent quotes for specific cryptocurrency assets, but for any portfolios comprising less liquid assets, managers might need to get a valuation from an independent third-party that aligns with the original requirements established in the PPM.
But it’s still a challenge to value crypto funds accurately, especially for those holding illiquid tokens or investments in cryptocurrencies through SAFTs. Some details are also crucial for funds that trade more liquid crypto assets, including valuation time cut-off (crypto markets are 24-hour) or which price sources should be utilized (exchanges may price assets differently).
Assessing Liquidity, Lock-ups, and Gates
Different types of funds have different liquidity. Quant funds are known to be providers of the most liquid funds, and those trading liquid crypto assets listed at exchanges can bring their investors better liquidity than investors focusing on early-stage or multi-strategy instead.
Locks are another key aspect to consider. There are two kinds: hard and soft. With hard locks, investors are unable to redeem before a lock-up period ends. Soft locks, on the other hand, enable investors to redeem early if they pay a penalty. Both lock types are utilized across all fund strategies, with 65 percent employing one.
Hard locks are typically used in situations where liquidity might be an issue, though terms in plenty of quant funds are similar. That’s due to quant funds’ negotiating power primarily, and various funds are capable of negotiating reduced fees through side letters in exchange for capital being locked up.
With the industry continuing to mature and get increasingly competitive, it remains to be seen if new crypto fund vintages lead to a shift in the mix of fund terms.
Following on from lock-ups, we have gates. These are a helpful mechanism enabling fund directors to establish restrictions in certain situations, intended to reduce the speed with which investors are able to redeem. The core goal is to protect the fund’s shareholders and prevent assets from being liquidated in fire sales to accommodate the high rate of redemption requests.
As with locks, gates come in two kinds: fund-level and investor-level. Fund-level gates are activated when redemptions exceed specific fund thresholds, such as reaching 30 percent of a fund’s NAV. Investors will usually get pro-rata redemptions, though this depends on the number of investors looking to redeem, and the overall redemption amount will be capped.
There’s no priority with fund-level gates, which means scaled-down requests for redemption are treated on the next redemption day on a pro-rata basis, along with any new requests.
For investor-level gates, these are applied when investors choose to redeem. For example, an investor could redeem just a quarter of their investment on every redemption day no matter if others redeem the same day.
Around 63 percent of crypto hedge funds have a redemption gate of some kind: 38 percent use fund-level gates, and 25 percent opt for investor-level gates. It’s still unclear, though, which type will become more prominent in the near future.
Yes, fund-level gates may be considered to be more fair, as they’re only triggered if specific redemption request points are crossed on a specific redemption day. For instance, if just one investor is redeeming and having a limited effect on the fund, a gate is unlikely to be necessary.
However, for investors, the drawback is they have no way to know if their redemption request is likely to be fulfilled. This could lead to issues with cash management if the investor is working to personal liquidity requirements. Fund-level gates place extra pressure on a fund’s directors, too, as they’re responsible for determining when gates are enacted.
Investor-level gates, though, are typically considered better for fund managers. Why? Because the investor will be prevented from redeeming their capital all at once, and must do so across several months instead, enabling the manager to collect fees as usual.
But some investors actually lean more towards investor-level gates: while they can’t redeem their total investment in one portion, they know how much they’ll get. This can aid their management of cash flow.
In general, investors tend to feel comfortable with fund-level and investor-level gates, but the final choice is usually made upon consultation with the day-one investor.
Crypto Hedge Fund Locations and Jurisdictions
For crypto hedge funds, the British Virgin Islands and Cayman Islands are the most common offshore jurisdictions, while the U.S. is the preferred onshore jurisdiction. For example, in a list of top crypto hedge fund domiciles, the Cayman Islands account for 42 percent, while the U.S. accounts for 38 percent, followed by 8 percent for the British Virgin Islands.
The top locations for crypto hedge fund managers are the U.S., accounting for 52 percent, followed by the UK, accounting for 15 percent. Next is Gibraltar (10 percent), Switzerland, and Hong Kong (both 8 percent). Less than 5 percent are located in the Cayman Islands.
So, while investment management entities may be located in the Cayman Islands, a tiny percentage of managers are based there. A lot of managers live in the U.S. and UK (financial centres with substantial traditional hedge fund activity), despite being involved in crypto hedge funds scattered globally.
It’s likely to remain this way, or close to, unless certain governments implement initiatives to attract more fund managers to their respective areas.
How Crypto Hedge Funds are Taxed
Nobody likes to pay taxes, but, unfortunately, crypto hedge funds are subject to them too. Fund teams and their managers must think about the same multi-jurisdictional taxes that affect traditional hedge funds. Common issues and considerations include:
On top of this, crypto hedge funds face unique tax issues. Such as:
How crypto investments are treated
The way in which the fund’s investment income/gains are characterized may be based on how said investments are treated: as commodities, securities, or other properties for tax reasons.
Crypto hedge funds may derive income from various sources, which could demand special tax considerations. These might include staking income from the running of PoS nodes or mining.
These different income sources may lead to unexpected tax issues. For instance, when income is derived from staking/rewards but treated as services income, activities that led to the income could be classed as a trade, business, or permanent establishment of the fund.
So, if activities like these were undertaken in the United States, any investors from outside the U.S. could be hit with U.S. taxes and the fund could have withholding obligations. It’s likely that the fund would lose its likelihood of consideration for electing investment partnership status.
Loss limitations and crypto fund trading
Are crypto fund trades subject to loss limitation regimes? Let’s consider the wash sale or straddle rules in the U.S.: the former refers to sales of shares of stock/securities, and the latter refers to losses related to offsetting positions with respect to personal property which is traded actively. Every crypto asset must be assessed separately.
Availability of mark-to-market elections
In the United States, the mark-to-market regime refers to all losses or gains being ordinary in character. Traders in securities or commodities may generally make a mark-to-market election, with respect to “securities” or “commodities” being held in connection with its trade or business of trading. To repeat our point above, every crypto asset must be assessed separately.
Fund tax safe harbors availability
When funds are set up in a jurisdiction where the manager is not based, it’s important to think about whether the investment team’s activities could lead the fund to face tax obligations. A number of jurisdictions have put safe harbors into place to stop funds being hit by tax charges where the investment team is located.
In some cases, these special considerations were made law before digital assets were created, so it’s unclear if safe-harbor regiments and exemptions apply to crypto funds. For instance, such rulings as the UK’s investment manager exemption, Singapore’s offshore fund exemption, and Hong Kong’s unified fund exemption all list investments that qualify. Sadly, a lot of crypto assets, specifically utility and payment tokens, don’t qualify.
It’s crucial to take extra care, as tax positions taken on by crypto funds can be surrounded by uncertainty. Managers will likely face more scrutiny from investors as the market continues to become institutionalized.
This brings our detailed crypto hedge funds guide to a close.
We hope this has given you the insights you need to decide if crypto hedge funds are right for you, what sort of considerations you will need to make, and other key factors to think about. There are real benefits available if you can find or set up a successful hedge fund. You just have to do your research, make the most well-informed decisions you can, and mitigate potential hedge crypto risks.