Hedge funds and retail investors are entering the cryptocurrency space with high expectations, but more needs to be done to mitigate the risks of this new world of investment. Regulating exchanges can help to provide greater transparency and to protect investors from this exciting new asset class. Reservations about the investment opportunities of cryptocurrency assets are justifiable, and much of the problem lies in the lack of regulation around the crypto trade exchanges. This exposes retail investors to high levels of risk, with very little protection — and in many cases they don’t even realize the full extent of their vulnerability.
Asia is home to some of the world’s leading exchanges — but how much do we know about them? They don’t all follow the same playbook. Binance, for example, is one of the leading spot and futures exchanges in the world, and is famous for having professional, transparent and clear communications. However, it is not clear where their office is located. When team members conducted meetings before Covid-19, they never held them in the office because they didn’t want to reveal the company’s business location. This clandestine activity is not what you’d expect from an exchange running volumes in the billions each day.
Another major issue is fake volume, something that several exchanges in Asia are infamous for but they continue to operate. Professional cryptocurrency traders know how to quickly identify between a legitimate exchange and one that is faking volumes — but this is not the case for retail investors. The industry clearly has to step up to the plate and take action if we are going to move forward to promote greater transparency and foster confidence about the crypto asset class.
There’s a lot of talk about self-regulating exchanges but that would be a mistake, since there’s so much variation in the way in which exchanges manage their activities and very little common ground to start from. Some exchanges have hidden dangers and carry a much higher risk of being scammed or hacked than other rivals or even conventional financial markets. How the exchanges address the challenges of the risks also varies — as well the response.
Some behave honorably during crises, such as the case involving Binance, which was hacked in May 2019, leading to US$40 million in assets stolen. In response, Binance gave a full refund, an action that not only acknowledged accountability and responsibility but also created a lot of trust among investors and the community. But if regulations were in place, perhaps the regulator could have monitored the level of cyber security Binance uses and prevented the hack.
Yet for every Binance there are many other exchanges that don’t follow these relatively high standards and fail to mitigate risk, and losses or lack of trust ensues. This sets our industry back unnecessarily, and makes it harder to win confidence amongst the retail investors that ultimately bear the brunt of the risk.It could also minimize the potential for future crises — like the aforementioned Binance debacle. If regulations had been in place, a regulator would have been monitoring the level of cyber security Binance uses from the start and possibly prevented the hack.
Indeed, regulators should be given greater authority to rein in the exchanges. The lack of regulation around cryptocurrencies and relevant financial products are leaving investors exposed to many risks without any of the protections usually afforded to retail investors, such as access to compensation. Crypto assets are here to stay, and people will still want to invest. Until regulation is put in place, the industry should do more to educate people about the opportunities that are possible in this space, especially with a product that can reduce risk, while allowing exposure to these appealing returns. An example is a fund of funds (FoF) approach, where professional investors with expertise in the asset class choose the best-of-breed funds. This is a pooled investment fund that invests in different types of cryptocurrency funds by creating a diversified pool that can mitigate risk. This is a high returns and high-risk environment that is best left to the professionals.
A growing number of hedge funds are exploring the potential of crypto assets through this type of investment vehicle, and some are outperforming conventional capital market hedge funds. The new crypto asset class has created a once in a decade opportunity for young hedge fund managers to set up their own quantitative funds for digital assets, which the new money transfer recipients and family offices can invest in.
As the return on investment can be immense from early on, it would help these new fund managers to overcome the heavy ongoing costs related to setting up a structured fund. These costs kept the hedge fund industry as a closed club over the last decades. But with potential high returns early on, the fund can overcome this barrier. And so, we see a flow of top talent, leaving the leading proprietary shops of the world — with teams made of PhD graduates departing funds like Jane Street, Jump Trading or Two Sigma — to set up their own shops. But the risks will still remain high unless regulation is put in place. Hopefully this will come soon — and more investors will be able to enjoy the opportunities that digital currencies can bring.