This year, several crypto and traditional hedge funds were hit by declining cryptocurrency prices and rising interest rates.
Several major crypto hedge funds, and traditional hedge funds with crypto exposure, collapsed or barely escaped in 2022. The price declines have tested the risk tolerance of these firms and have begun to build pressure on leveraged betting.
Hedge funds pool investors’ money to earn significant returns, using advanced investment strategies. According to the Securities and Exchange Commission (SEC), a hedge fund does not need to follow specific rules designed to protect investors, nor does it need to file reports with the SEC.
The Risks of Leverage
Due to the risky nature of hedge funds’ investment strategies, the funds often only accept accredited investors. Part of those strategies includes leveraged investing, which involves borrowing money to increase the potential return on investment.
However, the lenders, like prime brokers, will often require an investor to provide a minimum amount to borrow, called margin.
The borrowers are responsible for ensuring that a particular relationship is maintained between the amount borrowed and their margin. If the borrowers fail to maintain that ratio, the lender liquidates its position and the borrower loses their margin investment.
A hedge fund may borrow securities through a prime broker to maximize returns for investors while practicing proper risk management.
When a hedge fund is liquidated, it may be due to sharp declines in the value of assets recorded as margin for leveraged investments, or poor risk management.
The ongoing crypto winter has seen its fair share of declines in the value of digital assets, some of which have resulted in the bankruptcy of crypto-focused and hedge funds.
3AC Hedge Fund Fell First, Others Soon Followed
The first domino to fall was Singapore-based Three Arrows Capital, whose co-founder Kyle Davies made a series of leveraged bets on rising cryptocurrency prices based on the so-called supercycle thesis promoted by fellow founder Su Zhu.
The supercycle thesis posits that cryptocurrency prices will appreciate as adoption grows without the risk of a near-term bearish pivot.
Unfortunately for Zhu and Davies, the thesis did not hold up, with Bitcoin falling more than 50% in June 2022 from its all-time high of $69,000 on November 10, 2021.
The price crash came against the backdrop of the collapse of the TerraUSD stablecoin in May 2022. The crash shook confidence in the cryptocurrency industry and sent many investors fleeing for the hills.
A case of mismanagement of risk and falling cryptocurrency prices led to the downfall of Alameda Research LLC. This quasi-crypto hedge fund borrowed heavily, using a relatively illiquid FTT token as collateral.
Anthony Scaramucci’s investment management firm, SkyBridge Capital, suspended withdrawals from his Legion Strategies Fund on July 19, 2022, amid falling cryptocurrency prices.
This has been a difficult year for traditional hedge funds without cryptocurrency exposure, as macroeconomic conditions caused a pullback in leveraged betting to reduce risk exposure. Rising interest rates and geopolitical tensions have raised the cost of borrowing for hedge funds.
By Audy Castaneda
