Cryptocurrency Derivatives Series: Counterparty Risk in Crypto-Hedge Funds and Need for Custodian Service

Counterparty risk in the crypto-derivatives markets, is no new thing where notional values can exceedingly increase the size of the underlying cryptos. To mitigate this risk, these derivatives trades must be cleared via central counterparties. 

Each crypto hedge fund requires a different level of sophistication in their custody process depending on their investment strategy. 

That’s why the recent instance is that Bakkt came up with the arrangement of Warehouse custody that has been opened to enable clients to deposit Bitcoin into their accounts and become familiar with the process.

The Bakkt Warehouse opens recently and it is regulated by the New York State Department of Financial Services (NYDFS) as a Limited Purpose Trust Company, providing customers with a Qualified Custodian of bitcoin, clarified in its official tweet.

A long only fund which seeks to pick winners in the space by investing in individual coins and early stage projects will need a secure cold storage custody solution as it seeks to hold these assets for a long time. Alternatively, a quantitative fund which trades at a very high frequency might have no need for a cold storage solution because its strategy requires it to keep all crypto assets on an exchange. In such instances, counterparty risk monitoring of such crypto exchanges becomes fundamentally important.

For fundamental and discretionary fund managers, custody is likely to be a very important part of the operational due diligence process for investors. Having clearly defined cold storage or third party custodian solutions with clear internal guidelines on its governance and controls becomes fundamental. Questions regarding existing insurance coverage levels and scope are also likely to come up in such investor discussions. 

If your crypto fund trading strategy requires leaving substantial assets at exchanges, having a proper counterparty risk framework with constant monitoring is key. This may involve strategies such as using numerous exchanges, limiting the maximum exposure to one exchange at any point and conducting regular counterparty risk assessments on these exchanges. 

Institutional investors will likely focus on this area as part of their operational due diligence. It is therefore very important if a fund intends to target that investor base. Courtesy: BNC