Despite the near 40% drop in the value of Bitcoin this year and the growing spectre of regulations, arbitrage hedge funds are announcing relatively strong performance numbers compared to the wider market. One such hedge fund is the Nickel Digital Asset Management arbitrage fund which is only down 0.6% this year. This compares to the considerable drop in the value of Bitcoin and a 24% fall in the NASDAQ index. So does arbitrage work?
Market neutral trading
In an age where cryptocurrency, technology shares and green finance are seen as the sectors of the future, good old-fashioned arbitrage is still alive and kicking. As tempting as it might be to "buy on weakness", the extreme volatility of late has opened up relatively low-risk opportunities. However, it is essential to bear in mind some of these funds are worth hundreds of millions of dollars; therefore, relatively small mispricing can lead to significant returns. So, where is the discrepancy in cryptocurrency valuations?
Spot and derivative market pricing
Even though the cryptocurrency market is vast, the extreme volatility and uncertainty of late have led to significant price mismatches. Hedge funds, such as those operated by Nickel Digital Asset Management, have taken advantage of these discrepancies. Historically, there was not the required liquidity to deal in size or a guaranteed exit route. However, over the last couple of years, we have seen the emergence of cryptocurrency derivatives.
These derivatives have significantly increased liquidity, allowing (some may say even encouraged) leverage, leading to substantial price swings. As spot prices struggle to maintain fair value with derivative prices, and vice versa, there is the opportunity to buy and sell the same asset in different markets to crystallise a profit.
Market inefficiency is the key
The whole concept of arbitrage is based upon market inefficiency, where the value of the same asset quoted on two different exchanges varies. These differences may be relatively small and fleeting but dealing large and frequently can culminate in impressive annual returns. Under normal market conditions, market neutral equity arbitrage funds would expect to post returns of around 8% per annum. However, due to the volatile/inefficient crypto-asset market, some hedge funds have announced returns upwards of 15% for 2021.
Over the last couple of weeks, there has been something of a "flight to quality" in the crypto stablecoin market. As a result, some coins have come under severe pressure, while others are trading at a premium to par value. This is yet another example of the vast anomalies within the cryptocurrency markets – food and drink for the arbitrage hedge funds.
Returns will fall as markets become more efficient
There are numerous factors impacting the cryptocurrency market, with many likely to continue for some time to come. On one side, we have central banks worldwide, in excess of 100 at the last count, looking to create their own cryptocurrency. On the other hand, we have the Financial Conduct Authority (FCA) actively warning investors of the dangers of crypto assets and looking at a future regulatory framework. In the middle, we have many investors looking at the upside while sometimes dismissing the potential downside.
Slowly but surely, cryptocurrency markets will become more efficient, although they will likely be volatile for some time to come. This increased efficiency will eventually erode the current returns posted by arbitrage funds. However, until then, it would appear there are numerous opportunities to take advantage of pricing mismatches!
Day traders looking towards crypto assets
The creation of cryptocurrency derivatives and ETFs also allows professional traders to take advantage of pricing mismatches. The opportunity to use various derivative strategies to minimise the downside while maximising the upside has also attracted interest. Consequently, we appreciate the need to provide a competitive charging structure for our execution-only clients. This has only been possible via our ongoing investment in new technology and highly efficient trading services.