Why Are Hedge Funds Betting Big on Bitcoin?

Hello and welcome back to the show. And we're going to try and have this conversation and put the episode out as fast as possible because Bitcoin is knocking on that door, 100,000. And so I don't want to miss it either. It's going to, by the time this airs, be down at 80,000 or it's going to be at 125,000. So time is of the essence, Piers. But in this conversation, I thought we could talk a little bit about that in itself. Uh, I did see that US ETFs investing directly into Bitcoin have surpassed now $100 billion in total assets, um, and that's a group of 12 Bitcoin ETFs. So those issuers being big ones— Fidelity, BlackRock— they've only been going 10 months. So it's been one of the most successful fund category launches ever. So we can have a look at about Bitcoin, some of the dynamics that are driving price at the moment. Also, you always tend to hear a lot about something called 13F filings, people diving into those to try and ascertain clues as to what's going on, what are the broader market investors doing. And then there was an interesting article in Reuters this week talking about why hedge funds are piling into Bitcoin. This always raises the eyebrows when you see the likes of Millennium Capital, Tudor Management, their exposure to US spot Bitcoin ETFs in the third quarter coming out of those securities filings has grown quite considerably. And there's a few things there, a Bitcoin basis trade, leverage trades. We can unpack some of the terminology and hope to explain, but I'll kick it off. Piers had my haircut. In the barbershop last week, if you can see, if you're looking on the video. Nothing too drastic. But, you know, after the normal pleasantries, you know, oh, what are you doing today? Anything, any plans, big plans for the weekend? Football, so forth. There's a bit of silence, you know, he's just doing his good work. And then he started chatting to the other guy cutting hair. And he was like, yeah, so How much are you onside now? And he was like, oh, I'm up about 5, 6% since yesterday. And I was like, oh, hang on. Sorry, guys, what are you talking about? And they were like, Bitcoin. He's like, you haven't seen it? And I was just like, déjà vu. It felt like we were right back in the mix of a few years ago. And they were declaring to me their own 13F filings, I think, of their entire crypto portfolio. And I was just like, wow, it always amazes me how active people are actually day trading this stuff, um, which they were literally on their phones whilst cutting hair. But I thought, yeah, very timely though, because the guy will be very pleased if it breaks $100K next time I go and get my hair cut.

Yeah, exactly.

Uh, but yeah, what are your thoughts on the whole thing?

He won't be, he won't be cutting hair anymore. Bitcoin millionaire. Um, I actually saw— well, I just kind of reading up on all things sort of crypto, just a quick funny story to— from my side, actually. Um, there was a— there was— so there's this guy, a cryptocurrency entrepreneur, um, a guy called Maurizio Catalan, okay? Um, and, uh, Oh no, sorry, that's the artist. Apologies. The crypto entrepreneur is called Justin Sun. All right, so he founded this platform called Tron. Okay, it's a crypto platform. Anyway, there's an artist called Maurizio Cattelan, and he, uh, had an exhibit that was up for auction. I think this was yesterday, and Justin Sun, this crypto guy, won the auction. Okay, and the, the, the item, the lot got sold for triple what was expected, and it got sold for $6.24 million. Okay, do you know what the, the actual piece of art was? It was a banana, like a real, just a banana duct taped to the wall. That was it.

That, that would go very nicely in that office you're sat in, right on that wall beside that picture.

But you know that these crypto guys, uh, are making some good wedge this year when, uh, they're throwing $6.24 million just a banana on a wall. Um, so you know we're in, we're in, yeah, crypto frenzy is back. Um, but look, Bitcoin, I mean, let's start there. I mean, we perhaps will touch briefly on some of these other coins, but Bitcoin's obviously the big one and has had a sensational year. I mean, it's up, I'm looking now, year to date is up 130% as we speak. And as you're saying, just shy of that, that, that big $100,000 level. It's, you know, at all-time highs at these levels anyway. Uh, we just briefly touched above $98,000 just, um, about 15 minutes ago. But look, up hugely. It's up 40% since the 5th of November, which, um, those who are on the ball will know that was the election day. So the Trump win has certainly helped, but there's been other stuff that's kind of been It's been an amazing year for Bitcoin, and the Trump thing is just this kind of latest sort of really positive catalyst. So the other things, you kind of already alluded to one of them, that's when the SEC on the 1st of January, you know, paved the way for Bitcoin ETFs to be legalized. And that was the date that the big guns like BlackRock launched their ETFs, meaning that it became a much easier vehicle for kind of big institutional investors to start really getting on board with some, you know, Bitcoin exposure. So that was the 1st of January, that really kicked off the year nicely, right? 20th of April, we had a Bitcoin halving event. This happens every roughly every 4 years. I won't go into the technicalities of this, but essentially it means that for the mining reward in, in bitcoins halved. So you now get 3.125 bitcoins per mined block, okay? That halved from the previous 6.25. What, what does that mean? It just means less reward for mining. So you might say mining activity will reduce because there's less reward, which means then there's less supply. Less supply, price goes up, right? So that halving event back in April was something that was of significance. And then look, Trump, right? Trump on his campaign trail has just been very vocal. He wants the US to be the Bitcoin superpower of the world, you know, these kind of throwaway lines. But basically he's gonna, you would have thought, reduce regulation around all things Bitcoin. And again, this should pave the way, I would say, for institutional investors to really start to kind of get wedged in here. And we're going to talk about Millennium and the likes, um, in a second. But you're, you're already hearing, you know, what does institutional money mean? Well, actually, you're already— now I've been hearing about like several big pension funds that are now thinking— and pension funds, you know, they run massive, massive amounts of money. Um, actually, the randomly, the Canadian Pension Fund is actually one of the biggest kind of asset managers in the world. But they're— and then generally they run a diverse set of investments, pension funds, right? They want to diversify their investments. And now they're saying, right, really we should be allocating some of our funds to Bitcoin. They're not talking about a lot, like 1 or 2% of our fund, you know, really probably should be allocated towards crypto now. It's becoming more serious. And so, but that 1 or 2% of a massive pot of money starts to add up, right? So you're getting on the demand side from institutional players, that's definitely helping with this rally as well. I think broadly, I mean, we talked about the US dollar last week and how generally speaking the rest of the world is just trying to wean themselves off dollar dependence. And I think you probably will see in the future, I don't know when, I can see a time where, you know, an emerging economy will have their own domestic currency, and then in parallel they might have something like Bitcoin rather than the US dollar as that kind of alternative sort of international, um, sort of currency thing. And people are starting to talk about it being like, for the next 100 years, you know, Bitcoin might be the inflation hedge, gold playing that role for the last 100 years. And are we in this transition phase from gold to Bitcoin. I don't know how long that phase takes. Well, years and years and years. And yeah, maybe we are some way down that path. But you know, this is all like kind of added all up to 2024 being a mega year for crypto broadly, you know, Bitcoin particularly, 130% up as we speak and gunning for $100,000.

So you mentioned there about big pension funds, and they're taking a little sliver of this allocation towards crypto in the form of spot ETFs and so forth. So a hedge fund's doing the same thing. So they're just diversifying a little bit of allocation, but the hedge funds act at a different end of the, I guess, agility spectrum in terms of how they manage money. And so they see opportunity, and so they jump on it, but again with just a small level of exposure. Would that be a natural—

Agility is a very good word there. I think, um, you definitely can't say in one sentence that now pension funds and hedge funds are piling into Bitcoin. That's an inaccurate comment. Pension funds, asset managers, you know, the kind— we, we often might refer to these lot as kind of long-only type funds, you know, where it's just straight up what these days quite vanilla basic strategies, whereas buy and hold, you know, it's, it's kind of that value, maybe that Buffett, Warren Buffett buy and hold long-term, you know, value play. All right, so if a pension fund's looking to get into some Bitcoin, it's just for diversifying their portfolio, and they'll be buying and holding for years, right? That's one thing. Hedge funds, it's an entirely different story. I mean, they— yes, they might be buying Bitcoin, but they'll also then be playing, you know, hedging that off with probably getting short some kind of form of Bitcoin derivative. And they're, they're more about tactical, um, you know, opportunities where they're spotting, you know, short-term divergences where you've got two correlated assets and they're moving apart, and they're like, well, hang on, that shouldn't be sustainable, so let's latch on to that divergence. And it's kind of a reversion to the mean play where they're looking to then go long and short, so they're hedged. But their idea isn't that— their trade isn't, ah, Bitcoin's going to go up. Their trade is two things that are normally quite aligned have diverged. Let's trade that because they're going to come back to being aligned.

So I know when you started trading, you were trading a similar idea or approach, and that was, you know, I'm going back to what, early 2000s? This was looking in the German bond market and looking at different maturities of bonds and the differences that one might signal another move or against another European counterparty or so on. Is it because the spot Bitcoin ETFs are so new that it takes time for the market to eradicate these opportunities? And as the size of the market gets bigger and the investors get more sophisticated, then that arbitrage trade is only there for a finite period of time before eventually it starts to erode.

So I think you've kind of got two things in that comment that I probably want to separate. So firstly, I would say that immature markets— I mean, look, you can't really describe Bitcoin as immature necessarily anymore, but I mean, certainly some of these crypto, you know, if you step outside of what whatever, Bitcoin and Ethereum, and maybe then they are really immature, right? In an immature market, the liquidity is lower, meaning the volume of trades going through that product on a day-to-day basis, the volume of orders on the order book is just less. It tends to mean then that the, the price can be a lot more erratic, okay? So it's more volatile. Right, so if you've got a less liquid, more volatile asset that's pinging around, then it tends to be you'll get much more, many more divergent situations when you're comparing that asset's one price with, with another asset's price that's correlated. Because of the noisy volatility, you're getting much more divergent scenarios that then can be tradable. Okay, so that's, that, that's one thing. So another thing then is, as a market matures, yes, you can say that those divergent opportunities reduce, and actually the very action of trading that divergence means more volumes coming into the market and the market's becoming more liquid. If more hedge funds are trying to do that trade, these markets are becoming more liquid. And because these hedge funds are using algo strategies, the time period over which the divergence exists is very, very small. So actually, it goes so small you can hardly even see it from a kind of human eye point of view, right? So that is true. Now, there is a separate thing Which is, that doesn't mean to say divergent episodes then never happen in a mature market, because they do. And they do often when something big macro thing happens that kind of drives perhaps more volume than normal into these types of products. And here it depends on whether you're trading spot or whatever the correlated asset might be— Bitcoin futures, So here, if you've got a big pension fund that now wants to pile into spot Bitcoin, well then that means you've got a huge buyer just in one of these two correlated products, right? And that huge buyer can move Bitcoin spot price, and because you're not getting the volume of trade necessarily on the futures side, there can be a lag, all right? So you can get a lag effect when you're getting big events that result in big trades going through. And then these lag events, you know, that's perfect for these hedge funds that are looking to try and firstly identify the divergent scenario, secondly execute a strategy to exploit it, and then thirdly profit as that divergence reverts back.

Just following these relationships then we discussed with the, the pension fund, the hedge fund, one thing that has been in the news recently is I think it was Bridgewater teaming up with State Street. And then there's also been BlackRock taking a little sliver of ownership in Millennium. So is this all connected in some way in terms of mixing the diversity of some of those big, those funds like what BlackRock, its AUM is just so big.

Yeah. What's 11.5 trillion?

Yeah. And what, it's just trying to find other, um, what, an ability to have a tactical arm? Is that what a hedge fund gives you?

I think that, look, the hedge fund world is growing, you know, rapidly. Hedge funds, these big boys like Citadel and Millennium and the like, they're becoming such a massive player in the market Um, that, and you know, other companies like Jane Street or Citadel Securities, which is on the market-making side, they are winning huge market share off the big investment banks when it comes to facilitating trades. So my point is they're just becoming ever larger entities in the financial system, in the financial landscape. And so as an asset manager with huge amounts of capital You want to be running a diverse portfolio that's got exposure to all of these different important elements within the system, and hedge funds are becoming an ever bigger and important element. So that's one reason. And then, yeah, I— the beauty of the hedge funds that are running multi-strat— so again, Citadel, Millennium, and the like— they're multi-strategy, meaning that they— their consistency of return It's phenomenal when you're getting, you know, big swings in, in kind of market scenarios. And so if you go back to COVID, ever since COVID we've had massive swings going on, you know, during COVID post-COVID, inflation, rate hikes. Now it's inflation's dropped, rates are being cut, China's— hang on, that's lagging. Trump's won an election. You've got all these mega events and it's causing big changes in market dynamics. Now, if you're running one strategy, then during those 5 years there's been certain times where your strategy's been awesome and has outperformed, but then quite quickly conditions change and your strategy isn't performing very well anymore. But these multi-strat funds just ride above all of that because they they're running lots of strategies, meaning that it doesn't matter what the market condition is, they've got a strategy that's going to perform well in that, at that time.

And just to add to that example then of the different types of strategy hedge funds deploy, I did see some statistics saying that quant— so the different, just to be clear, what are the different categories we're talking about here in terms of hedge fund strategies? There's equity long-short, Multi-Strat, Quant, Macro, Credit, Long Biased, Event Driven. One thing that stood out was Quant dropped from being the top performing strategy in the first half of the year to second from the bottom year to date after returning a negative 2.3% for the third quarter. So explain that to me. I mean, you've mentioned their whole catalog of market events. Is that the reason?

Well, I mean, that is the reason, but I'm just digging into quant. Like, under the quant bonnet, there's lots of quant. And actually, under there, the multi-strat quant has actually performed really well. But when you get single strat, single strategy quant, then that's the one that, right, might have been doing well in the past that has now started to underperform. And that's because, yeah, like Trump winning the election is a really good example of what you would call a macro-driven event that has created huge market movements, right? And so your macro strategy has really performed really well in that condition, okay? And so I think that Whilst quant maybe over the last 10 years, generally speaking, has been a highly successful part of the hedge fund landscape, you're going to get short-term episodes where there's a big market event where, right, for a short period these other single strategies might come in and actually outperform them. But, you know, long term the quant side is certainly, you know, we're not going to start thinking, oh well, quant, that's the end of quant then because they haven't done well in the last month. Um, that's not really the case.

Well, there is, there is one stat there that the normal folk on the street will enjoy, which is that hedge funds generated a positive performance in Q3, up 2.4%. Hmm. I'm not, I'm not sure what the, uh, S&P has to say about that. The trusty old S&P. Over Q3.

Yeah, I mean, the S&P, I mean, smashed that. I mean, remember Q3, that's before the election. So I, I would, I would expect to see those hedge fund, uh, performance kind of numbers looking pretty, pretty, pretty good, um, over the election scenario. But the S&P started Q3 at 5,450 and it ended Q3 at 5,750. So yeah, that's up 300 points, let's call it. So it's about 6-7%. So yeah, the hedge funds have been underperformed the broad index, which is never a good look.

Okay, well look, let's, um, did mention that Reuters article at the top of the show. So given what we've discussed, maybe just, just to break that down a little bit. So There's a couple of names here, some that you've already mentioned, uh, likes of Millennium, Capula, Tudor, and they're talking about this so-called Bitcoin basis trade. So just want to understand a little bit more what that is, uh, and then also given that it involves futures, what a leveraged trade is, what the pros and cons of that are.

Yeah, so basis— a basis trade, it's quite a popular one in the hedge fund space. And actually, I mean, like, the formal definition of it is basically a strategy that's— that's— it's like a multifaceted trading strategy, okay? So again, a bit more complex than those boring old long-only pension fund type thing where you're just buying something, okay? This is then multifaceted And it's a strategy that's basically built— it's kind of what we've already been saying— it's built around the difference between the spot price of a commodity and then that commodity's derivative futures price. Okay, so the futures market, that's a whole set of financial products whose value is derived from the underlying physical asset. Okay, so then you've got these two things, and they're highly, highly correlated. And again, back to that word correlation, and back to that principle that hedge funds use about, right, let's, let's spend a lot of time— and actually, a lot of their quants, um, it's actually just scouring global markets and measuring kind of betas, measuring correlation between assets, and they're trying to find assets that are highly correlated. So obviously a commodity and its futures price is highly correlated, okay? So once you've got a highly correlated setup, all you're then looking for is when that correlation momentarily, or in a short-term scenario, breaks down and you get divergence from the two. And all they're saying, it's very simple, they're just saying that that's not a sustainable setup. These are, you know, fundamentally correlated assets, and if they diverge, that ain't right, that's not going to last. So how can we place a trade to profit from and exploit this very short-term dislocation of the relationship, on the principle that that relationship will come back together and the correlation will kind of reform? And so this basis trade is a long-short trade. So that again is hedged, right? Hedged fund. So using this Bitcoin example, they'd be buying. So this would be a long basis trade where you're buying the spot and you're going short the futures, okay? That's a long basis trade. A short basis trade is the opposite, where you're shorting the spot and you're buying the futures. But let's just talk about a long basis trade. So if your view is that, right, the, the, um, the price of Bitcoin spot versus the price of Bitcoin futures has diverged. It's wide, the spread. So we use a word called the spread. The spread between those two prices has got wider, and that's unusually wide. And this, this relationship's diverged a little bit, right? Let's get on it. So if we think the gap has widened, how would you profit from then the gap narrowing? So at its widest point, you want to be going long the price that's the cheaper of the two, and you want to be going short the, the product that's the more expensive of the two, on the basis that all your trade is, is that the gap will narrow and then you'll make money. In the meantime, it doesn't matter where the overall price is moving. The trade is not, I bet Bitcoin's going to go up. That's not the trade at all, because the Bitcoin could go up or down, it doesn't matter. What we're trading is the gap between spot and futures narrowing, okay? The spot and the future, they're correlated, they're generally going to move up and down in tandem. And so we don't care if it goes up or down, that's not the point. The point is we're hedged, we're market neutral. It's other words to describe it— relative value trade, okay? And we're just looking to kind of trade the narrowing of that gap. It's a less risky trade, okay? Number one, this is how these hedge funds generate consistent returns. They place trades that are less risky on, on the face of it. However, they then leverage these up. They're basically trying to find low-risk trading opportunities, but they then bet huge amounts on that trade. And they'll do that through— well, there's traditional kind of a traditional idea of leverage, which is basically, you know, a derivative product, and that allows you to leverage your exposure to that underlying asset. But actually, a lot of work that the investment banks do— there's a division within an investment bank sort of global markets arm, there's a division called prime brokerage And the Prime Brokerage division services hedge funds, okay? They provide all services that hedge funds could want. One of those is financing their leveraged positions. So essentially, I'll just simplify this: hedge funds borrow money from the banks to double, triple, quadruple, quintuple down their bet on these types of trades, which in principle are low risk, but then they just amp it up. So they're generating huge profits from a low-risk trade where the price movements are actually quite small.

Yeah, it's really interesting actually listening to you describe it, and I was just thinking of if you're a student and you're thinking about careers because— and how that ties to skill sets, because I'm just thinking when you were describing correlations, looking at data from the, the kind of the engineer's perspective, the researcher, and then ultimately the trader, which makes up that kind of quant trio, if you like, that would work in uniform. And it's interesting how you can have one marketplace, but such different tactics. Whereas they're just looking at nuance in data structure and is it giving any signal as opposed to the macro discretionary fund, which are going, well, I've seen this before and this domino falling here will mean this here. I think it's a wonderful place is what I'm saying, is that you can basically apply quite a different skillset and motivation to what you find interesting. And still sit and trade pretty much exactly the same thing but in an entirely different way.

Yeah, I mean, it's fascinating. I mean, that's one— like you say, engineering. I mean, I did an engineering degree. I guess I've got a bit of engineering in my blood, um, and I find that all highly fascinating. And it's just there's so many parallel skill sets, right? If you're listening to this and you're a math student or you're a computer science student or whatever, right, you're Actually, the skill sets you're learning are eminently transferable to the financial sector because, yeah, the quant researchers, they're the ones that are building these kind of correlation models. They're the ones on the hunt, scouring out across the globe, trying to find and measuring beta and measuring correlation, basically trying to find correlated products, right? Then it passes to the trader. 'Right, okay, you've identified these correlated products, right? How can I, the trader, now build a trading strategy that can exploit what you found?' Okay, then it passes to the engineer who goes, 'All right, trader, I see your strategy. I'll now code that so that it's automated.' And then bang, you're away. And then these funds are just making these, you know, I don't know what the— like hundreds of thousands, millions of trades based on these correlation kind of mismatches. Um, and it's just, it's just an— yeah, it's a— you're immune to market shocks. You know, the macro is, is irrelevant, to be quite frank. And it doesn't matter if Trump wins or Bitcoin breaks $100,000 or, you know, the Fed hikes rates by 1% or whatever. It's just not relevant to the way that they're operating.

Okay, well, to conclude then, Bitcoin is knocking $100K. In your experience, you know, you've been around the block long enough, you've seen enough record highs and big psychological levels tested. Is there any behavioral takeaways using your past experiences that you could kind of help people with just dealing with what's about to come with these big figures. I mean, this is kind of compounded by it's $100K. We're not at like $50K, $80K, $90K anymore.

Yeah. I mean, I'd say because crypto is generally speaking still a relatively immature market, and I know Bitcoin, all right, it's the most mature of that set of immature products, but it's still immature. So what typically happens is it's very, uh, uh, the behavior of its price is heavily influenced by technical or indeed emotional factors. All you need to do is look at a Bitcoin chart for this year to understand what I mean, because the previous high of the year was back in March, okay? And that high was, was around— let's just round it to $73,000, okay? And that was a really key resistance level for the whole of the first half of the year. We then dipped a bit through the summer, then we came back up, and then the Trump effect obviously got things right up, pushing back to the upside. Now we broke that March high basically on the 5th of November, the Trump win. Immediately, or relatively immediate, in a matter of days— so we broke 73,000, and a matter of days we hit 90,000. It's like bang! And that's what we call a technical breakout. That's like that. Think about it from a psychology point of view. If this thing has been held back below $73 for, for 9 months, each time it's hitting it, it's a barrier, a barrier, a barrier, and people are going, well, you know, that's the top, I'm not buying, not buying here because this is resistance. What you need as a signal to go, actually, all right, this thing is going up and I am going to buy— what you need is to see it break that previous high. That's what we call a bullish breakout signal. And so people are like, okay, we're not— we're kind of over that barrier, okay, I'm buying because we're on to the next phase of the upside, right? And when so many people have that same attitude, the volume coming in on the buy side of the market is huge, and that's what ramps and accelerates the price movement upwards. So it's called a technical breakout. So we went from 73 bang to $90 straight away. But as soon as we hit $90, it stopped. And we had a lot of volatility around the very round figure of $90 when we spent from the 12th of November all the way through to the 18th of November, basically just locked in around $90. And this is what we call a psychological level. It's just a big round number. Oh, it's broken the March high, right? I'm buying. Okay, we're at all-time ever highs, so there's no reference point of previous behavior at these levels. So right, where am I going to sell? Well, $90,000. You know, I'll sell it, I'll sell at the next round number, right? But $90,000 of course isn't as big a round number as $100,000. And so whilst we did pause at $90,000 there for a few days, here we are now on a journey inevitably to $100,000. We're trading at $97,500 at the moment. We're gonna hit $100,000. What happens there, I can't tell you, because one of two things will happen. That will be that it's such a big psychological level, you get a lot of profit-taking, which of course then will drive the price back down. Or there's enough appetite in buying that it breaks $100,000, in which case people will be going, all right, where's the next stop? $150,000. And I remember this vividly. Back in, I think it was 2008, when the price of oil broke $100. And it was knocking on the door of $100, and it was key resistance, key resistance, key resistance. It then broke, and we went bang, went $150, like pretty much in the matter of a couple of weeks. I mean, I will finish that story though, because, uh, 3 months later, having hit $150, or maybe 6 months later it was trading $35,000. So I will just caveat that. But yeah, $100,000 is a very important price point for Bitcoin. Inevitably there'll be some profit taking there, but if we were to break it, then yeah, it's kind of probably hold on to your hats.

This is all education content, folks. Yeah, as you said, it could go two ways is the, the normal historical— absolutely. All right. Well, look, thank you as ever, Piers, for sharing your thoughts. Thanks everyone for listening, and we will see you all next week.

See you later.