German funds' crypto investments will pose liquidity risks, says Fitch Ratings

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Regulatory changes allowing certain German funds to invest up to 20 per cent of their assets in cryptocurrencies could increase demand for cryptocurrencies. However, there are significant risks – notably liquidity risk – for the funds that invest in such assets, says Fitch Ratings.

The new regulations, which came into force on 2 August, apply only to Spezialfonds, which are reserved for institutional investors. Insurance companies and pension funds dominate the investor base for Spezialfonds. The changes bring cryptocurrencies into the traditional, and more regulated, financial system and could result in increased, albeit intermediated, exposure to crypto-assets for retail investors whose assets, retirement benefits or insurance policies are managed by such institutions.

Open-ended Spezialfonds had assets under management (AUM) of EUR2 trillion at end-March 2021, or around EUR1.8 trillion net of property funds, funds of funds and feeder funds. This could imply maximum crypto-asset investments of up to EUR360 billion – which compares with bitcoin’s current market capitalisation of around USD860 billion (around EUR730 billion). However, we do not believe that allocations to crypto-assets will reach close to the 20% threshold, considering the traditionally risk-averse asset allocation patterns of the main institutional investors in Spezialfonds, as well as other regulatory restrictions on their asset allocation.

The volatile nature of crypto markets will present particular challenges to fund managers that include cryptocurrencies in Spezialfonds. The price volatility among cryptocurrencies suggests that pricing and redemption terms will be important for investors in cryptocurrency-exposed Spezialfonds. We believe that managing the liquidity risk of mutual funds invested in such highly volatile assets would be an important consideration for fund managers.

If price volatility triggers trading breaks for exchange-traded cryptocurrency assets, this could make it more difficult for managers of cryptocurrency-exposed Spezialfonds to meet investors’ redemption requests or other obligations. However, this would also depend on various factors, such as the extent of cryptocurrency exposure, the duration and materiality of market interruption, the availability of other liquid assets within the fund and the degree of liquidity offered to investors.

Liquidity risks could increase if Spezialfonds’ crypto investments become material in the asset class, increasing the difficulty of managing positions without exacerbating market stress during periods of volatility. Under such circumstances, the risk of mutually reinforcing sell-offs in cryptocurrencies and the funds exposed to them could add to volatility in crypto markets.

If these factors caused a temporary suspension of fund redemptions (known as ‘gating’), or fund failure, this could result in reputational damage to the relevant fund managers, particularly if gating was perceived to be damaging to retail investors’ savings, for example. In turn this may affect their ability to launch new funds and attract or retain assets in existing funds, and potentially heighten regulatory scrutiny.

Liquidity risks are not limited to crypto-asset funds – several European funds investing in traditional assets gated in March 2020, for example. The primary unifying feature in these funds’ suspension was their temporary inability to value their assets due to material price movements.

Fitch Ratings is not expecting large volumes in cryptocurrency-exposed funds in the next one to two years, but if other regulators follow Germany’s lead in allowing institutional – and potentially direct retail – access to cryptocurrency funds, AUM could eventually reach levels sufficient to pose greater financial stability risks. If AUM in cryptocurrency-exposed funds rose significantly above EUR100 billion, for example, contagion risks posed to the broader system by fund gatings in the crypto-asset sector would be more substantial. Banks or other lenders might also be affected if those affected funds used these institutions for leverage or liquidity facilities.