The growth of the crypto assets ecosystem, including the 1500-plus different cryptocurrencies now available, has encouraged many to set up crypto funds to allow them to trade this new and exciting asset class. However, launching a crypto fund has very unique challenges that have to be considered. Here’s what you need to know if you’re thinking about launching your own crypto fund or investing in one.
Setting up a crypto fund requires important legal work. There are many types of fund structures that can be used for crypto funds, ranging from standalone and “one-legged” funds to segregated portfolio companies (SPC) and master feeder structures.
To the surprise of many, the right structure is often driven not by the nature of the assets traded in the portfolio but rather by the tax jurisdiction of your investors, especially if you’re looking to target US investors. For example, the right type of structure will vary depending on whether you are hoping to attract US taxable investors (e.g. high-net-worth individuals), US non-taxable investors (e.g. some pensions or endowments) or non-US investors (i.e. investors based outside of the US). Also, investors from certain countries may prefer other types of legal structures; for example, unit trust structures for Japanese or Australian investors.
While it is, in theory, possible to change a fund structure after it has been set up, there are many downsides to doing so. It is therefore important to seek proper legal guidance initially to ensure you set up the appropriate fund structure and that it is scalable.
Launching a crypto fund brings up a number of tax considerations. Many jurisdictions have some type of tax legislation or incentive intended to encourage fund managers to set up a presence in that jurisdiction. The exact name differs in each jurisdiction (e.g. Offshore Fund Exemption, Safe Harbour), but the rules broadly state that an offshore fund will not be taxed onshore even if it is managed by a fund manager based onshore. The aim of such legislation is to encourage fund managers to base themselves in that particular onshore jurisdiction.
However, this legislation was never drafted with crypto fund managers in mind, and crypto assets are generally not included in the list of instruments covered by such an exemption. The risk for a crypto fund manager is that tax may be due on any gains from the fund, in addition to the tax each investor will subsequently need to pay depending on its personal tax situation. This may make your fund less competitive versus other crypto funds, as well as in relation to more “traditional” funds.
Although, from a policy perspective, many jurisdictions would probably welcome crypto fund managers and many expect tax legislation to change over the coming years to include crypto assets, such changes do not happen overnight, unfortunately. This is why seeking proper tax advice before launching your fund is essential.
In the traditional fund management space, using an independent third-party custodian is expected and there are a large number of established players, from licensed custodians to prime brokers, who can take custody of fund assets. This is not as straightforward in the crypto as in the non-crypto space, given the reality of public and private keys — which is why many crypto fund managers often use multi-signatory wallets, hot/cold wallet set-ups or other innovative ways to hold the private keys of the fund’s crypto assets. In addition to hacking risks, holding private keys may also raise regulatory concerns in some jurisdictions where regulations forbid a manager from directly holding client assets.
Most institutional investors will raise these issues as part of their operational due diligence, and it is important for a crypto fund manager to have thought through these issues and have proper controls and risk frameworks in place.
While there is no perfect fix to this custody problem yet, the good news is that many players globally are now working on it and expect to continue to see solutions come to market in the coming months.
4. Counterparty Risk
When Lehman Brothers went bankrupt during the financial crisis, many hedge funds lost control of their assets that were held there. In many cases, it took years to get them back. Crypto funds that don’t trade actively need to implement an adequate custody approach that often involves cold wallets. However, crypto funds that are actively trading (e.g. quant funds) often have no choice but to leave their assets directly with the exchanges. This raises serious counterparty risk issues in the event that an exchange gets hacked for example.
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 centralized and decentralized exchanges, limiting how much can be left at an exchange at any point and conducting regular health checks on these exchanges.
Institutional investors will likely focus on this area as part of their operational due diligence, so it is therefore very important if you intend to target that investor base.
Corporate governance has been a key area of focus following the financial crisis and most institutional-grade funds today have independent directors on the board of the fund. This is critical, especially when difficult decisions need to be taken that will impact shareholders, such as whether a side pocket needs to be set up to hold certain assets or whether some restrictions need to be imposed on investor redemptions.
Unfortunately, many crypto fund boards today are controlled directly by the fund manager with no governance frameworks in place. Although this may work for “friends and family” type funds, it is unlikely that an institutional investor will invest in such a fund without proper fund governance.
Putting in place an independent board of directors with a broad range of backgrounds and skills is thus invaluable if you are looking to raise capital from institutional investors.
6. Valuation and Fund Administration
Independent valuation is key for any fund as not only does it verify fund performance, but also, in many cases, the fund manager’s entitled fees. This is why having a reputable independent fund administrator is crucial to give institutional investors peace of mind that their assets are being properly valued. There are, however, some particular challenges in the crypto space — such as the cut-off time for valuation (crypto markets don’t sleep) or the price source to use (the same crypto asset may be priced differently at different exchanges globally).
Having a detailed and rigorous valuation policy that determines the process and the related checks and balances on valuation is vital. While today there are only a limited number of fund administrators servicing the crypto space, this looks set to change over the coming months as the industry matures and some of the more established players become more comfortable with crypto assets and decide to move into this space.
About the Author
Henri Arslanian is the PwC FinTech & Crypto Lead for Asia, the Chairman of the FinTech Association of Hong Kong and an Adjunct Associate Professor at the University of Hong Kong, where he teaches the first FinTech university course in Asia.
Before joining PwC, Henri was with a FinTech start-up and previously spent many years with UBS Investment Bank in Hong Kong. He started his career as a financial markets and funds lawyer in Canada and Hong Kong.
With over 400,000 LinkedIn followers, Henri has been awarded many industry and academic awards over the years, from being regularly named one of the Most Influential Individuals in FinTech in Asia to being awarded the Governor General of Canada Gold Medal for Academic Excellence.
Henri was recognized as one of the Global 2017 LinkedIn Top Voices in Economy & Finance and is regularly featured on global media, including Bloomberg, CNBC, CNN, The Wall Street Journal and the Financial Times.
The author can be reached at Henri.Arslanian@hk.pwc.com
If you are thinking about launching a fund, you may wish to check out the author’s recent book, “Entrepreneurship in Finance: Successfully Launching and Managing a Hedge Fund in Asia”. Although focused on traditional hedge funds, many of these considerations are similar for crypto funds.