Why Hedge Fund Platforms and Institutions Don’t On-Board Crypto Funds (Yet)

Informative republished post by Jon L. Stein, CEO of Kettera Strategies. Jon is a thought leader in the hedge fund business and explains the process and changes that need to happen for crypto funds to thrive in mainstream alternative investment management. This is a great road map for any new #crypto fund managers, crypto investors or crypto institutional capital allocator.

Over the last year, our firm has been getting regular inquiries — several per week — asking if we offer crypto funds.

Or, just as often, why we do not offer them.

As the operator of a managed account platform, we are of course always looking to onboard managers that offer strategies that investors want — provided they pass our due diligence screening.

The Hydra Platform was created to offer efficient access to a myriad of liquid alternative investment strategies — in short, making it easier to invest, with greater liquidity, governance and transparency than one would have going into the manager’s own fund.

But to deliver this we also need to shine a light on how the investors’ money is being invested, including on the people and services involved. We want to reduce the risk of just about everything that could go wrong with an investment in a hedge fund program (at least those things in our control, of course).

So, in addition to researching the manager itself, we’ve also chosen a stable of service providers, largely uniform across all cells on our platform, and we only allow the manager to use exchanges or approved OTC bank counterparties have also similarly been vetted.

When it comes to the crypto world, unless we’re missing something, we would not be able to deliver the goods. At least not just yet.

We get it. We’re operating in a new, de-centralized (or “distributed”) paradigm that is going to destroy the dusty old financial regime currently in existence. We also recognize that hacks of exchanges, where billions of dollars have disappeared with a criminal’s single keystroke, are probably over-publicized. (And it’s worth mentioning that a young family member of this author has staked his entire career on the crypto trading industry.) There are plenty of forces that may compel us to tweak our business model a bit.

But the crypto world itself could use some tweaking also. It’s not out of the question that cryptocurrency funds will be available in a liquid, secure and transparent format one day that will meet our standards.

We are intrigued by the cryptocurrency and related markets, and will always be the first ones to cheer for the addition of a new market — let alone a new asset class. However, we cannot allow our fascination with a new market supersede our platform’s principles of transparency, governance, liquidity and safety of assets.

Below is a partial list of due diligence questions that we’ve been asking managers of cryptocurrency funds. These aren’t “gotcha” questions — they all stem from the same due diligence standards we hold to established hedge fund managers. If these managers answer these with authority — and relevant service providers create technology and processes to legitimately assuage our concerns — this would be a welcome development toward the acceptance of crypto managed accounts.

Choice of Coins, and the Exchanges that Trade Them

- Not all cryptocurrencies — or the companies behind them — are created equal. Before you decide to add a #cryptocurrency your lineup, how much investigation have you done on the currency — e.g. a search for fraud, scam or hacks?

· If it is a fund that can sell short: How are you able to short the currency in a regulatory compliant manner? Do you use a futures exchange?

· If your fund also includes tokens, please provide as much detail as possible on the types of tokens bought and sold. (A token can be either a commodity, derivative contract, or security depending on the facts and circumstances, resulting in oversight by the #CFTC or #SEC or both.) Does your investment team have an up-to-date understanding of these differences, and their potential legal consequences?

- Please list all the exchanges you use. Do you know, and can monitor, the credit worthiness of these exchanges and their operational and financial integrity? What is your criteria for choosing one exchange over another?

Valuation, Liquidity and Transparency for Managed Accounts

· Can your strategy be replicated in a single account structure where we, and not you, own and control the accounts? Are your seats/memberships/accounts at these exchanges so numerous that it would be burdensome to do so?

· If it will be difficult to obtain a direct managed account, then what are the options if you or your fund continue to maintain the accounts? Can investors enjoy the necessary transparency into the underlying holdings on a 100% absolute basis, continued without interruption?

· Assuming you do not have anything in the role of either a “custodian” or “clearing broker” involved with the transactions, how do you know that the pricing of any purchase or sale of the cryptocurrency was valid? Is there some other party involved that can provide this assurance?

Security and Counterparty Risk

· When buying cryptocurrency or related tokens via an exchange, how do you ensure their security? Do you regularly move these offline to a what is referred to as a “cold wallet” or “cold storage”? Or do you feel comfortable just leaving them in the wallet or account associated with the exchange? If you also invest in tokens, what measures do you take to ensure the tokens (private keys) are under your control?

· How will you ensure that you / your fund owns the cryptocurrency asset, as well as the existence of the asset itself? Does your fund have a custodian or intermediary that plays a somewhat similar role? As we assume there are no certificates issued, what is considered the verification of existence? Do you or your custodian get some form of electronic confirmation from the exchange?

· If you “self-custody” using cold storage, who has access to the storage? How do you protect the encryption keys? What back-ups do you have in place in case your team misplaces the hard drive ledger or it gets hacked or stolen?

· What are the controls to move the money from the fund to the crypto platform? What are the settlement controls do you have? What are the controls to move the money from the platform back to the fund? Who has access to make a trade and therefore who will have access to the crypto’s platform password?

Unfortunately, at least to date, too many of these inquiries have typically been answered by the manager with either “no one has ever asked us that” or “that shouldn’t matter” — assuming we get an answer at all.

We are not “anti-crypto.” On the contrary, if our clients want to invest in these markets, we want to make it happen for them. But we want to do so the right way with the right protections in place.

The lack of clarity on these points is also probably the reason many larger, institutional investors have not come into these programs. We may have demanding standards for our managers, but we are not in the business of telling people what markets or asset classes to invest in. We’re in the business of making sure that those investments are easy to access, transparent, and secure.

Key Takeaway:
We remain intrigued by the cryptocurrency and related markets, and will always be the first ones to cheer for the addition of a new market — let alone a new asset class. However, we cannot allow our fascination with a new market supersede our platform’s principles of transparency, governance, liquidity and safety of assets.