Guide: Crypto Fund Diligence Checklist for Family Offices
In 2017 one of the most searched for items was “How to buy Bitcoin”; in 2018 the energy and focus on cryptocurrency and blockchain has remained quite robust, leading to a new cottage industry of crypto funds. In this post I aim to provide some general information and diligence questions I am asking when presented with a hedge fund. (*I filter those that are actively trading as hedge funds and those investing in projects with a longer outlook as more VC, however there’s an understanding there’s hybrid models too*)
First, let’s take a look at the overall market. In comparison to the more traditional 10,000 public market Hedge Funds the number and size is quite different as this is an emerging asset class. According to research firm Autonomous NEXT the number of crypto hedge funds more than doubled in the four months to Feb. 15. The research firm recorded a record high of 226 global hedge funds with such a crypto strategy, up from 110 global hedge funds as of Oct. 18. That itself was up from 55 funds at Aug. 29 and just 37 at the start of 2017.
Some immediate issues to consider:
- Cryptoassets to trade: Most funds are using a similar strategy right now trading the “top 10 cryptocurrencies by Market Cap” listed by Coinmarket below. They have the highest volumes and are most liquid;
2. Size & Liquidity: There are over 1500 cryptocurrencies as of today, however most fund managers will usually refer to the 100 listed on the first page of Coinmarket; once you venture beyond that the daily trading volume’s/liquidity become a risk management and constraint issue.
3. Exchanges: A question you want to make sure you’re asking an emerging crypto manager is how many exchanges they have access to. Why? This falls into a risk management issue again; certain exchanges have far better volume, thus liquidity. Binance, as of writing this post, has been doing the most with
$1,974,320,266 in volume today. According to CryptoCoinCharts there are 190 cryptocoin exchanges with a total 24h volume of $4.75B on 6723 trading pairs.
4. “Pre-sales”: you will want to ask the emerging manager if they are participating in these. Certain crypto managers out there that have gotten access to “pre-sales” of ICO’s. This is a token sale event that blockchain projects run before the official crowdsale or ICO campaign goes live to raise the necessary funds to hypothetically get the product/service finished before the public launch of the ICO. There are usually significant discounts and at times, lock up periods. One unpleasant side-effect of ICO presales however is that early investors or adopters tend to dump tokens as soon as they trade on exchanges; thus known as “pump and dumps”. They often sell the tokens at ICO price when in fact they got the tokens for less than the price of the main ICO. This way, they make substantial profits while the value of the project token subsequently takes a downward hit. This is one of the areas the CFTC and SEC are both exploring heavily.
5. Custody: A question you will want to ask the crypto manager resolves around where the assets are being held. As more people are moving into crypto more issues are prone to occur. Tokyo-based cryptocurrency exchange Coincheck confirmed that it has suffered what appears to be the biggest hack in the history of the technology, estimated its loss at 58 billion yen (approx. $533 million). Everyone with minimum knowledge will tell you that the best way to solve the problem of storing your crypto funds is to use a hardware wallet (“cold storage”), and certainly it is one of the best solutions to date. Hot wallets ( i.e. software) are more prone to attacks because they are “permanently” connected to the network. But hardware wallets are “air gapped,” meaning not connected by design, until you connect them. So your funds are protected by your hardware key, itself protected by secure hardware elements.
6. Evaluation of team: As mentioned above there have been 200 new crypto hedge funds that have come to market in the last year. As cryptocurrency and blockchain is a relatively new field (comparable to equities or fixed income) that marries elements of computer science and complex technological concepts such as asymmetric encryption with elements of finance a majority of those in this new field are relatively young. Many more “institutional” investors (family offices, pensions, etc) may discount the fund because age of the general partners when running diligence on the fund, and for many, this is their first fund. I think a lot of investors will fall into the “age trap” but I have a different take on it.
In the US a lot of the necessary education and hands on understanding regarding the complexities of blockchain and cryptocurrencies has been happening at the university level. Universities such as Stanford University, which already launched Bitcoin and cryptocurrencies courses two years ago, University of California — Berkeley and Massachusetts Institute of Technology are providing hands on training that could potentially give those a superior edge.
One area to look further into when evaluating these new funds is who they are surrounding themselves with; do they have a distinguished, diversified advisory board? I would say it’s not a necessity but it’s sure nice to have a good group of people who have seen up and down markets around a young management team to provide some checks and balances from time to time.
7. Strategy: This is a touchy topic and I may offend some; many funds out in the market are stipulating they use social media signals to trade. Social media hubs like Reddit, Steemit, Twitter, Telegram, Github and countless others have developers and “whales” who apparently may be able to move mountains. “Whales” are the few individuals who adopted bitcoin (and a few altcoins) and they have now become the ‘whales’ of the market with vast stashes of crypto holdings. Moreover, the term ‘whale’ refers to an individual or a group of people that can manipulate the market using their massive crypto wealth.
In my opinion this is not a durable, long lasting strategy — it could be used as a component of an overarching strategy, one used with review of the multitude of intrinsic infrastructure components of cryptocurrency such as Hash Rates or Hash Power in addition to current valuation models.
For those that think hash is what comes wth your eggs in the morning a quick definition: hash rate is the measuring unit that measures how much power Bitcoin network is consuming to be continuously functional. By continuously functional I mean how much hash power is it consuming to generate/find blocks at the normal mean time of 10 minutes.
A discussion on valuation could be lengthy but in addition to an understanding of infrastructure there are multiple valuation models by Hayes, Burniske and others that are trying to come up with models on how to value cryptoassets. The more serious fund managers out there will have a very specific stance on the valuation model they prefer and why; this in my opinion is a signal you’d want to follow.
Conclusion
We have seen a significant exponential increase in hedge funds to market over the last year with the excitement and significant increases in certain cryptoassets like Bitcoin.
It is still very early in the evolutionary story of cryptocurrencies and blockchain. We have seen a massive amounts of crypoassets via ICO’s come to market over the last 12 months, however many have little to no volume/liquidity. With the lack of viable assets to trade and it still being early days there has been a lack of unique, differentiated alpha generating trading strategies comparably to the more traditional public market trading universe which boasts approximately 630,000 publicly traded companies throughout the world.
With this lack of assets that have viable liquidity there is also a lack of innovation in terms of strategies out there. Many new managers who had tremendous personal success during the run up are using the same tactics they’ve used for the past 2–3 years of social media signals; they need to, and are in the process of, beginning to implement more durable, long lasting strategies and governance structures. Those managers going the extra distance, understanding the more fundamental code, infrastructure, valuation models and regulatory environment of this new asset class are worth the mental bandwidth in my opinion; the others are what I am now classifying as “one hit wonders”.
