What are the problems facing the Hedge Fund industry today, and how can smart contracts on the Ethereum Blockchain play a role in solving them?

Today, fund management suffers from high and increasing barriers to entry. Fund managers also have to increasingly think about custody & counterparty risk when thinking about where to hold and how to transfer their assets. The recent Lehman Brothers and MF Global bankruptcies which I personally experienced the repercussions of, first hand from the trading floor are all too quickly forgotten examples of this.

Accurate audibility of portfolios has also traditionally been very difficult. Long settlement times often lead to delayed information and can unveil ‘errors’ when it is too late to fix them. Risk managers have imperfect information and a conflict of interest given they are compensated by the very person they are trying to risk manage. Too much reliance on a long chain of humans in the process of booking, reconciling and settling trades creates room for messy errors that often go unmentioned.

The success and security of a fund therefore relies on the existence of high working capital, the accuracy of its people and the solvency of the custodians it works with.

Setting up a hedge fund can take 9–12 months, and involves a very high initial start up and running cost which can eventually lead to fund failures. A friend of mine once told me that 8 out of 10 hedge fund launches fail and close down within their first year. Whilst I couldn’t find any supporting facts on this I did find an interesting Economist article on the difficulties around launches here

Although over half of hedge funds manage less than $100m, they represent only 1.4% of the industry’s $2 trillion or so in assets, according to Hedge Fund Research, a data provider — The Economist.

This, to me, is kind of crazy. Literally every other industry I can think of has been heavily disrupted by technology, except finance. Instead, we have built new technology on top of old technology for years and years and years making processes slow, inefficient and expensive. It’s time to re-invent the space from scratch and get rid of all these inefficiencies. The reason I get so excited about this is because smart-contracts don’t just “automate” these processes, blockchain technology also “enforces” and “regulates” that they don’t breach any parameters by which the fund is not supposed to abide by! But we’ll go into more detail on this a bit later…

Source: 2012 Hedge Fund Business Expense Survey, Citi

• AUM = Assets Under Management

If we think about listing the problems facing the industry today, I’d say they would break down into two groups;

• The problems incurred from the perspective of a portfolio manager
• The problems incurred from the perspective of the investor

I’ll start by identifying the problems that arise from a portfolio manager’s perspective. There are two types of portfolio management — managing one’s own wealth and managing the wealth of others:

Managing one’s own assets;

• Often requires a minimum amount of assets to be qualified to open a managed account with a top-tier bank (The minimum size is typically at least $500K).
• Often subject to higher fees (commision, fixed costs, etc) due to the higher amount of work required relative the amount of revenue you bring to the bank.
• No visibility. If you do really well at managing your own wealth and want to use your track record to raise more assets in future, you have no visibility unless you actively spend time and money on auditing your performance and marketing yourself (quite costly!!).

Managing the assets of other people;

• Often requires a regulatory license to set up a fund which is expensive and time-consuming — In order to run a fund and be eligible to market this fund to raise assets you will need to be regulated. Obtaining a regulatory license can cost over $100K and usually takes 3–6 months to obtain before it is processed. It is also necessary to show the regulator that you have certain boxes ticked (for example: an in-house risk manager, pre-trade checks, systems and processes which cost money etc). Not only is the license expensive, but also the regulatory requirements also increase the operational load substantially on a fund with requirements to provide regulators with necessary data and proofs.
• Low quality audibility — It is typically a legal requirement for funds to appoint ‘fund administrators’ to audit anybody who invests money other than their own. A contract between the fund and an impartial fund administrator is put in place to audit and calculate the NAV (Net Asset Value) of the fund, settle trades, calculate dividend distributions, maintain and file the fund’s financial books, act as the fund’s accountant and payout fund expenses. Since trades typically settle 2–3 days after execution, there is delayed accountability and room for undiscovered errors. Appointing a fund administrator typically costs at least $50K a year.
• Requires expensive operational support — The Portfolio Manager is required to execute and report all trades to the fund-administrator in a very specific and often cumbersome way. They then have to book these trades, update their risk management systems and P&l (Principal & Interest) calculations and reconcile trades from their end. Often, a hedge-fund’s staff is compiled of more than 50% operational staff (and often more).
• Investment in technology is expensive — Investment in risk-management systems is often necessary to monitor positions and reconcile exposures in one currency. It is also important to know your gross and net exposure, risk levels and P&L and keep record of it. Often these systems are expensive costing approximately $50K-100K per year.
• Obtaining access to analytical research requires writing checks -Typically research houses will require you to write checks of $20K-100K / year for access.
• Office and furniture space is costly
• Platforms can be misleading — very often, smaller ‘asset management platforms’ with regulatory licenses and office space try to lure Portfolio Managers in with ‘plug and play deals’. This often sounds attractive to Portfolio Managers who are keen to reduce the alarmingly high start up costs. The promise often involves shared risk-management, technology, marketing, trading & operational access etc in exchange for a large percentage of all future fees made by the Portfolio Manager. The reality is that most portfolio managers are disappointed at how little these platforms offer. Typically, they are just a way to get managers to share in the fixed costs incurred by the platform whilst participating on a lot of the upside.
• Low visibility — Smaller portfolio managers might be significantly outperforming their larger peers but without investing significant time and money in roadshows, networking and marketing materials, it would be very difficult to find investors.

These diagrams illustrate my points;

Source: Citi Prime Finance

From an investor’s perspective;

• High management fees: As the above points will have hopefully shown, the costs that go into launching a fund are extremely high. As a result, costs have largely been passed on to the population of savers over the years in the form of high management fees (a typically annual percentage fee charged on assets invested for managing the portfolio). The industry average for management fees is currently around 1.5–2% per year.
• The best funds can be difficult to find: There is no public, free global database of portfolio manager’s performance and strategies. The tendency is to invest in larger, well-known funds because they are more visible.
• The best performing funds are often impossible to invest in: In today’s worlds some of the best performing funds are closed funds which means the fund’s asset base is getting too large to effectively execute its investing style. If they are not closed, they often have ‘minimum investment’ requirements typically starting at $125,000 but can often be closer to $5–10mn.

How can smart-contracts reduce some of these issues?

Smart-contracts can largely automate some of the timely and costly functions involved in running a fund, improving competitivity by reducing barriers to entry with the blockchain enforcing the rules and parameters of the fund. In a digital asset world, blockchain can also replace custody risk with a trustless blockchain accounting system. This leads to much more transparent audibility and visibility.

The Melon protocol is exactly this (for more information please read the greenpaper). The Melon protocol is a collection of open-source blockchain smart-contracts and rules that we refer to as Melon. The protocol is based on Ethereum with a view of being deployable on further Blockchains in the future.

The protocol is made up of two sets of Smart-Contracts; Melon Core and Melon Modules.

Melon Core is the part of a portfolio (or fund) that provides Portfolio Managers with a tool to set up and interact with the functions that a Portfolio Manager may want to perform adhering to the specification of the Melon protocol.

Melon Modules correspond to all the functions that a Portfolio Manager might want to have available in their portfolio and are optional (e.g. price feeds, volatility calculations, NAV calculations, daily P&L calculations etc).

The nature of the protocol is open-source which means that as improvements are made, anyone can easily engage with it, audit it, and quickly upgrade to new and improved versions as the protocol continues to be developed. As the Ethereum Foundation’s Vitaik Buterin says;

Software that’s finished is software that’s dead.

This development choice quickly reduces costs & dependency of Portfolio Managers on all the human errors that can occur in the chain of traditional asset management set ups. A vast amount of time saved in setting up and running operations also becomes possible.

Here are a few specific examples of how Melon Protocol reduces some of the barriers discussed earlier:

Managing one’s own wealth:

• Virtually no minimum investment size. In fact, your minimum investment required to invest in a portfolio that already exists on the blockchain is 0.65 Ether (equivalent to <$10 today).
• Subject to lower transaction fees which are likely to be very competitive and only imposed on trading.
• Completely decentralised and trustless: Audibility, Security & Visibility on the blockchain. All portfolios that are set up, will be set up on the Ethereum blockchain. Assets within these portfolios will also held on the blockchain as well as the transparent performance of the portfolios.

Managing other people’s wealth:

• Regulation — Given this is still such a new space, the rules on digital asset management are unclear but once they are defined, there is a lot you can do to ‘automate’ the regulation requirements of your fund by building ‘Smart-Contracts’ to perform various actions at various trigger points. You can also design Smart-Contracts to alert you of certain things such as risk breaches or stop loss triggers. There is full transparency and auditablity via the blockchain and therefore your investors and regulators can both have cleaner data on risk exposure and performance faster.
• Fund administration, operational support & technology — Most of these actions can be performed safely by Smart-Contracts on the blockchain. Smart-Contracts can be programmed to perform a specific set of instructions on a periodic basis or, to be triggered by an event or outcome. This is all coded by developers and is recorded in the Melon Protocol library.
• High visibility — Performance visibility will be higher which is likely to lead to lower marketing costs. Your performance is standardised making it easily comparable and your track record will be published publicly on the blockchain in a reliable manner. Therefore, if you are performing well, potential investors or employees can easily see this and reach out to you. The blockchain performance data speaks for itself!!
• Office & furniture space — could be reduced due to the lower requirement for head count.
• Platforms — more cost efficient, lower costs, much faster and more accurate.

The Melon Protocol therefore greatly reduces barriers to entry. It aims to increase the quality of visibility and audibility and provides a decentralised system to run a fund on shifting trust from central parties and counterparties to rules of code, enforced by blockchain.

A large benefit of this is that it provides access to a deeper talent pool of Portfolio Managers. Initially the roadmap is to launch Melon on Ethereum to manage all Ethereum-based assets. However, our longer term view is for Melon to interact with many other blockchains and create a world where potentially you can hold and manage information and assets with wildly different properties, efficiently and securely.

The beauty of Melon is that literally anyone can interact, audit and experiment with this software given the way we have designed it. Individuals wishing to try out their luck at building fund management track record using blockchain technology can jump in with minimal financial cost. The technology can assist users in grossly reducing some of the costs involved through automation and blockchain enforcement. As users slowly build an auditable track record, this can be used to build their profile, reputation and visibility.

Developers alike can build modules openly on Melon and earn token for their coding contributions per usage of their modules. This creates a great incentive model where value creators are rewarded for their contributions.

Melon is, we feel, one step closer to discovering what the future of asset management could look like and we feel exceptionally proud to be pioneering this discovery process.

Mona El Isa,
CEO & Co Founder of Melonport

Former star-trader at Goldman Sachs, promoted to Vice President by the age of 26 and made the “top 30 under 30” list in Trader Magazine in 2008 and Forbes Magazine in 2011 after profitably trading the 2008 and 2011 crashes. Moved to Geneva-based macro fund Jabre Capital in 2011, before deciding in 2014 that the future of finance lay in blockchain technology. She studied Economics & Statistics at the University College London.

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Twitter: @perham83