The Anatomy of a Web3-Native Fund

Web3 hedge funds and venture funds explicitly acknowledge the advantages of blockchain technology by nature of their investment focus, but to date largely have not applied such efficiencies in their own tech stack.

• Wire transfers are still the dominant method used to invest in Web3 startups.
• Wire transfers are still the dominant method by which managers raise capital from LPs.
• Bank accounts are still the dominant cash custody method.
• Traditional fund administrators manually reconcile transactions, update cap tables and track management and performance fees.
• NAV is often calculated by hand using spreadsheets and verified by fund administrators.
• Identity Verification (KYC, AML) is often outsourced and verified manually.

So why are Web3-native funds not operating in a Web3-native way?

Such traditional operational methods are anachronistic to a digital asset environment, yet completely understandable given the motivations of a fund manager.

So long as government regulation prevents “retail” from delegating capital to fund managers for a fee, LPs will continue to be composed of mostly wealthy individuals and large institutions — pension funds, endowments, funds of funds, family offices etc.

The owners of such capital simply evolved in a different financial environment, one that develops natural habits that are hard to change despite their inefficiencies (ie. bank wires). Furthermore, there are softer consumer behaviors inherited from traditional finance, such as valuing the trust verification of a fund administrator over the immutable record of the blockchain. The traditional manager relies on the fund administrator for not mainly back office utility, but for CYA — an expensive checkbox and signaling device indeed.

As for front office operations, customer adoption metrics suggest decentralized finance has not attracted hedge funds as much as centralized exchanges have. Furthermore, few equity rounds are raised on chain and the web3 native go-to-market approach has yet to be solidified, replacing equity rounds and forcing traditional venture capital markets to move on chain to get access.

From the perspective of a fund manager, the incentives are structured in such a way that there is a tendency to play by the old money rules and optimize for capital raising rather than speed, capital efficiency and cost. Cayman super feeder, Fireblocks custodian, NAV or Sudrania as fund admin, top legal council and auditor, bank accounts etc. Check check check…

So what is the anatomy of a web3-native fund?

A crypto native fund:

• Manages an on-chain whitelist of accredited investors who can access the fund
• Accepts investments in stablecoins directly to a digital wallet (hardware wallet, multi-sig, Metamask etc), the fund’s general ledger
• Capital is kept on-chain to maximize investment access and capital efficiency
• Issues non-transferable ERC-20s representing fund ownership without enabling a non-compliant market
• Automates management of the cap table as shares are tokenized
• Invests in permissioned in equity rounds using stablecoins and/or in liquid DeFi tokens
• Automates NAV calculation using pricing services to aggregate liquid and illiquid asset values at the interval of your choosing
• With tokenized shares and automated NAV calculations, automates the tracking of management and performance fees.
• Redeems investors after lockup on chain using USDC
• Offers a real-time investor portal to LPs to track their investments
• Inputs immutable trade and fund administration records to generate tax and investor reporting

What does a future using a modern web3-native funds services stack like this unlock?

Balaji Srinivasan has stated that at one point in time everyone was a farmer and perhaps the dominant profession of the crypto era will be that everyone will be an investor.

In the sense that more people will have increased discretion in the allocation of their assets, that seems to be spot on, however the technical nature of most protocols, the time required for due diligence, the explosion of innovation as a result of composability and the nuanced informational environment renders the asset class accessible to those investors who have the time and interest to spend the time actively investing or to those who are able to accrue ownership as a natural byproduct of product usage.

As tokens should be as ubiquitous as businesses on the internet today, the convergence of the creator economy and the democratization of fund management suggests there should be thousands of niches that pop up for investors to professionally manage capital and charge fees.

Tens of thousands of fund managers will optimize their funds to invest in music NFTs, digital fashion, gaming and art NFTs, and various segments of decentralized finance.

With the blockchain reducing cost and trust assumptions, middle and back offices will be reduced to a minimum. As all costs are reduced to zero or variable, hedge funds, venture funds and SPVs of any size are now viable. The entire funds services stack before audits will be automated.

As a result, Solo Capitalists will abound, requiring a business-in-a-box, an operating system for the new web3 active manager.

This is the future we are building for at SmartFunds.

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