Software. Not Services — The Web3 Fund Stack
Written by : @patfitzgerald01
In our previous piece, we asked the question : Why aren’t crypto funds operating in a crypto-native way?
A logical assumption would be that investors in blockchain startups would be the early adopters, but the status quo points to a hesitancy to adopt new technology thus far. Let’s expand on some of the points addressed in our last piece, The Anatomy of a Web3-Native Fund, and lay out how the new various fund services legos could create a new trustless and automated fund services stack.
What is the status quo?
- Banks are the primary custodians of funds
- Wire transfers for inbound LP investments and outbound equity investments
- More use of centralized crypto financial services than decentralized
- Manual fund administration (nav calcs, cap table management, investment / redemption, management and performance fee tracking, reporting etc).
Understanding a fund’s incentives more granularly, the choice to not innovate in the area of fund services starts to look more rational for existing large funds in the short term, but as fund management gets increasingly democratized, new tools will be needed to serve the burgeoning class of micro GPs / solo capitalists.
- On-Chain Institutional Product Adoption
Most venture backed startup rounds aren’t completed on chain. As more capital vehicles are on-chain, bank wires and bank accounts will be of little use in a world standardized around USDC and the manual fund services stack built around the storage and movement of fiat will feel increasingly anachronistic.
“I’m sending USDC as much as I’m sending cash for web3 investments” — NY Crypto VC
Similarly, there are ways to go for on-chain investment products to properly serve the needs of large hedge funds. Until the product variety, quality and liquidity is sufficient to attract more committed hedge fund adoption, centralized exchanges, centralized lenders, prime brokers, otc desks etc will comprise the lion’s share of their product usage.
If the majority of your capital isn’t in on-chain vehicles, the pain of not having fund services optimized for an on-chain world may not yet be high enough to switch.
2. LP Comfort
Given the UX complexity of crypto, especially for non-natives, using onboarding processes that are compatible with existing expectations and workflows for institutional LPs and high net worth individuals is essential. Without hybrid alternatives, this incentivizes most funds to optimize their choice of services around LP comfortability and perception rather than cost and time efficiency.
“Good luck getting an endowment to send USDC to a smart contract lol”
Traditional LPs also have ingrained perceptions about and comfort with the existing fund service provider stack. Managers perceive any deviation from established vendors to be a fundraising risk. For large funds with the resources to compensate for this conscious inefficient trade off with in-house back office staff or outsourcing, we anticipate they will continue to do so.
Additionally, large institutional LPs may have a non-profit status that could be compromised by any on-chain yield strategies, may prohibit on-chain strategies due to the compliance risks of unknown counter parties, or may have other legal burdens that GPs must inherit in the form of restrictions on investments they can make or services they can use.
However, the nouveau riche individual LPs don’t think like old money. For those whose main wealth has been created on-chain and are more used to wallet transfers than bank wires, an inability to service this new investor class natively will be a huge cost to funds handcuffed by restrictions and a boon to a new class of more nimble managers with only individual LPs.
Once an LP closes in 30 seconds on-chain with USDC, we’ve never heard someone ask to go back to bank wires.
With fund administration at the base of the fund services stack, it is necessary that LPs perceive code as more trustworthy and transparent than manual centralized off-chain processes. We anticipate that funds with primarily individual accredited or qualified investors will be faster to adopt than those with institutional LPs given that their enhanced legal, tax, and regulatory compliance demands can create a tyranny of the minority effect on choice of fund services and on the diversity of strategies that can be deployed.
3. 3rd Party Services Compatibility : Creating the One-Stop-Shop
It is not only important that each crypto-native fund service lego is a better product in its own right than its web2 equivalent, but that it is compatible with the complimentary 3rd party service providers. The new stack must congeal together seamlessly with no missing links. It must be a one stop shop, a business-in-a-box, so managers can focus on what they do best.
However fund services won’t lurch into a new paradigm immediately. New tooling must be backwards compatible with any part of the existing services stack that cannot yet be fully automated to bridge the transition.
For example, the majority of startup equity in the world exists off-chain, so creating mirror versions of off-chain equity would allow for an aggregated NAV that encompasses liquid and illiquid assets. Similarly, with many hedge funds using centralized exchanges and other centralized financial services, API integration with such providers will allow for managers to aggregate their NAV across centralized and decentralized financial services as well as off-chain illiquid investments.
Furthermore, we mentioned LP discomfort with the self-custodied investment / redemption process. In our own fund administration product, we have been sure to add a manual share issuance feature and will soon be integrating more fiat on-ramps to provide compatibility with the existing system.
The bottom line: Most value isn’t currently tokenized, so we built a fund administration product that is flexible to adapt with that transition and account for liquid or illiquid, on-chain or off-chain assets. Most value is held in and transferred by fiat-centric services, so we ensured we are compatible with such services until value is primarily held in and sent between digital wallets.
The New Fund Services Value Chain
Since the new value chain of fund services relies on software integrations, every link must be connected from start to finish from the moment an LP invests to end of year audits and reports.
At its core, tokenized value’s benefit of 24/7 pricing unlocks the opportunity to create a more trustless and automated fund services stack.
The current value of any liquid token can be priced using data feeds and in the short term, mirrored versions of off-chain assets can help us bridge the transition to a world of mostly tokenized value.
When all the assets you hold (liquid and illiquid) can be priced with a data feed, an aggregated NAV can be sourced, enabling managers to stamp immutable and auditable updates into the blockchain daily rather than spending hours in spreadsheets.
With invested funds custodied in a digital wallet, and non-transferable shares issued to LPs by smart contracts, NAV updates automatically adjust each LP’s shares, automating the cap table.
With returns tracked and the NAV automated, management and performance fees can be calculated, incorporating the high watermark.
Using all of the above, investor reports can be auto-generated at any time interval and with the inclusion of transaction level data, a tax reporting integration can generate the necessary outputs needed for auditing.
The Future
Here we have discussed the barriers to adoption for existing funds whose decisions for fund services are dictated by their LPs rather than cost or performance. However, for the burgeoning long tail of crypto native funds and the many more who will launch, ignoring cost and time efficiency is a luxury they can’t afford.The high fixed costs of the existing fund services stack makes it prohibitively expensive to run a fund at a low AUM and the time it takes to work with fund administrators is exponentially more costly the smaller the team (est. 10–20 hrs a month).
Just as the transition to variable cost cloud computing from fixed cost servers reduced barriers to entry for startup creation, the transition to variable cost only fund services will enable funds to start with any amount of initial capital.
This is especially relevant given the increasing complexity and variety of digital assets. With regard to variety, we anticipate a market where tens of thousands of funds are specializing in both traditional niches like fixed income as well as new endogenous investing classes such as digital fashion, music nfts etc. As there may be as many investing niches as communities on the internet, a long tail of funds should emerge to cover a long tail of alternative digital asset classes.
While investing has been completely democratized, the complexity of surfacing high quality investments from noise of global memetic narratives has only increased. Perhaps we will find a golden mean between a small priestly class of investors and unhinged retail speculation by giving better tools to a wider set of knowledgeable managers.
Written by : @patfitzgerald01
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