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Performing operational due diligence on crypto funds
As crypto gains popularity, it is useful for investors to understand how to adapt operational due diligence when assessing crypto funds.
Performing operational due diligence on crypto funds: Should you take a different approach?
The first bitcoin fund was launched in 2013 and since then, more than 800 funds have been launched. PwC estimates crypto hedge funds globally equate to almost $4bn AUM and, far from slowing down, this segment of the market is gathering pace. Strong returns are starting to attract institutional investors, alongside the typical high net worth individuals and family offices that have dominated to date.
There are some considerations for institutional investors in managing the risks surrounding crypto fund investments. The fact that many of these funds are very new, with little or no performance track record to assess means ODD teams must pay even closer attention to the operating models, investment strategy, technology infrastructure, team members and custodians.
Because of the way crypto funds are run, institutional investors will need to adapt their typical ODD approach and the Standards Board for Alternative Investments (SBAI) has recognized the need for guidance.
In the ODD for Crypto Funds toolkit, The SBAI outlines the main areas for scrutiny being custody, trade processes, valuation and asset verification, conflicts of interest and regulatory risk.
Crypto asset custody
Custody of crypto assets is managed with a private key, that enables the asset to a new owner. Custodians can be either the manager themselves, or an independent third party. PwC reported that the percentage of crypto funds using an independent custodian decreased in 2020, as did the number of fund managers with at least one independent director on the board. The resulting lower levels of independent governance should mean investor ODD teams are extra vigilant. Whoever the custodian is needs to clearly demonstrate the processes, checks and controls they use to store and secure private keys. Are they licensed and insured and do they have appropriate access permissions and backup plans in place?
Crypto trade processes
Crypto assets can be traded verbally, with email confirmations and speedy trade settlements. ODD teams should ensure they see the usual voice trade controls in place.
Crypto asset valuations and asset verification
With round the clock trading, it is important for ODD teams to check time stamps or audit trails. The SBAI advises checking high and low prices in the market, monitoring outliers and comparing against previous trade prices.
Asset verification should be possible, so that ODD teams can see who manages wallet addresses and private keys.
Conflicts of interest
The crypto fund eco system can involve some conflicts of interest, as it has been created from scratch, with the lines between service providers and managers blurring at times. The SBAI recommends that crypto managers have documented compliance policies and procedures to manage and mitigate conflicts of interest.
AML and KYC
As crypto assets have been used for money laundering historically, ODD teams should focus on the risks associated with crypto asset fund subscriptions and the level of oversight the manager has on the exchange.
Other areas for ODD consideration
ODD teams should also focus on traditional areas, such as fees, segregation and experience, reconciliations, counterparty risk, service providers, fund documentation and personal account trading.
Because of the decentralized nature of crypto, it can be more prone to fraud and abuse. In addition, because it is such a young asset class, the regulatory framework is still unclear, with each jurisdiction is following its own rules. This regulatory uncertainty is one of the biggest barriers to investment in crypto. Investor ODD teams should be aware of possible classifications and test the managers’ understanding of the regulations in its jurisdiction.
Using the SBAI’s guidance
The SBAI has provided some useful questions for ODD teams to use when researching crypto funds. These can be incorporated into a standard ODD questionnaire and address all the areas that differ from a standard fund manager investigation. Diligend users can quickly and easily ingest the SBAI’s questions and roll them out to fund managers as part of an ODD exercise. Get in touch today to find out more about adapting your approach to ODD for crypto funds.