When it comes to investing in cryptofunds, institutional investors will need to be extra cautious in deciphering the trading and operational risks involved.

So far, institutional investors – pension plans, endowments and insurance firms – have been hesitant to dive into the cryptofund market due to the lack of regulatory clarity on how cryptoassets should be categorized and how they should be safekept. Should that change, institutional investors might also decide to jump on the cryptofund bandwagon, according to Sinkevich who spoke at a recent cryptocurrency conference co-hosted by media firm ALTS Capital and the law firm of Sadis & Goldberg.

Of the 276 crypto-investment funds launched so far, about 174 have been set up as hedge funds and 90 as venture capital crypto-funds, says Crypto Fund Research,a Rohnert Park, California-based research firm. The remainder are ETFs and private equity funds. Sinkevich classifies cryptofund managers in three broad categories reflecting their strategies: cryptotraders looking for arbitrage opporunities, early investors in initial coin or token offerings or venture-capital-like investors taking equity or debt positions in underlying companies. Most cryptofund managers invest in the top ten cryptocurrencies by market capitalization, including Bitcoin and Ethereum.

Picking a inexperienced cryptofund manager who doesn't know how to properly execute its strategy could prove financially deadly. So could selecting a cryptofund manager with the best trading skills if he or she trades on an exchange or uses a custodian with poor operational controls. Once a cryptoasset is lost it is gone forever. Investors won't be compensated unless the cryptofund's custodian has purchased insurance that covers the loss of a crypto-asset.

Trading Questions

Institutional investors can ask cryptofund managers many of the same questions they would of a traditional or hedge fund managers, but they can't count on similar answers. "Inquiring about a performance track record sounds like a logical first step, but most cryptofund managers are new to the game," says Peter Murrugarra, co-founder and head of due diligence for ClearVest Advisers, a New York-based firm specializing in alternative fund allocation for independent advisors and their high-net worth clients. "They might not have managed any client assets in their previous lives."

At best the cryptofund manager might have some background in managing a hedge fund or private equity fund with semi-liquid or illiquid assets. Most cryptofund managers are blockchain or smart contract development gurus or traders who made good returns in cryptocurrency with their own monies. "That knowledge doesn't necessarily translate into making profits with client money," warns Murrugarra who also spoke at the recent cryptocurrency conference co-hosted by ALTS Capital and Sadis & Goldberg.

Because institutional investors can't always count that a cryptofund manager will have a track record, they need to be more careful when evaluating the technical qualifications of the fund's entire management team, cautions Sinkevich. He says that institutional investors must ultimately be confident that the cryptofund managers they pick can successfully execute their strategies, correctly use hedging to minimize the risk of cryptocurrency volatility, and recognize the difference between an investable and non-investable blockchain idea. Cryptofund managers, who have venture-capital like strategies, will likely be investing in underlying companies focused on blockchain development.

"The best cryptofund managers will have a good understanding of investment techniques, indepth knowledge and experience with blockchain technology and cryptocurrencies," says Sinkevich. He estimates that about three-quarters of cryptofund management firms aren't ripe for investment, because their portfolio managers cannot make informed trading decisions.

"Regardless of the trading strategy, investors should ask the cryptofund manager to explain how it knows it achieved the best prices for its trades," recommends Sonia Goklani, chief executive officer of Cleartrack, a South Brunswick, New Jersey technology firm specializing in customized trading and clearing systems for derivatives and cryptocurrencies. "The principles of best execution should apply even to cryptocurrencies."

Finding the right data to prove best execution isn't easy. There are a few cryptocurrency data providers who have consolidated trade data from multiple exchanges, but they might rely on transaction prices rather than actionable bid and offer prices, according to Dave Weisberger, director of equities for ViableMkts, a New York consultancy specializing in market structure and technology. Goklani suggests that institutional investors ask cryptofund managers whether they use historical 200-day moving averages or Bitcoin futures contacts traded on the CME or other exchanges as benchmarks.

Making successful trade execution even more difficult for cryptofund managers is the fact that traditional order management, trade execution and smart order management systems aren't adapted for the cryptomarket, claims Weisberger. who spoke at a recent event in New York hosted by ViableMkts. CoinRoutes, a separate San Francisco company, headed by Weisberger, provides smart order routing, algorithmic trading and consolidated data products for cryptocurrencies. The firm's RealPrice platform shows the cost of executing defined quantities of Bitcoins and other cryptocurrencies.

Bitsian, a New York firm, also says that is is creating a smart order platform, using pricing algorithms to access liquidity across forty-five electronic order books and private pools of liquidity. While CoinRoutes is broker-neutral, Bitsian will operate as a prime broker and custodian.

Cryptocurrency consultants recommend that institutional investors also pay attention to how crypfofund portfolio managers decide to split their transactions among cryptoexchanges and broker-dealers who trade over-the-counter. Transaction costs can vary and broker-dealers who use their own capital to execute orders will charge a premium to assume risk.

Boston-based research firm Aite Group estimates that about 21 percent of the $465 billion in cryptocurrency trades completed in the first four months of 2018 were executed through broker-dealers over-the-counter. Fund managers who want to fill large block-orders might prefer to use an OTC broker where they can immediately access liquidity and minimize market impact, says Gabriel Wang, an analyst at Aite and author of a recent report entitled "The Cryptocurrencies Market Landscape: New Frontier."

Ops Questions

Once institutional investors overcome any concerns they have about a cryptofund manager's trading abilities, they need to focus their attention on operational controls. One of the key questions that must be addressed, say cryptocurrency consultants, is how the cryptofund manager calculates the fund's net asset value correctly. Akin to hedge fund managers, cryptofund managers must strike a net asset value at the end of the month. However, they typically outsource that task to fund administrators.

Institutional investors can't afford to worry about potential errors in NAVs or being unable to audit the financial performance and records of a cryptofund manager. Therefore, cryptofund administrators tell FinOps, institutional investors should verify that the prospective cryptofund manager's administrator has experience handling cryptofunds and uses a middle and back-office system designed specifically for cryptoassets. Platforms built for equities and fixed-income can't be easily tweaked for cryptoassets.

Institutional investors shouldn't settle on investing with cryptofund managers who expect their administrators to calculate an NAV based on a digital snapshot of their holdings as evidence of ownership. Neither should institutional investors rely on cryptofund managers who provide their fund administrators with transactional data through manual file transfers only.

"Ideally the fund administrators will have developed automated connections with multiple trading venues and counterparties as well as data cleansing procedures," says Jeremy Drane, chief commercial officer for Libra, a New York-based middle and back office technology firm whose clients include cryptofund administrators. Libra's Crypto Office platform allows cryptofund administrators to calculate NAVs based on trade, transfer and fee data programmatically extracted and normalized from exchanges and broker-dealers used by the cryptofund managers they service. Libra won't specify how many cryptofund administrators use Libra Crypto Office, but says they include Trident Trust and Theorem Fund Services.

Ultimately, striking any cryptofund's NAV correctly depends on using the right valuation methodology. "Institutional investors will want to ask thorough questions about how the cryptofund manager values its positions," recommends John Ward, a managing director in the Alternative Asset Advisory Group at Duff & Phelps, a New York-based global valuation and corporate finance advisory firm.

Cryptocurrencies trade on multiple platforms that value the same cryptocurrency at a different price at the same day and type. Therefore, different cryptofund managers could easily strike a different price for the exact same cryptocurrency depending on how each values its closing price.

Common sense should apply when it comes to validation policies. A fund manager that cherrypicks a price for a cryptocurrency from whichever exchange shows the highest price is incorrectly inflating the price of the digital asset and likely its performance results.

Among the questions institutional investors should ask cryptofund managers about their valuations, says Ward, is whether they rely on bids and offers or executed prices from one exchange or multiple exchanges. In addition, does the cryptofund manager use a single price to value both long and short positions or does it average bid prices to value the portfolio's short positions and average offer prices to value the long positions.

At the very least, says Ward, institutional investors need to be reassured that cryptofund managers have a written repeatable and consistent process for asset valuation. "One of the biggest red flags when evaluating a cryptofund manager will be whether it uses a valuation policy based on back-of-the envelope calculations." he warns.

Naturally, institutional investors will want to be reassured that the assets the fund administrators value actually exist. That comfort level can only be given by a custodian, which has possession and control of a cryptofund manager's private keys. Those are the secret alphanumeric codes that allow a user to access its cryptocurrency.

Most cryptofund managers have decided to do their own custody work rather than rely on third-party "qualified custodians" because they don't meet US Securities and Exchange Commission's threshold of US$150 million in assets under management. Therefore, they don't have to register as investment advisers and follow the regulatory agency's custody rule to hire a "qualified custodian" such as a bank, futures commission merchant, broker-dealer or trust company. Instititutional investors worried about whether the cryptofund manager could safely act as its own custodian could always require it to hire a third-party service provider.

Some firms offering custody services for digital assets have decided to become "qualified custodians" to attract registered investment advisers as customers or to help cryptofund managers nab institutional clientele. However, institutional investors need to keep in mind that each regulatory designation has its own level of oversight and that some custodians are also exchanges.

Murray, Kentucky-based Kingdom Trust is registered as a trust company in South Dakota. Its technology provider BitGo, a Silicon Valley bitcoin wallet startup, has scrapped plans to acquire Kingdom Trust and applied for a trust charter in South Dakota so it can offer its own qualified custodian service for institutional investors.

Cryptocurrency exchanges Genesis and itBit are registered as trust companies in New York. CoinBase, the US' largest cryptocurrency exchange, has just launched its institutional custody service leveraging the systems of Electronic Transaction Clearing, an SEC-registered broker-dealer and member of the Financial Industry Regulatory Authority. Newcomer Digital Asset Custody Company (DACC) has applied to the SEC and FINRA to become a qualified custodian as a broker-dealer. "Being a broker-dealer allows us the same strict regulatory oversight as our clients." says Adam Healy, chief information security officer for DACC in Secaucus, New Jersey. "It is the golden standard for crypto-asset custody."

Legal designation aside, institutional investors also need to know exactly how the digital asset custodian will protect their assets. Digital asset custodians often use the phrase "cold storage" to refer to devices or methods that store the private keys of their customers in secured facilities without any online connectivity to a network. Digital asset custodians require the signatures of at least two operations managers in their shops to access the private keys to complete the cryptofund manager's request to withdraw the assets from the digital custodian's blockchain platform.

However, there are subtle variations of "cold storage" institutional investors need to keep in mind when deciding whether they will want to do business with a cryptofund manager. Depending on the number of signatories and private keys held by the digital asset custodian it can typically take anywhere from a few hours to more than a day for a cryptofund manager to complete any transaction.

Cryptofund managers with active trading strategies might end up with opportunity losses because of the time delay. Therefore, institutional investors might want to consider whether the investment strategy of their cryptofund portfolio manager also requires the use of "hot wallets" or online access to funds and what precautions will be taken to prevent hacking.

BitGo and Kingdom Trust insist that their cryptofund clients want the ultimate safety of a "cold" wallet with one-day wait to access assets. DACC says it will give cryptofund managers a choice of as little as a fifteen-minute wait or longer depending on the level of security they want. "We can achieve the fifteen minutes timeframe by locating our signatories in the same location as our vault," says Healy. Bitsian's Miller says that her firm is reviewing a type of cold storage technology that will allow fund managers to move their cryptoassets from offline to online within minutes.

Fund of Funds Option

For institutional investors wanting to invest in cryptofunds, but don't have the knowledge or time to do all the due diligence legwork on dozens of cryptofund managers, investing in a cryptofund of funds could be a logical option. "We will ask all the tough due diligence questions on investment strategy, compliance and operations," says Constantin Kogan, a partner at BitBull Capital, a cryptofund of funds manager in San Francisco. Out of over two hundred thirty cryptofund managers BitBull Capital evaluated, it ultimately narrowed the list down to ten funds.

Kogan says that for compliance reasons he cannot publicly disclose the investment strategy of BitBull Capital's cryptofunds, the total value of assets under management, the percentage of assets representing institutional monies, or even the minimum initial investment required for compliance reasons. As a rule of thumb, cryptofund of funds have a far lower minimal initial investment threshold than individual cryptofunds do.

Ultimately, institutional investors wanting to invest in cryptofunds might just have to take a greater leap of faith in their cryptofund managers than they would with traditional fund managers. "The market is still evolving when it comes to price transparency and there is no way to know for certain whethe the cryptofund manager has executed an order correctly," says Raakhee Miller, Bitsian's chief executive officer.

Still, institutional investors in cryptofunds can't be too vigilant. "If you are worried about the qualifications of the cryptofund management team, can't interpret the portfolio manager's investment strategy or can't understand the fund's procedures with service providers, its time to look elsewhere," says Sinkevich.

This article, written by Chris Kentouris, first appeared on FinOps Report (www.finops.co) on July 20, 2018. It is republished with permission.

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