"Our firm is starting to look at Crypto funds and hedge funds and I don't know where to start." Next in our Ask an Expert series, we guide you through the due diligence process for cryptocurrency funds.
Cryptocurrency funds have a variety of ODD issues that need to be reviewed and understood; some of which are unique concerns based on the new and emerging technology. Many of the ODD issues, however, are basic and fundamental to the ODD process. Below is a list of concerns that need to be reviewed and have supporting documentation before one can get comfortable with approving a cryptocurrency fund investment:
- Valuation. As the SEC noted in their recent statement, valuation is at the core of any portfolio asset. You need to understand how the asset is being valued. Keep in mind that the cryptocurrencies are being traded on siloed markets. Bitcoin and Ethereum are not interchangeable assets. Unlike most other financial assets that can be traded among various broker dealers, or other market participants, cryptocurrencies are unique to their platform. The price of one cryptocurrency is not a data point that can be used to value a different, competing cryptocurrency. Valuation is a core ODD concern.
- Counterparty Viability. You need to understand the viability and the trustworthiness of the cryptocurrency platform. We have seen several platforms fail (GBL, GEMS, Paycoin, DAO, Youbit), and we have seen some of the platforms get hacked (Mt. Gox, NiceHash, Youbit, Tether, Ethereum). You need to be sure that the platform is robust, secure, and healthy. This concern is similar to how ODD would think about the viability of any counterparty for a typical fund investment.
- Liquidity. You need to understand the depth and liquidity of the cryptocurrency platform. Like residential real estate, the value of any asset is worth what someone else is willing to pay for it. You need to see a depth of market that assures that the "pricing" is based on real activity and real transactions, not bids and offers that are not being transacted on. One can ask for $1 million to sell their house. Until someone buys it, it is a data point and not a true value. If one later sells their house for $500K, the $1 million asking price has no asset value relevance. Asset liquidity is a core ODD concern.
- Trading Controls. You need to understand how the investment manager puts cash into the cryptocurrency and how they get it out. What are the transaction fees (this is an upfront cost to get access to the cryptocurrency and it is an immediate loss to the investment) and what is the timing? If you decide to invest at noon today is it transacted like the stock market where immediate price discovery exists and you will know within a few pennies where you own the asset, or is there a transaction delay wherein my eventual price/cost could vary widely? What is the depth of the market and could a fund manager invest or redeem millions or tens of millions worth of the cryptocurrency efficiently? What about getting money out of the crypto? Can you see the cash value "immediately" and can you convert it to hard currency quickly or is there a delay in cashing out? Given the significant volatility in crypto markets, the ability to get out is very important. We saw during the 2008 financial crisis that in certain markets, bids dried up and the value of certain credit assets plummeted. Could this similarly happen with cryptocurrency investments? Lastly, what is the cost of carry? Are there any costs associated with holding the currency in addition to the transaction fees?
- Hedging. The current lack of hedging options is a real risk. We unaware of any cryptohedges (though we are sure they either exist or soon will) that a manager could use to hedge the investment. How does the manager hedge their cryptocurrency investment to reduce market volatility risk? Are you comfortable with a fully unhedged position in your portfolio which has shown worrisome high volatility?
- Custody. How will you ensure that the fund manager actually owns the cryptocurrency asset? Will you be able to ensure asset existence as part of your ODD process? What will be considered the verification of existence? There is no physical deed, certificate, or contract for cryptos. Will the custodian accept and email, or other electronic confirmation as an assurance of asset existence? If the manager sells the cryptocurrency but fails to inform the Custodian, how can you get comfortable with the fund having an accurate valuation? This is a core ODD concept that crosses all investment styles.
- Controls. Controls. Controls. What are the controls to move the money from the fund to the crypto platform? What are the controls to time the purchase or sale (trading controls) of the cryptocurrency? What are the settlement controls - does the fund manager get a confirmation and how are the "trades" settled (same day, next day...)? What are the controls to move the money from the platform back to the fund? Who has access to make the trade and therefore who will have access to the crypto’s platform password?
For more information, see our blog on this topic here.
Duff & Phelps, LLC
If you have any due diligence-related questions of our own, feel free to submit them here: