Cryptocurrencies have take the world by storm over the last six months. The rise and fall and rise and fall again for Bitcoin, Ethereum and Ripple continue to make news literally on an intra-day basis. The excitement around the big three is almost as great as the excitement and coverage around initial coin offerings or ICOs.
With the continued volatility of these "things" – we are not prepared to call them securities, has also come a significant interest by investors of all shapes and sizes to take part in this digital gold rush through both direct investment and hedge funds. While the jury is still out on what will happen with these "things" one thing is for sure many people are getting into the space. We have two words of advice "Buyer Beware" there are lots of issues surrounding in crypto funds and below we pointed out a few of the areas that need to be paid attention to during the due diligence process.
During an online conversation amongst the alumni of the IMDDA Hedge Fund Operational Due Diligence Masters Course the question of how to conduct ODD on Cryptocurrency fund investments was raised. The Instructor of the class, John Ward from Duff & Phelps, shared his thoughts and concerns on performing ODD on these types of 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 confirm 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?
Other thoughts and concerns include:
- Fund liquidity and investor liquidity. Can another investor redeem out of the crypto fund and get their cash and how will that impact you and your fund investment? Must the manager redeem out of the cryptocurrency to provide liquidity to redeeming fund investors, or do they have access to a line of credit? What about leverage? Is the manager leveraging the investment using a credit facility or other mechanism to get access to the cryptocurrency? What if the manager used $10 million in investor subscriptions and bought US Treasuries. They could leverage those Treasury securities very easily to $50 million or more which could then be used to buy cryptocurrencies. Are you OK with leveraged crypto investments?
- Can the fund’s administrator value the asset and can they assure the asset exists? This is ODD 101!
- We have read about the accidental loss of crypto passwords – Bitcoin uses a 256-bit long alphanumeric code which is randomly generated. Without the password, the crypto "wallet" is inaccessible. Below is a diagram of how a bitcoin transaction occurs that we found on the internet.
How will the manager both (a) appropriately safeguard the crypto password, and (b) allow the password to be used quickly to affect trading? Institutional controls must exist to ensure that the password isn’t stolen by an employee/colleague. Think about it: what if the fund manager's CFO puts password protection on the Excel file that holds the crypto password(s) and then demands a pay raise before he will unlock the file, or goes on vacation and forgets to give the file password to his staff. While the manager argues with the CFO, the crypto price could skyrocket or plummet. How does the manager ensure the cryptocurrency password is both highly secure and also sufficiently accessible within his own firm to allow trades to occur?
Many of the thoughts above are basic ODD concepts that can be adapted to the specific asset class. Similar hurdles exist for investments in funds that hold assets like physical gold, or real assets (valuable paintings, collectables, musical instruments, etc). These are all are potential investments, but each has major concerns or issues (fake wine or a fake Stradivarius violin, how to buy/sell/trade the asset, who is the custodian, what are the costs of ownership, etc). If you use the skills we cover in the IMDDA Masters Classes they will guide you through the landmines and hopefully provide your firm with the ability to complete a thorough due diligence examination.
This article was written by IMDDA Staff and John Ward, Managing Director Duff & Phelps, LLC.
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