By Skyler Steinke
Bitcoin has gotten a lot of media attention in the last few months, and understandably so. The price for a single bitcoin was around $1,000 at the beginning of 2017 but had skyrocketed to just under $20,000 in December, before falling to around $6,000 and then climbing back up by early March to around $11,000. Any asset showing the potential for that kind of explosive growth is likely to attract the attention of return-hungry investors and asset managers looking for new opportunities. And bitcoin is far from the only cryptocurrency. In fact there are currently more than 1,500 of them being traded on various exchanges.
Although many individuals both in financial services and the world at large have only discovered the world of cryptocurrencies in the last few months, bitcoin has actually been in existence since 2008. And managers with experience and expertise in the digital asset space have identified the volatility in this asset class as a great opportunity to generate alpha. There are a range of strategies that can be used to accomplish this goal—buy-and-hold, arbitrage, active trading and indexing—which has helped pique the upturn in interest regarding cryptocurrency hedge funds.
For wealth managers who might be contemplating such a move, there are the usual questions and considerations associated with the launch of any fund structure, plus some that are unique to the cryptocurrency space.
As with any fund launch, once the manager has determined that they have a sound strategy and a viable rationale for starting a new fund, the next thing to consider is the range of service providers that you will need to draw upon—legal firm, independent auditor and fund administrator. In the case of a nascent asset class such as cryptocurrency, it becomes even more important than ever to make sure you are dealing with firms that have experience in handling digital assets.
One of the challenges cryptocurrencies present to potential fund managers is that the exchanges on which they are traded are open 24 hours a day, seven days a week, unlike a traditional stock exchange which has a posted closing time at which point fund valuations can be set. Because of this the process of launching a cryptocurrency fund usually starts with an experienced legal firm working with the manager to establish a valuation policy for what assets they will be trading and how they plan on determining values going forward.
Another challenge is custody of the digital assets themselves. There are very few regulated custodians operating in the cryptocurrency space at this time. And the custodians that do handle this asset class have very limited service offerings and cannot custody all available cryptocurrencies on their respective platforms. As a result, the fund manager needs to work closely with the various service providers of the fund to develop a process and best practice for custody.
Since data on the cryptocurrency exchanges is updated constantly, the cryptocurrency fund administrator will have to create procedures to support the valuation of the fund for the advisors and investors. For example, the administrator might take a snapshot on the last business day of the month at 6 p.m. Eastern, verifying the price on the exchanges that the manager is trading on and compare to independent pricing sources to determine the fund’s valuation, while also working with the auditor and the legal firm who wrote the offering memorandum outlining their specific strategy.
Another thing that would-be managers need to be even more cautious with than the typical fund is adherence to anti-money laundering protocols. Because cryptocurrencies aren’t regulated by any governmental authorities, they have become popular with criminal enterprises and have been linked to finance drug and weapons transactions on the “dark web.”
As would be the case with any hedge fund, regardless of strategy or asset class, investors in a cryptocurrency fund would still need to verify they are accredited and pass an anti-money laundering review. The manager needs to be assured that the administrator is working with digital wallet providers that have a protocol to screen customers and sources of funds.
The need for limiting these funds to accredited investors was stressed by Vitalik Buterin, founder of Ethereum, the No. 2 cryptocurrency after bitcoin when he recently tweeted: “Reminder: cryptocurrencies are still a new and hyper-volatile asset class, and could drop to near-zero at any time. Don't put in more money than you can afford to lose.”
Reminder: cryptocurrencies are still a new and hyper-volatile asset class, and could drop to near-zero at any time. Don't put in more money than you can afford to lose. If you're trying to figure out where to store your life savings, traditional assets are still your safest bet.
— Vitalik "Not giving away ETH" Buterin (@VitalikButerin) February 17, 2018
With that in mind, the most important thing for potential managers is to make sure they are aligning themselves with providers who have experience in the cryptocurrency space. Ideally these should be partners with whom they’ve had a long-term relationship based on mutual trust. It’s difficult enough to launch a new fund without having to deal with headaches that can arise from working with an auditor or fund administrator who is learning on the job about this up-and-coming alternative asset class and its unique attributes.
Skyler Steinke is VP of Business Development at The Gemini Companies.