Original title: How to Launch a Crypto Hedge Fund

Original author: L1 Digital

Original translation: 0x26, BlockBeats

For a long time, market makers and crypto funds have been regarded as one of the top of the food chain in the crypto industry. Everyone says that market makers make a lot of money, but few people stand from the perspective of a veteran and give a detailed introduction to how to start a fund from a process perspective. L1 Digital's Fund of Funds has invested in well-known institutions such as Multicoin Capital, DeFiance Capital, Castle Island Ventures and 1kx. As a VC, it has also invested in market makers such as Wintermute, amber and Byte Trading. The L1 Digital team explained in detail the preparations and operational procedures required as a compliant crypto hedge fund. The following is the full text of the article.

This article is intended to provide guidance and reference for launching institutional grade crypto hedge funds (“Crypto HFs”) from an operational perspective. Our intention is that this will assist teams planning such launches and serve as a resource on their journey.

Cryptocurrencies remain an emerging asset class, as does the infrastructure that services them. The goal of establishing a robust operational framework is to enable trading and investing while ensuring technical and legal security and control of the fund’s assets, and providing appropriate accounting treatment for all investors.

The information and perspectives contained in this article draw on L1D’s experience as one of the most active investors in crypto hedge funds since 2018, and our team’s long track record of investing in hedge funds across multiple financial crises prior to our own launch in 2018. As active asset allocators in the years leading up to the 2008 global financial crisis, and participating as investors and liquidators in its subsequent treatment, our team has learned many lessons and applied them to investing in crypto hedge funds.

This document is lengthy and covers a number of topics in depth as a guide and reference. The level of detail given to any particular topic is based on our experience with new managers, where these topics are often less understood and often left to legal counsel, auditors, fund administrators and compliance professionals. Our goal is to help newly launched managers navigate this space and work with these expert resources.

The service providers mentioned in this article are included based on their established brand identity and our experience working with them. No service provider has been intentionally excluded from this article. The crypto space is fortunate to have many high-quality service providers who have created a robust infrastructure that is constantly evolving and there are many options for newly launched managers. The scope of this article is not particularly focused on an exhaustive review of the infrastructure available in the space, which is well covered in other publications.

The goal here is to review processes and workflows in detail, identify operational risks, and present best practices for managing risk in the context of launching and operating a crypto hedge fund. This article will cover the following:

1. Planning and Strategic Considerations

2. Fund Structure, Terms and Investors

3. Operational Stack

4. Trading Venues and Counterparty Risk Management

5. Financial Management - Fiat and Stablecoins

6. Custody

7. Service Providers

8. Compliance, Policies and Procedures

9. Systems

Certain chapters contain case studies of certain crypto hedge funds that failed or nearly failed due to operational reasons covered in this guide. These cases are included to show how even seemingly minor operational details can have large negative consequences. In most cases, managers had the original intention of doing the right thing for investors, but their oversights had consequences that they could not fully anticipate. We hope that newly launched managers will be able to avoid these pitfalls.

Investors and investment managers coming from a traditional finance (TradFi) background entering the crypto space recognize the differences and similarities in managing funds in these different environments. This article uses operations in traditional finance to introduce these differences and how the resources available to crypto hedge funds can be used to implement an operating model that can properly serve institutional investors.

Planning and Strategic Considerations

Identifying and vetting appropriate partners, and establishing, testing, and refining pre-launch procedures can take months. Contrary to popular belief, institutional-grade crypto investing is not the “Wild West” from a compliance perspective, in fact quite the opposite. High-quality service providers and counterparties are very risk-averse and often have cumbersome and comprehensive onboarding processes (KYC and AML). Such planning also includes consideration of redundancy in areas such as banking partners. As a rule of thumb, it can take anywhere from 6 to 12 months to set up a typical fund. It is not uncommon to launch in a step-by-step manner, gradually expanding to new assets as the full scope of certain strategies may not be achieved on day one. This also means that investment managers must consider a certain expense burden when preparing to launch, as income will take longer to materialize.

The investment strategy of a crypto hedge fund effectively defines the operational characteristics and requirements of the fund, as well as the corresponding workflow to prepare for launch. The following diagram shows the layout of the strategies we categorize at L1D. As each strategy further defines itself through sub-strategies, implementation, and liquidity, the operational characteristics of the fund are also defined - as they say, form follows function. This ultimately manifests itself in the structure of the specific fund, legal documents, counterparty and venue selection, policies and procedures, accounting choices, and the responsibilities of the fund manager.

L1D Strategy Framework

Fund Structure, Terms, and Investors

The structure of a fund is generally determined by the assets traded, the tax preferences of the investment manager, and the residency of potential investors. Most institutional funds choose a domicile that allows them to face offshore exchanges and counterparties and attract both US and non-US investors. The following section details the fund’s offering documents and provides further detail on several key items. Included are several case studies that highlight how certain choices in structure and offering document language can lead to potentially negative outcomes for investors and outright failure.

The following diagram illustrates a typical Cayman Islands-based master-feeder (also known as master-feeder or parent-subsidiary) structure.

Typical Fund Structure

Investor Types and Considerations

At a high level, when setting up a fund, investment managers should consider the following characteristics of potential investors to address legal, tax and regulatory implications, as well as commercial considerations.

Residence – US vs. non-US

Investor Type – Institutional, Qualified vs. Non-Qualified, Qualified Purchasers

Number of Investors and Minimum Subscription Amount

ERISA

Transparency and Reporting Requirements

Strategy Capacity

Offering Documents

The following items are key factors when considering fund structure and are usually contained in the fund’s offering documents – the Private Placement Memorandum and/or Limited Partnership Agreement.

Domicile

Institutional funds often choose the Cayman Islands as their primary domicile, and to a lesser extent the British Virgin Islands. These domiciles enable the fund entity to be counterparty-facing – to trade with offshore counterparties.

· The choice of the Cayman Islands as a preferred jurisdiction is a result of traditional financial hedge funds being established there, and a system of service providers has formed around it, including legal, compliance, fund administration and audit, with a good track record in the alternative asset management space. This advantage also carries over to the crypto space, as many of the same well-known service providers now have established operations in the space. The Cayman Islands is still seen as the "best choice" compared to other jurisdictions, as evidenced by the increased supervision of its regulator, the Cayman Islands Monetary Authority (CIMA).

· The maturity of these jurisdictions is reflected in greater regulatory clarity and legal precedent in fund management, as well as highly developed anti-money laundering (AML) and know your customer (KYC) requirements, which are essential for a well-functioning market. These jurisdictions are generally associated with higher costs.

· The Cayman Islands have the highest costs and the legal set-up is time consuming, leading many managers to consider the BVI. The BVI is continuing to establish itself as an accepted jurisdiction and its comparability with the Cayman Islands is increasing as more high quality and reputable service providers offer services there. The premium paid for the choice of a well-known jurisdiction is usually justified over the life of the fund.

Fund Entities – Master and Feeder Funds

Based on the structure diagram above, there are typically master and feeder fund entities, with the master fund holding investments, participating in and executing all portfolio investment activities, and distributing financial returns to the underlying feeder funds.

The master fund is typically a Cayman limited company (LTD) that issues shares.

Feedback funds targeting offshore investors are typically Cayman limited companies that issue shares, while feedback funds targeting U.S. onshore investors are typically Delaware limited partnerships (LPs) that issue limited partnership interests. U.S. onshore feeder funds can also be Delaware limited liability companies (LLCs), but this is less common.

Fund Entity Form – Limited Company vs Limited Partnership

Offshore funds and master-feedback fund structures can target a variety of capital sources, including U.S. tax-exempt investors and non-U.S. investors.

The choice of whether to structure as a limited company (LTD) or a limited partnership (LP) is often driven by the fund manager’s tax considerations and how they wish to be compensated for performance fees, which are usually applied at the master fund level.

Cayman Limited Company (“LTD”): A separate legal entity from its owners (shareholders). The liability of shareholders is usually limited to the amount invested in the company.

LTDs often have a simpler management structure. They are managed by directors appointed by the shareholders, and day-to-day operations may be overseen by senior management – usually investment managers.

The shares of an LTD can be transferred, providing flexibility in terms of ownership changes.

LTDs have the flexibility to issue different classes of shares, with different rights and preferences. This can be advantageous for structuring investment vehicles or accommodating different types of investors.

LTDs often choose to be treated as corporations from a US tax perspective, and therefore pay taxes at the LTD level, without passing them on to investors.

Cayman Limited Partnership (“LP”): In a limited partnership, there are two types of partners – general partners and limited partners. General partners are responsible for managing the partnership and are personally liable for its debts. Limited partners, on the other hand, have limited liability and do not participate in day-to-day management.

LPs involve general partners (“GPs”) who are responsible for managing the partnership. The GP has unlimited personal liability and the LP enjoys personal liability protection.

Cayman does not tax foreign limited partnerships.

LPs have a different structure, with limited partners typically contributing capital but without the same flexibility in terms of share classes.

Delaware Limited Partnership (“LP”): The choice of implementing a Delaware LP or a Cayman LP can be delicate and is often related to the tax and governance preferences of investors. The most common for onshore funds is a Delaware LP.

Delaware’s LP laws define governance and investor rights.

A “pass-through entity” for tax purposes, meaning the LPs/investors pay their own taxes.

Flexibility is provided through the fund’s governance documents to define the relationships between the parties.

Delaware LPs are generally cheaper and quicker to set up.

Investment Manager/Advisor/Sub-Advisor/General Partner (GP)

The entity that has decision-making power over portfolio management and is compensated through management fees and incentive fees.

The entity that has decision-making power and collects fees generally depends on the Ultimate Beneficial Owners (UBOs), their respective nationalities and tax preferences.

Often formed as a Limited Liability Company (LLC) to take advantage of limited liability protection, as the GP (General Partner) has unlimited liability.

Asset Holding Structure

Investments are typically held at the master fund level, but other entities may be formed for certain assets/holdings, which may be driven by tax, legal and regulatory considerations.

In some special cases, investments may be held directly by the feeder fund for the same reasons as above, and the ability to do so must be clearly stated in the fund's legal documents.

Share Classes

A fund may offer different share classes with varying liquidity, fee structures and the ability to retain certain types of investors; founder share classes are often offered to early investors who make significant capital contributions. Such share classes may offer certain preferential terms to early investors to support the growth of the fund in its early stages.

Special classes may be created for special circumstances, such as for assets with limited liquidity, often referred to as side pockets (see below).

Different share classes may have different rights from one another, but the assets in each share class are not legally distinct or segregated from the assets of the other share classes - examples of this are covered in the case studies below.

Fees

The market standard for charging management fees is to align with the liquidity of the fund - for example, if the fund provides monthly liquidity, then the management fee should be charged monthly (ex post). This approach is also the most operationally efficient. As discussed below, a lock-in period is often imposed during which the management fee is charged.

Performance fees are usually accrued over a given year and are settled and paid only on an annual basis based on the corresponding high water mark (HWM). Performance fees are also usually settled and charged if an investor redeems at a net asset value above the HWM during the performance fee period.

Some funds may prefer to settle and collect performance fees on a quarterly basis – this is not considered best practice, nor a market standard, is unpopular with investors and is less common.

On assets held in side pockets, performance fees are not collected until they are realized, until they are transferred from the side pocket back to the liquid portfolio, either held as liquidity or in cash after realization.

Liquidity

Redemption terms and corresponding provisions – should be consistent with the liquidity of the underlying holdings.

Lock-up periods – determined at the discretion of the investment manager and usually driven by the strategy and underlying liquidity. Lock-up periods can vary, 12 months is fairly common but can be longer. The lock-up period may apply to each investor’s initial subscription, or to each subscription – initial and subsequent. Different share classes may have different lock-ups, i.e. the founder class may have a different lock-up period than other share classes.

Side pockets – see below.

Gates – a fund may impose restrictions at the fund or investor level – a gate means that if more than a certain percentage of fund or investor assets (e.g. 20%) are requested for redemption during any redemption window, the fund can limit the total amount of redemptions accepted – this is done to protect (remaining investors) from the impact of large redemptions on price or portfolio construction.

Gates are often relevant to illiquid assets as the impact of large redemptions may affect the actual price of the asset when it is sold/liquidated to raise redemption cash, and this feature does protect investors.

The choice of whether to impose restrictions at the investor level or at the fund level is driven by the liquidity structure and the concentration of AUM in the investor base. More often, however, restrictions are imposed only at the fund level, which is more investor friendly and operationally efficient.

It is also important that the terms of the restrictions clearly state that investors who submit redemptions before the restrictions are imposed should not be given priority over investors who submit redemptions after the restrictions are imposed – this ensures that later redemptions are treated equally to earlier redemptions and removes any incentive or possibility for large investors to game the system and receive unintended preferential treatment in terms of liquidity.

Expenses

Funds may charge certain operating expenses to the fund, which are effectively paid by investors.

Best practice is to charge expenses to the fund that are directly related to the management and operation of the fund and do not create a conflict between the fund and the investment manager. Keep in mind that managers receive management fees for their services, so operating and other expenses associated with the management company and entity should not be included in the fund. Direct fund expenses are generally related to servicing investors and maintaining the fund structure - including administrators, audit, legal, regulatory, etc. Management company expenses include office space, personnel, software, research, technology, and the costs required to operate the investment management business.

Managers should focus on the Total Expense Ratio (“TER”). Newly launched crypto funds will typically have relatively low assets under management (AuM) for a period of time. Institutional investors' allocations to cryptocurrencies may carry new risks of exposure to the asset class, which should not be exacerbated by high Total Expense Ratios (“TER”).

In order to keep TER at reasonable levels, enforce accountability, and align managers with investors, it is recommended – and a sign of confidence – that managers commit to covering certain start-up and ongoing operating expenses. This demonstrates a long-term commitment to the space, with the expectation that the AuM growth from such a commitment will compensate the manager for this investment and discipline.

Good fee management can also further align managers and investors by mitigating potential conflicts of interest. There can be grey areas between what directly benefits the fund and what benefits the manager more than the fund – industry presence at conferences and events, for example, and the associated fee policy is one such area. The costs incurred to maintain such a presence are not direct fund expenses and are often more likely to be included in the management fee or even borne by the manager itself.

The crypto space is already rife with conflict, and taking a truly fiduciary approach to fee policy is critical to enabling institutional investors to invest in cryptocurrencies.

Accounting

In order to properly track the high water mark for investors to use in performance fee calculations, there are two accounting methods that can be applied - series accounting or the balanced method.

Series or multi-series accounting ("series") is a procedure used by fund managers whereby a fund issues multiple series of shares for its fund - each series starting at the same net asset value (NAV), usually $100 or $1,000 per share. A fund that trades monthly issues a new series of shares for all subscriptions received each month. Thus, a fund would contain share classes such as "Fund I - January 2012 Series", "Fund I - February 2012 Series", or sometimes referred to as Series A, B, C, etc. This makes tracking the high water mark and calculating performance fees very straightforward. Each series has its own NAV, and depending on where the series sits at the end of the year relative to the investor's high watermark, those series that are at the high watermark will be "rolled up" into the major categories and series at the end of the year, and those series that are below the high watermark will also be rolled up because they are "below the watermark." This process requires a lot of work at the end of the year, but once it is done, it is much easier to understand and manage going forward.

In the Balanced Method ("EQ") accounting, all shares of a fund have the same NAV. When new shares are issued/subscribed, they are subscribed at the aggregate NAV, and depending on whether the NAV is above or below the high watermark, the investor receives a balancing credit or debit. Investors who subscribed below the high watermark receive a statement showing their number of shares and a balancing debit (for future performance incentive fees from their entry NAV to the high watermark); if subscribed above the high watermark, the investor receives a balancing credit to compensate for any incentive fees that may have been overcharged between their purchase NAV and the high watermark. Balancing Act accounting is considered to be quite complex and places an extra burden on fund administrators that many are not competent to perform. This is also true for fund managers’ operational and accounting staff.

Neither approach is superior, as investors are treated equally in both cases, but series accounting is often preferred because it is more straightforward and easier to understand (with the disadvantage that many series are generated, which may not always aggregate into a main series, so there may be many different series over time, which increases the operational and reporting work for the administrator).

First-in, First-out (FIFO) - Redemptions are generally handled on a "first-in, first-out" basis, meaning that when an investor redeems, the shares redeemed belong to the series they subscribed to the earliest. This is more beneficial to the manager because such redemptions will trigger the settlement of the performance fee if these (older) shares are above their high watermark.

In some cases, a manager may choose to apply leverage to the strategy through an accounting mechanism rather than a separate fund vehicle - this is not recommended, and the reasons for not doing so are detailed in the case study below.

Side Pockets

In crypto investing, certain investments, typically early protocol investments, may not be liquid. Such investments are typically held outside of the regular portfolio and segregated into a side pocket category that cannot be redeemed with liquid holdings during normal redemption intervals.

Side pockets gained widespread attention during the 2008 crisis/global financial crisis - side pockets were originally provisions that allowed funds running otherwise liquid strategies to invest in less liquid holdings, typically with restrictions in terms of percentage of AuM and with certain defined liquidity catalysts such as IPOs. However, as a larger portion of the otherwise liquid portfolio became illiquid and placed in side pockets due to the impact of the global financial crisis, such funds experienced significant redemptions, meaning that all liquid assets needed to be liquidated. The side pocket mechanism ultimately protected investors from assets being sold at a discount, but investors in liquid funds ended up holding unexpectedly larger amounts of illiquid holdings. The original intent of the side pocket provisions did not anticipate these compounding effects of the crisis, and therefore the treatment of side pockets and their impact on investors - including valuation and fee bases - was not fully considered.

Side pockets themselves are a useful tool in the crypto space, but their implementation requires careful consideration. Side pocket investments have the following characteristics:

Should only be created where there is a genuine need to protect investors.

Should ideally be limited to a certain percentage of the fund’s AuM.

Cannot be redeemed within normal redemption intervals.

Should (must) be held in its own legal share class and not just separated by an accounting mechanism.

Available for management fees but no performance fees – performance fees are charged on holdings when they become liquid and are moved back into the liquid portfolio.

Not all fund investors are exposed to side pockets – typically, only investors who are already investors in the fund at the time the side pocket investments are created will be allocated side pocket exposure, and investors who enter the fund after the creation of any particular side pocket investment will not be exposed to existing side pockets.

Key considerations when structuring side pockets:

Offering documents – side pockets should be clearly stated as permitted and intended; if the fund is structured as a master-feed fund, both sets of offering documents should reflect the side pocket treatment.

Separate share classes – side pocket assets should be placed in their own class with corresponding terms – e.g., management fee, no performance fee, no redemption rights.

Accounting structures within fund structures – side pockets are typically created when illiquid investments are made and/or when existing investments become illiquid; only investors who are already invested in the fund at the time the side pocket is created should be exposed to side pockets, and such investors typically subscribe to that side pocket class. When assets in a side pocket become liquid, they are typically redeemed from their class and then placed into a liquid share class, with investors with that exposure subsequently subscribing to the newly created liquid class - this ensures accurate tracking of investor exposure and high watermarks. If the fund is structured as a master-feeder fund, side pockets at the feeder level should have corresponding side pockets at the master fund level to ensure there is no potential liquidity mismatch between the feeder and master fund.

The following matters are not directly contemplated in the fund's offering documents, but policies must be established to ensure alignment of interests and clear communication to investors:

Migrating from side pocket classes to liquid classes - there should be a clear policy for when assets become sufficiently liquid to be moved from a side pocket class to a liquid class. The policy and rules are typically based on some measure of exchange liquidity, trading volume, and the fund's ownership of existing liquidity.

Valuation - when a side pocket is created, it is typically valued at cost as the basis for charging a management fee. Assets in a side pocket can be valued upwards, but clear and realistic valuation guidelines must be followed. One approach could include applying a marketability discount (“DLOM”) based on recent large transactions in an asset (e.g., a recent capital raise at a valuation above the fund’s original cost).

Reflection in investor reporting – Investors should have a clear understanding of their liquidity in the fund, so side pocket categories should be reported separately from liquidity categories (each liquidity category should also be reported separately) to ensure that investors know the number of shares and net value per share that are redeemable under standard liquidity terms.

Example Side Pocket Structure

The example structure diagram below reflects a generic version of how an investor might allocate side pocket exposure.

For illustrative purposes, an Offshore Feeder LTD is used here as an example, as a limited company uses share class accounting and is more suitable to illustrate certain key points related to this accounting concept and its application in side pockets. A similar mechanism applies to an Onshore Feeder Limited Partnership, but is not reflected in detail in this example.

The Master Fund makes and holds actual crypto investments in its portfolio. Each Feeder invests in the Master Fund's share classes and is a shareholder of the Master Fund.

The investors of the Feeder receive shares of the Feeder Fund - this is a fund that accepts subscriptions monthly, and when an investor subscribes in a particular month, a series is created for that month to properly account for and track performance and calculate the corresponding incentive fee. The investors of the Feeder Fund share the performance of the Master Fund portfolio through the change in the value of the Feeder Fund's investment in the Master Fund's shares, and the corresponding increase in the value of their Feeder Fund shares.

When the Master Fund holds only liquid assets, the Feed Fund investors indirectly own a proportionate share of the entire Master Fund's liquid assets. In this case, the Master Fund shares are 100% liquid, and the Feed Fund shares are therefore also liquid and eligible for redemption according to the terms of the fund. 100% of the performance of their Feed Fund shares will be based on the performance of the Master Fund shares, which ultimately comes from the Master Fund's portfolio (specific performance is accounted for at the series level).

In Figure 1 below, the Master Fund held only liquid investments in January, the entire performance will be distributed to the Feed Fund investors, all Feed Fund series will benefit from the performance of the Master Fund, and each identical series (i.e. subscribed in the same month) will have the same performance.

Master Funds Support Liquid Investments

Figure 2 shows a master fund portfolio that determined that 10% of its portfolio was illiquid in February.

Master Funds Hold Liquid and Illiquid Assets and Issue Side Pockets

When portions of the master fund portfolio are illiquid, those assets cannot be sold to satisfy redemption requests from feeder fund investors. There are two main reasons why assets may be illiquid—either some assets become illiquid due to some distress, or the master fund invests in illiquid assets for special opportunities. In either case, only investors in the feeder fund who were already invested when these illiquid assets entered the master fund portfolio should have exposure to these illiquid assets—from a fee and performance perspective, as well as from the perspective of changes in the liquidity of their holdings.

To deal with the illiquidity of some of the portfolio, the Master Fund will create a side pocket in February to hold these illiquid assets, and only Master Fund investors who have invested before February will have exposure to the side pocket - they will receive gains or losses from the future performance of the side pocket. The key is that after the creation of the side pocket (which will be done by converting and transferring 10% of their liquid shares into side pocket shares), only 90% of their shares will be eligible for redemption (because 10% of their initial liquid shares have been converted into side pocket shares). Investors who subscribed to the Master Fund in March will not have exposure to the side pocket created in February.

The Master Fund will create a special share class to hold the side pocket assets - the SP class shares. When this happens, the feeder fund's portfolio will hold two assets (liquid Master Fund shares and non-redeemable Master Fund SP shares) and a side pocket share class must be created accordingly to hold the illiquid exposure, such as Master Fund SP shares. This is to ensure proper accounting and liquidity management to match the Master Fund’s liquidity exposure, as the investor’s investment date is now critical in determining their exposure, performance and fees. When a feeder fund investor redeems (only from the liquid class, i.e. Class A shares), the feeder fund will redeem some of the liquid shares from the Master Fund to raise funds for the redeeming investor. The feeder fund’s SP shares (like the Master Fund’s SP shares) are non-redeemable.

Separate accounting for each side pocket and corresponding class is necessary to ensure that value is fairly distributed.

In this structure, investors in the offshore feeder fund receive matching exposure at the Master Fund level from both an accounting and legal perspective (a similar mechanism also exists for investors in the onshore feeder fund). This ensures that only actual liquid assets are sold at the Master Fund level to raise cash to pay redemptions at the feeder fund level.

Investors in offshore feeder funds will receive an investor statement reflecting their liquidity category and side pocket category so that they know what their total capital is and which capital is available for redemption.

Feeder Ltd. Investor Statement

This accounting treatment and proper structuring is not well understood by many managers and service providers. Close coordination between investment managers, legal advisors, fund administrators and auditors is essential to ensure the enforceability of structures and rights and compatibility with the terms of the offering documents.

Governance

Board of Directors – Good governance practice requires that a fund’s board of directors have an independent member, and should generally be a majority of independent directors, i.e., more independent directors than affiliated directors (e.g., the CEO and/or CIO). Typically, offshore funds have directors provided by firms specializing in such companies in the fund’s domicile. Where possible, it is best to have an independent director with real operating experience and expertise who can add value when dealing with complex operating issues – such individuals can also provide value in an advisory capacity rather than as a formal director.

For newly formed crypto funds, independent boards are becoming more common, but the costs associated with the directors are borne directly by the fund.

Side Agreements – A fund may enter into side agreements with certain investors to provide them with certain rights not directly set out in the fund’s offering documents. Side agreements should generally be reserved for large, strategic, and/or early investors in the fund. Side agreements may include clauses relating to information rights, fee provisions, and governance matters.

Regulatory Status

Funds are typically regulated by the local corporate or mutual fund laws of the jurisdiction in which they are located. In the U.S., even if a fund is exempt from registration with the SEC and the investment manager is not a registered investment adviser (RIA) under the Investment Advisers Act of 1940, the SEC and other regulators (such as the CFTC) may still conduct supervision and enforcement.

Emerging managers often choose to be treated as ERAs (Exempt Reporting Advisers), which have much lower reporting requirements. In the U.S., funds will be classified under the private fund categories under the Investment Company Act of 1940. Two common categories are 3(c)(1), which allows fewer than 100 investors, or 3(c)(7), which allows only qualified purchasers (individuals with $5 million in investable assets and entities with $25 million in investable assets). Many new funds choose to be 3(c)(1) because of the lower reporting requirements. However, managers must recognize that they may not wish to accept small subscriptions due to the limited number of investors permitted in order to manage this investor “budget” in terms of the number of investors acceptable to the fund.

Under the Securities Act of 1933, private funds may raise capital through Rule 506(b), which permits capital raising but prohibits broad solicitation, or through Rule 506(c), which permits broad solicitation but comes with heightened reporting requirements.

Establishing an entity generally requires retaining legal counsel in each jurisdiction, making appropriate filings, and ongoing maintenance and compliance.

In-Kind Subscriptions and Redemptions

A fund may choose to accept subscriptions from investors in crypto (in-kind).

In some cases, a fund may be permitted to pay redemptions in-kind - this is generally not ideal and may raise regulatory and tax issues as investors may not have the technical capability to custody assets or may not be permitted to hold crypto assets directly from a regulatory perspective.

In-kind subscriptions may raise valuation, tax and compliance issues. Typically, in-kind subscriptions are only accepted in BTC or ETH to avoid valuation issues. From a tax perspective, in-kind subscriptions may trigger a tax event for investors in the US, which needs to be considered. In terms of compliance, in-kind subscriptions will be wallet-to-wallet transactions, so the fund administrator and the fund agent accepting subscriptions should have the ability to perform appropriate KYC on the sending wallet address, and investors should also be aware of this. If the fund does accept in-kind subscriptions from investors, then when that investor redeems, best practice from an AML perspective is to pay the redemption amount in-kind equal to the in-kind subscription amount, with any profits paid in cash.

Key Person Risk

Key Person clauses allow investors to redeem outside the normal redemption window if a key person (e.g., CIO) becomes incapable or no longer involved in the fund – the inclusion of such clauses is considered best practice.

Case Studies

The following case studies highlight how choices made in the fund structure, and reflected in the offering documents, can lead to adverse or potentially disastrous outcomes for investors. These choices are understood to have been made by the respective managers with the best intentions, typically to achieve operational and cost efficiencies.

Side Pockets

A fund provides investors with side pocket exposure without creating a legally separate side pocket and only records the side pocket exposure for accounting purposes.

The manager and fund’s intent is clear and the accounting treatment is correct.

However, because no legal side pockets were created, investors in the fund are theoretically and legally able to redeem their entire balances—including both liquid and illiquid side pocket holdings—and are legally entitled to their entire balances under the terms of the fund documents.

Investors receive investor statements that do not reflect the side pocket categories (because none were created) and therefore may believe that their entire reported net asset value (NAV) is available for redemption.

If a large investor in the fund did make such a redemption within its legal rights, it would force the manager to liquidate illiquid assets on extremely unfavorable terms to the detriment of the remaining investors, and/or sell the fund’s most liquid assets, leaving the least liquid assets to the remaining investors and exposing the entire fund to the risk of collapse.

Ultimately, this issue was corrected with clear definitions provided in updated fund legal documents, the creation of formal and legal side pockets, and appropriate investor reporting.

Notably, this issue was discovered by L1D.

The fund’s manager, auditor, fund administrator, and legal counsel all considered the structure originally designed and implemented to be reasonable and appropriate. A further lesson is that even experienced service providers are not always right, and managers must acquire such expertise themselves.

Structural Design

The strategy in which L1D intended to invest was actually a share class of a larger fund (the “umbrella fund”) that offered various strategies through different share classes. Each share class had its own corresponding fee terms and redemption rights.

The umbrella fund was a standard master-feeder fund structure.

On the surface, this appears to be a way to spread out various strategies through a single fund structure in order to save costs and execution fees. However, one of the provisions in the "Risks" section reads:

Cross-class liability. For accounting purposes, each class and series of shares will represent a separate account and separate accounting records will be maintained. However, this arrangement is binding only between shareholders and not on external creditors who deal with the fund as a whole. Therefore, all of the assets of the fund may be used to satisfy all of the fund's liabilities, regardless of whether those assets or liabilities are attributed to any separate portfolio. In practice, cross-class liabilities will generally only arise in the event that a class becomes insolvent or exhausts its assets and is unable to satisfy all of its liabilities.

What does this mean? This means that if the umbrella fund is liquidated, the assets of each share class will be considered available to the umbrella fund's creditors, potentially wiping out the assets of each share class.

What happened? The umbrella fund ultimately failed due to poor risk management, leading to its collapse and liquidation, with the assets of each share class, including the specific share class that L1D had considered as an investment opportunity, being included in the bankruptcy estate. The fund and the assets of that share class subsequently became the subject of extensive litigation, leaving investors largely powerless and with no hope of recovery.

Failures in risk management at the investment level led to the collapse, and weaknesses at the operational/structural level led to further capital losses for investors who were not exposed to the actual failed strategy. An ill-considered structural decision, relatively blandly expressed in the PPM, led to large losses for investors under a stress scenario. The risk was effectively buried in the PPM as a key risk factor, albeit not intentionally hidden.

Based on this structure, L1D abandoned the investment during initial due diligence.

Accounting Leverage

The following case study provides a perspective on the risks involved when attempting to apply different strategies at the share class level rather than through separate funds with their own assets and liabilities. The narrative is very similar to the previous example – a failure to manage risk in the investment process, amplified by structural weaknesses.

The fund offered both leveraged and unleveraged versions of its strategy through share classes within a single fund.

The fund was a single pool of capital with all collateral held in a single legal pool with the fund’s counterparties – all gains and losses were attributed to the entire fund and the manager allocated gains and losses on an accounting basis based on share class leverage.

The fund’s strategy and corresponding risk management processes were changed without notifying investors, coinciding with a major market event that effectively wiped out the fund’s collateral with its counterparties, leading to a large liquidation.

Based on the leverage ratios defined at the share class level, investors in the non-leveraged share class would have expected larger losses, but not to be wiped out. Similarly, the cross-class liability risk expressed in the PPM communicated this risk, but was not well understood by investors in the non-leveraged share class.

The fund’s failure was a confluence of events – unannounced strategy changes and poor risk management, coinciding with market tail events, coupled with structural choices that meant that investors who intended to gain non-leveraged exposure were still subject to the application of leverage.

Delays in reporting of net asset value (NAV)

See the Service Providers section, Fund Administrators.

Operational Stack

The operational stack is defined here as the complete system of all functions and roles that a manager must undertake to execute its investment strategy. These functions include trading, treasury management, counterparty management, custody, middle office, legal and compliance, investor relations, reporting, and service providers.

In traditional finance (TradFi) trading activities, there are several dedicated parties ensuring secure settlement and ownership - the diagram below reflects the parties involved in US equity trading.

In crypto trading and investing, trading venues and custody form the core infrastructure as their combined functionality forms a parallel architecture to traditional financial settlement and prime brokerage models. Since these entities are at the core of all trading, all processes and workflows are developed around interacting with them. The diagram below illustrates the roles played by prime brokers and the services they provide.

In traditional finance, a key function of a prime broker is to provide margin, collateral management, and netting. This allows funds to achieve capital efficiency across positions. To provide this service, prime brokers can often rehypothecate client assets held in custody (e.g., lend securities to other clients of the prime broker).

While prime brokers play a key role in managing counterparty risk, prime brokers themselves are the primary counterparties to the fund and pose a risk in their own right. The rehypothecation mechanism means that client assets are loaned out, and if the prime broker fails for any reason, the fund's clients become creditors, as rehypothecation means that client assets are no longer the client's property.

In the crypto space, there is no direct counterpart to a traditional finance prime broker. Over-the-counter (OTC) desks and custodians are attempting to fill this role or aspects of it in different ways. FalconX and Hidden Road are two examples. However, given the discrete nature of cryptocurrencies – particularly where the underlying assets are located on different blockchains that are not necessarily interoperable – exchanges also have more limited reporting systems and operate in a variety of jurisdictions, the prime brokerage business in the crypto space is still evolving. Most importantly, the motivation for an entity to become a prime broker in the first place is to be able to rehypothecate client assets, which is an explicit aspect of its business model. Prime broker failures during the Global Financial Crisis (GFC) showcased the counterparty risk that prime brokers themselves pose to their hedge fund clients. This counterparty risk is amplified in crypto, given that brokers and exchanges are less capitalized, have less risk management oversight from regulators or investors, and are not bailed out in a crisis. This is further exacerbated by the inherent volatility of cryptocurrencies and the risk management challenges they present. These factors make it very difficult to apply the prime brokerage model of traditional finance to cryptocurrencies in a “safe” way from a counterparty risk perspective.

The prime brokerage model is useful in defining the operational stack of a crypto investment manager, as the manager takes on much of the functionality of a prime broker in-house, and/or assembles various functions across multiple service providers and counterparties. These roles and skills are often both internalized and outsourced, but given the nature of the service providers available in this space, much or even most expertise should be expected to be in-house, with the manager's own domain knowledge being critical.

Operational Stack of a Crypto Hedge Fund

Below are the main operational functions within a Crypto Hedge Fund (Crypto HF). It remains important to maintain a degree of separation between operations and investing/trading, which is typically addressed by a signed policy involving the movement of assets.

Middle/Back Office: Fund accounting, trading and portfolio reconciliation, Net Asset Value (NAV) generation – typically overseeing and managing fund administrators.

Financial Management: Managing cash and equivalents, collateral on exchanges, stablecoin inventory, banking relationships.

Counterparty Management: Due diligence on counterparties including exchanges and OTC desks, opening accounts and negotiating commercial terms with counterparties, establishing procedures for asset transfers and settlements between fund custody assets and counterparties, setting exposure limits to each counterparty.

Custody and Staking: Internal non-custodial wallet infrastructure, third-party custodians – including establishing whitelisting and multi-signature (“Multisig”) procedures, maintaining wallets, hardware and related policies and security regulations, and due diligence on third-party custody providers.

IT and Data Management: Data systems, portfolio accounting, backup and recovery, cybersecurity.

Reporting: internal reporting, investor reporting, auditing.

Valuation: developing and applying valuation policies.

Legal and Compliance: managing external legal counsel, internal policies and procedures, handling regulatory filings and other matters including AEOI, FATCA, AML/KYC, etc.

Service Provider Management: due diligence on service providers, review and negotiation of service agreements, management of service providers, with a focus on the administrator of the fund.

Operational Roles

Given the above operational functions and responsibilities, when considering the appropriate skillset for an operations staff member (typically a Director of Operations and/or a Chief Operating Officer), the necessary skill set should include experience in these areas and may also depend on the fund’s strategy and underlying assets. The experience required generally falls into two categories:

Accounting and audit – applies to all funds, but is particularly critical for funds with high turnover, numerous programs and complex share structures (such as side pockets).

Legal and structure – applies to funds trading structured products and strategies that include tax and regulatory components, typically some form of arbitrage.

In both cases, if there are gaps in an individual’s expertise, such as an accountant without a legal background, these gaps are often filled by an external party (such as legal counsel). However, it is important to note that fund administrators in this area – as discussed in more detail below – typically require a significant amount of supervision and management before launch and in the first 3-6 months after launch. Individuals with experience in fund operations, fund management or dealing with fund administrators, or accounting professionals, are often well suited to manage this process.

Best practice is for the investment manager to maintain a set of shadow records for the fund, effectively implementing a "shadow" system that corresponds to the records kept by the fund administrator. This enables three-way reconciliation between the investment manager, fund administrator and financial counterparties. The three-way reconciliation is performed at the end of the month to ensure that all records match consistently.

Overview of entities involved in fund operations

Asset life cycle

The flow of assets from fund subscription, trading to redemption demonstrates the functionality of the operations stack. The following generic lifecycle indicates the key points of the operation:

Investor subscriptions are transferred to the fund bank account

Investor subscription funds are transferred to the fund's investor bank account, and after passing the KYC/AML review, the funds are transferred to the fund's trading or operating account.

Fiat currency is transferred to the fiat currency gateway (exchange or OTC) and converted into (usually) stablecoins; typically, the fund administrator must be the second signatory for the transfer of fiat currency from the bank account.

Stablecoin balances may be held in exchanges and/or third-party custodians.

Investment Committee/Chief Investment Officer (CIO) decides on transactions/investments

Pre-trade approval is performed for compliance (e.g. personal trading policies) and/or risk management purposes.

Traders access liquidity through counterparties – exchanges or OTC – specify order types such as market orders, limit orders, stop orders, and may also include execution algorithms such as TWAP (time-weighted average price), VWAP (volume-weighted average price).

Interact with counterparties through APIs, portals, or chat tools such as Telegram.

If listed assets are traded on exchanges, stablecoin balances are used and the settled assets are transferred to a third-party custodian.

In OTC trading, some trades may require pre-funding, or the OTC desk may provide a certain credit line - the order is executed, settled, and then the assets are transferred to a third-party custodian.

In case of perpetual contract trading - collateral balances need to be maintained on the exchange and funding fees are paid regularly.

Clearing and settlement - transaction details are verified during trade settlement; once the trade is settled, the assets are transferred to a storage/custodian.

The investment team assesses the impact on exposure and risk parameters.

The operations team reconciles all positions daily - assets, account balances (counterparty, custodian, bank), prices, volumes, price references, calculates portfolio P&L; issues internal reports.

At month end, provide trade documentation and reconciliations to fund administrators

The fund administrator independently verifies assets and prices with all counterparties, custodians, banks - typically manually, via API, support from OTC desks (e.g. Telegram chats), and/or using third-party tools (e.g. Lukka), applies fee and expense provisions.

The investment manager works with the fund administrator to resolve differences in reconciliations and calculates the final Net Asset Value (NAV).

The fund administrator applies internal quality assurance (QA) processes to calculate fund NAV and investor NAV.

The fund administrator provides the final NAV to the investment manager for review and sign-off, and issues investor reports.

Investor submits redemption request

Invested assets are transferred from the custodian to the exchange/OTC, converted into fiat currency, and sent to the fund’s investor bank account.

After the NAV is approved

The fund administrator authorizes the payment of redemption proceeds to the redeeming investor.

Summarized Counterparty Fund Flow

This chart reflects the flow of funds depicted over the life of an asset.

Trading Venues and Counterparty Risk Management

Since the FTX debacle, the Fund has reevaluated its approach to managing counterparty risk, specifically whether to keep assets on any exchange and how to manage exposure to any entity that holds Fund assets at any time, including OTC desks, market makers, and custodians. Exchange custody is a form of custody (described in more detail in the Custody section) whereby an exchange holds customer assets that are commingled with the exchange’s assets and are not bankruptcy remote. Funds hold assets on exchanges because it is easier, less costly, and more capital efficient.

It is also worth noting that the agreements with OTC desks provide for delivery versus payment (DVP), whereby the customer pays before the assets are delivered. Furthermore, these agreements typically provide for such assets to be commingled with other customer assets, rather than segregated or bankruptcy remote. Therefore, there is still the risk of an OTC counterparty defaulting before the assets are delivered. During the FTX collapse, certain OTC desks themselves had unsettled customer trades with FTX. These OTC desks became creditors of the FTX estate and, despite having no obligation, chose to fully reimburse their customers using their own balance sheets. Formal underwriting of exchanges and OTC counterparties has been difficult as financial statements are not necessarily available and can be of limited use, although transparency is improving.

Methods for Counterparty Risk Management

In order to appropriately manage counterparty risk, an investment manager should have a policy that is compatible with its investment strategy. This may/should include defining:

The maximum exposure allowed to any counterparty.

The maximum exposure allowed to any counterparty type – exchange, OTC, custodial.

The maximum exposure allowed to any sub-category – qualified custodian vs. other.

The maximum time limit for trade settlement – typically measured in hours.

The proportion of fund assets that can be unsettled at any given time.

Other measures may be taken to monitor the health of counterparties, including periodically “pinging” a counterparty with small trades to test response times. If response times are outside normal ranges, the manager may move exposure away from that counterparty. Fund managers are known to continuously monitor market activity, news, and wallets of key players to identify unusual activity, get ahead of any potential defaults, and move assets.

DeFi Considerations

Decentralized exchanges (“DEXs”) and automated market makers (“AMMs”) can complement a fund’s counterparty coverage and, under certain conditions, can serve as alternatives. When certain centralized players experience distress, their DeFi counterparts perform relatively well.

When interacting with DeFi protocols, the fund transforms counterparty risk into smart contract risk. Generally speaking, the best way to cover smart contract risk is to size exposure in the same manner as defining counterparty exposure limits (as described above).

In addition, when interacting with DeFi protocols, there are access and custody considerations, which are covered in more detail in Section 6 - Custody.

Tripartite Structures

To manage counterparty risk associated with exchanges, several service providers have developed innovative approaches that implement tripartite structures. The solution detailed below has gained significant traction.

As the name suggests, there are (at least) three parties involved in this arrangement - the two parties transacting with each other, and a third party - the entity that manages the collateral in the transaction, typically a custodian. The third party will monitor and manage the collateral assets involved in the transaction.

A key feature of the structure is that the party managing the collateral maintains the assets in a legally segregated manner (typically a trust), protecting the parties to the transaction from the entity that manages the collateral and secures the structure.

In this structure, the entity managing the collateral ensures delivery and payment by both parties, and then settlement takes place.

As part of the process, excess collateral is posted or returned based on margin requirements, reports are provided to both counterparties, and assets are continually monitored to ensure they are sufficient to support financial transactions between counterparties.

Copper ClearLoop

Copper Technologies enables over-the-counter or in-custody settlement through its ClearLoop product. In this setup, both parties – the fund client and the exchange counterparty – effectively post collateral (such collateral is held in trust) to Copper, which acts as a neutral settlement agent on behalf of both parties. This protects the fund from the risk of an exchange counterparty defaulting, protecting the principal (collateral), but there is still a risk of profit or loss if the counterparty defaults before the (profitable) trade is settled.

Copper has been an early innovator in this setup, and has leveraged its custody technology and existing exchange integrations.

All other major custodians, including Anchorage, Fireblocks, Bitgo, Binance, are developing their own tripartite agreements using legal structures and technology, and/or may work with Copper.

Hidden Road

Hidden Road Partners (“HRP”) has developed a form of prime brokerage that provides capital efficiency and counterparty risk protection. HRP raises capital from institutional investors and pays them a return on capital, which is funded by financing trades for clients. HRP reduces its risk by setting risk limits and requiring partial collateral to be posted upfront. Clients can then hedge positions between trading venues.

Under this framework:

Funds do not need to post collateral to exchanges or trading partners.

Counterparty risk is transferred to HRP’s balance sheet.

Trades are recorded under ISDA and standard prime brokerage agreements.

Clients can margin trade their portfolios in different venues.

Financial Management - Fiat Currency and Stablecoins

In a Crypto HF, the financial management function is usually a combination of managing small fiat currency balances and stablecoin inventory. Once investor subscriptions are accepted, funds are usually converted into stablecoins through a fiat currency entry (exchange or OTC counter). Considerations for the financial management function are as follows:

Banking Partners

Stablecoins

Banking Partners

Given that most activities are conducted in cryptocurrencies, typically stablecoins, Crypto HFs typically maintain very low fiat currency balances. Nonetheless, all Crypto HFs will need to establish banking partnerships to accept subscriptions from investors, fund fiat-based payouts and pay service providers. The number of banking partners willing to work with crypto clients continues to grow, but the account opening process can be cumbersome from an Anti-Money Laundering (AML) and Know Your Customer (KYC) perspective, often taking months to complete.

Given that banks’ willingness to work with crypto clients may change depending on their respective risk appetite, funds should work with at least two banking partners to ensure redundancy. When Silicon Valley Bank, Signature Bank and Silvergate Bank collapsed, many funds lost their banking partners and were unable to reliably conduct certain operations, including funding redemptions that had been submitted and accepted before the collapse of these banks.

The account opening process requires a lot of documentation, which may be submitted through a portal or directly. From the bank's perspective, the goal of the process is to ensure that the client does not pose any risk in terms of AML and KYC. To this end, the bank will conduct due diligence on the fund structure, its ultimate beneficial owners (UBOs), controlling persons (such as directors), and investment managers. Funds and investment managers with more complex management and ownership structures should be prepared to explain the relationships between the various entities - it is useful to prepare an organizational chart for this purpose.

The following is a standard set of documents required by US banks for the onboarding process. These documents are fairly standard, but they themselves may contain up to 100 basic questions related to the fund's operations, the investment manager, all service providers, and potential investors. In addition, once the account is successfully opened, there is usually ongoing/annual compliance work, which may amount to a re-opening of the account.

Document requirements for bank partner account opening:

Account application form

Due diligence questionnaire

Certificate of incorporation – usually requires notarization or certification

Private placement memorandum

Articles of incorporation or limited partnership agreement

Financial statements

Directors list

Business register extract

Form W-BEN-E

Foreign Account Tax Compliance Act (FATCA) ID – Global Intermediary Identification Number (GIIN)

US Tax ID

Passport/Driver’s License of Account Signatory and Authorized User

Ultimate Beneficial Owner Proof

Passport/Driver’s License/Residence Proof of all Underlying Ultimate Beneficial Owners (UBOs, holding more than 10% or 25%)

Regulatory Registration Status

Service Agreements with Key Service Providers – Fund Administration, Compliance, Directors

Stablecoins

Stablecoins are integral to doing crypto trading. Stablecoins also present certain operational risks. Stablecoins themselves, especially USDT/Tether, are periodically subject to “panics” regarding regulation, reserve backing, depegging, and the possibility of redemptions being suspended (although this has never occurred). Therefore, it is wise to diversify your stablecoin inventory across multiple stablecoins.

Bank partners do not typically impose monthly minimum balance requirements, but also do not typically offer a full suite of services for small fund accounts, including the ability to purchase and hold US Treasuries. As a result, funds may choose other forms of stablecoins, including Ondo (a tokenized note backed by short-term U.S. Treasuries and bank deposits), or similar products offered by Centrifuge, including real world assets (RWAs). Stablecoin products with yields may have their own risks, and each stablecoin product should be structured with due diligence to properly understand these risks.

Custody

In the crypto space, the term "custody" is a metaphor because assets do not have a physical form, such as a stock certificate.

In traditional finance (TradFi), custody is identity-based, where the custodian acts as an agent for the ownership of physical assets of individuals and companies. In crypto, the custodian acts as an agent for access and control of private keys.

There are multiple types of custody for cryptocurrencies, and the appropriate form of custody is often determined by the investment strategy of the trading assets and trading frequency. It is likely that multiple types of custody will be implemented simultaneously.

Where the policy permits, the use of a third-party custodian is considered preferred as they provide multiple levels of redundancy and are generally scalable. In addition, as discussed in Section 4, custodians may be able to extend their technology to support three-party arrangements. A rigorous due diligence process should be applied when selecting a third-party custodian. In some cases, some form of self-custody may be required - this may include the use of hardware wallets and/or smart contract multi-signature wallets.

Custody Policy

It is important to understand the technical differences between the various types of custody, and the top custodians’ offerings each implement several industry-standard security architectures. Existing crypto custodians have a fairly good track record, with no major losses, either systemic or individual, and have weathered the various crises that have characterized the industry. In fact, custodians have benefited from these crises, as investors now place increasing value on third-party custodians.

Each fund strategy is different, and a complete custody setup may include multiple forms of custody to meet the full needs of the strategy. This process should lead to the creation of a practical custody policy that considers the following factors:

Traded assets: Not all custodians support all assets, and ensuring comprehensive asset support may mean working with multiple custodians.

Trading frequency: Strategies that implement relatively high-frequency trading may retain a portion of fund assets on exchanges; however, there are now third-party custodians using MPC architecture that also support relatively fast access to assets.

Diversification and Limits: As with counterparty management, a similar approach can be applied to custody – such limits will typically apply to the allocation between custody types – third-party custody, exchange custody and self-custody.

Investor Preferences: Some institutional investors may prefer or require that a majority of a fund’s assets be managed by a regulated third-party custodian. However, it is ultimately up to the manager to decide on the best approach on behalf of investors.

Internal Resources: For teams whose strategies require the use of self-custody, those teams should have the necessary technical expertise and/or access to establish appropriate operational security programs to ensure that hardware and recovery phrases are properly safeguarded. The same is true for teams that rely primarily on third-party custodians – there needs to be a secure and practical way to back up seeds and recovery phrases.

Recovery Protocols: In all cases, managers must have protocols in place for the recovery of private keys, seeds and recovery phrases in the event of a catastrophic event, including the incapacitation of key personnel. These protocols typically involve a combination of technical and legal measures, including the use of safes and other forms of physical security, and the designation of a third-party legal agent to act on behalf of the fund in the event of a disaster.

Access Control: Determine who within the manager, under what circumstances, and by what method, can create whitelisted addresses, access assets, and move/withdraw assets from custody - this includes defining 2FA methods, use of smartphones, and quorum requirements for multi-signature wallets.

Segregation and Control of Assets: When working with any third party (exchange, custodian, or other counterparty), it is important to understand the extent to which assets are legally segregated and belong to the fund, and the fund’s legal recourse if the counterparty fails.

Third-Party Oversight: When working with third parties, it is important to understand the extent to which they are subject to oversight by auditors and/or regulators.

Regulatory Considerations: Funds may have their own regulatory considerations. A US-based manager may not be able to use certain custodians in Europe or other regions and, if they wish to do so, will need to design and implement a management and ownership structure that allows this.

Redundancy: Redundancy of key services is preferred, but not always possible. There is a certain amount of overhead and cost involved in opening and maintaining an account with a third-party custodian that may not be worthwhile for a newly launched manager, but redundancy should be considered where feasible.

The primary consideration in selecting a custodian is, by definition, security. Ultimately, the nature of the strategy's underlying assets and the frequency of trading will determine the custody method and custodian. For more complex strategies involving multiple trading styles and sub-strategies, multiple custody methods and custodians may be selected.

Below is a detailed breakdown of the pros and cons of the four main custody categories:

Self-custody

Browser-based, software, cold wallet/hardware/offline.

Broad asset support, greater control.

Secure, but requires a very good framework with multiple layers of redundancy, coordination, and technical knowledge.

Usually used for assets that have no third-party backing.

Non-custodial

Smart contract custody/multi-signature wallets: assets are stored in smart contract wallets created and managed by the user (e.g. EVM’s Safe, Solana’s Squads).

More suitable for low-turnover strategies, not for strategies with a higher transaction frequency, as moving assets between wallets is more operationally complex.

Non-custodial

Smart contract custody/multi-signature wallets: assets are stored in smart contract wallets that are created and managed by the user (e.g. EVM’s Safe, Solana’s Squads).

More suitable for strategies with low turnover, not those with a higher transaction frequency, as moving assets between wallets is more complex operationally.

May involve use of hardware to access non-custodial wallets.

Third-party custody

Institutional grade.

Clearly defined capabilities and controls.

May have some compliance/light regulatory status, such as qualified custodian, and subject to SOC audits; others (such as Anchorage) have been placed under the supervision of the Office of the Comptroller of the Currency (OCC); may be insured to a limited extent.

Assume responsibility for assets, services, and manage complex technology.

Sub-custody, institutional investors can outsource custody operations to a custodian in a pooled account or segregated account setting (the custodian is unaware of the end investor).

Can be warm wallets, hot wallets, cold wallets (see below).

The following table provides a high-level overview of the characteristics of each wallet type.

Third-party custodians

These custodians are usually the most technologically advanced, providing a complete custody infrastructure and corresponding workflow. Third-party custodians are considered to hold both the keys (or part of the key material) and the assets themselves. Third-party custodians generally adopt two architectures:

Multi-party computation (MPC)

MPC is a method of combining key fragments to sign transactions. MPC is used when a client wishes to hold a portion of a private key (a “shard” or “share”) in addition to the portion held by the custodian. This prevents the custodian from abusing the key, making it virtually impossible to steal the key from any party, but also increases the overall responsibility for the safekeeping of the key. MPC implements a custody solution where the multi-signature requirement replaces the need to store private keys offline. Shards are geographically and architecturally distributed.

Hardware Security Module (HSM)

HSMs are hardware that allows for secure and controlled decryption of private keys. Private keys are generated on the device and cannot be extracted without destroying the device - they are never exposed, copied or hacked, even to the device holder. HSMs are often promoted as a better way to “cold storage” because they allow for faster decryption of private keys, resulting in more real-time access to assets. The biggest potential disadvantage of HSMs is that keys are held in a single central location and could be used to sign transactions that should not be signed - thus requiring custom business logic and requiring biometric authentication.

This article does not advocate the merits of MPC vs. HSM when choosing a third-party custodian provider. To date, both have been relatively well-tested and have demonstrated adequate security. In fact, an MPC custodian can store each shard in an HSM module, so the technologies are complementary.

Opening an Account with a Third-Party Custodian

Working with a custodian requires negotiating a custody agreement, conducting a comprehensive AML/KYC process, and creating a custody vault. The security measures for interacting with the custody vault are a combination of the policies of the custodian and the investment manager, and can form the basis for the security of assets in investment management operations. The technical and security aspects of working with a custodian typically involve the following steps and processes:

Access and authentication: Setting up secure access to the custodian's platform. This may involve creating strong passwords, enabling two-factor authentication (2FA), defining access controls for authorized personnel, enabling biometrics and video call-backs.

Testing and validation: Testing the deposit and withdrawal process with small amounts of funds to ensure everything is smooth before processing larger holdings.

Security training: The custodian may provide training on how to use its platform securely, including best practices for protecting login credentials and managing assets.

Asset transfer: Transferring digital assets to a wallet or address designated by the custodian. This may involve a one-time transfer or a gradual transfer.

Create Whitelists and Whitelist Creation Policies: Develop internal policies for who can create and approve whitelists; create whitelist addresses and test them.

Specify Transaction Permissions: For each whitelist address, specify the types of transactions that are allowed. Common permissions include:

Deposits: Allow funds to be deposited into whitelist addresses.

Withdrawals: Allow withdrawals from whitelist addresses. Set internal withdrawal permissions.

Transfers: Allow transfers between whitelist addresses and other addresses within the custody solution.

Regulatory Status

More established custodians will typically seek some form of regulatory oversight in the jurisdictions in which they operate. This is positive, as such oversight is often accompanied by requirements, including undergoing a third-party controls audit, such as a SOC or ISAE (International Standards on Service Organization Controls and Assurance Engagements). These audits assess and test the organization’s internal control framework. Such audits do not guarantee that the custodian is necessarily suitable for the fund, or is a well-run business, and most importantly, do not mean that security is guaranteed. But these audits do provide some comfort that the custodian has a consistent internal control environment.

In the United States, a custodian may seek qualified custodian status granted by the SEC, or become a state-chartered trust company. In both cases, such custodians are permitted to provide custody services that comply with the SEC's custody rules so that they can act as a custodian on behalf of registered investment advisors (RIAs). RIAs often choose to work with qualified custodians or state-chartered trust companies, but they are also increasingly working with MPC providers that are not actually qualified custodians, which RIAs and their legal counsel believe is justified in order to operate their funds in a fiduciary manner that best matches their investment strategies. Fireblocks is one such MPC provider, and recently launched the Fireblocks Global Custodian Network to address this issue. Fordefi is another similar MPC provider.

Institutional Grade Third-Party Custodians

There are a number of institutional grade players, each of which should be properly due diligenced and selected on their merits. The following institutions are relatively well-known brands, each with their own unique characteristics.

Coinbase Custody

Perhaps the best known custodian, Coinbase is a New York State chartered trust company (with a similar structure in Ireland for European clients). As a public company, it is considered a relatively good business risk, although customer assets are segregated, cannot be rehypothecated, and are subject to the strict scrutiny of public company reporting requirements.

Anchorage Digital

Anchorage is an HSM-based custodian. It is also a (US) nationally chartered qualified custodian, supervised by the Office of the Comptroller of the Currency (OCC), and has a limited banking license. Anchorage seeks to position itself as the most regulated digital asset custodian in the US.

Copper Technologies

Copper is a UK based custodian (now licensed in Switzerland). Copper is an MPC based custodian and has innovated with its Walled Garden custody solution. The Walled Garden solution enables funds to easily and quickly move collateral within the confines of whitelisted exchanges, but withdrawals are not permitted outside of Walled Garden without multi-layered certification. Copper leverages its custody technology to power its ClearLoop product.

Fireblocks

Fireblocks is an MPC based infrastructure provider that is not considered a custodian as it is not mandated to safeguard client assets, but rather their private keys, and therefore cannot obtain a US federal or state charter to become a custodian. However, it is in fact a custody provider as it offers multi-signature wallets and a secure transfer network.

Fordefi

Fordefi is an MPC-based infrastructure provider and a relatively new player but has quickly gained traction, especially among funds active in the DeFi space and those with shorter trading holding periods. Similar to Fireblocks, it is not considered a custodian as it is not authorized to safeguard customer assets, but rather their private keys, but is in fact a custody provider as it offers multi-signature wallets and a secure transfer network.

Staking

Many investment strategies involve staking assets to earn a yield.

The core service of a staking provider is to provide staking services to a Proof of Stake (PoS) blockchain. Staking occurs when the owner of a PoS token delegates their tokens to a validator, also known as a staking provider. Validators run software that is hosted in the cloud or on bare metal servers. This software maintains a complete record of the state of the blockchain and contains complex rules for how validators should operate. Established players in the staking space include Figment, Coinbase, and Blockdaemon, and these services are fairly commoditized.

The operational considerations for staking are fairly simple. Assets are held in custody by a third-party custodian, who then delegates the assets to be staked to a third-party staking provider. If some assets are stored in a non-custodial wallet, they can also be similarly delegated to a third-party staking provider. In this case, the assets never "leave" custody, and the staking provider can only use the assets to validate the network. The risk posed by a staking provider is that it is technically impossible for a staking provider to fail to properly validate due to a malfunction or downtime, resulting in a slashing of rewards without resulting in a loss of assets. Nevertheless, staking providers should also be subject to similar due diligence as third-party custodians, although as mentioned earlier, the failure of a staking agent does not result in a loss of assets, which remain under the control of the custodian.

Essentially, each asset has two management keys - a transfer key (which transfers assets from one party to another) and a staking/validation key, which only participates in the proof-of-stake mechanism. These two keys can be custodied independently as they are different and cryptographically unrelated.

Due Diligence and Assessment of Third-Party Custodians

A proper review of a custodian involves examining its operations in a number of categories. Such information is typically contained in the due diligence questionnaire, SOC/ISAE report, and account agreement.

Asset backing

Tokens, forks, airdrops, staking, governance, lending

Security and controls

Internal security measures

Access control and fraud prevention

Network security and disaster recovery

Key generation and management

Terms

Segregation of customer assets and bankruptcy remoteness

Contractual obligations

Tripartite agreement support and integration

Business

Trade Record

Financial Strength and Balance Sheet

Customer Support

Technology

Asset Custody Methods

Authentication Methods/MPC/2FA/Biometrics

Accessibility – Time Required to Retrieve and Move Assets

Regulation and Compliance

AML/KYC – Customer Onboarding Practices

Third Party Oversight – Regulators, Auditors

p>Background Checks

Reporting

Net Asset Value (NAV), Balance Transfers, Orders

Service Provider Support

Permissions and Access to Fund Administrators, Auditors

Segregation of Client Assets

The following is an excerpt from a custody agreement with a globally recognized institutional custodian, demonstrating clear language that specifies segregation and rehypothecation of client assets. All custody agreements should contain similar language.

Account Agreement Excerpt

Self Custody – Key Generation and Management

The key generation process applies to both self-custody and third-party custodians. The process described below is a comprehensive framework for creating a self-custody wallet. Smaller teams need to consider available resources to create an asset retrieval process that is both efficient and practical, with secure redundant recovery mechanisms.

Participants

Security

Access Control – Logging, Cameras

Employee Background Checks

“Four Eyes Principle” for Key Generation

No single person controls the end-to-end process

Separation of Duties and Independence – Prevents Collusion

Multiple Drills and Training

Redundancy

Audit Process – Carefully selected external review to provide independent assurance, external participants at key generation ceremony

Sharding and safekeeping of keys/seed phrases:

Master seed split into multiple components and stored in a decentralized manner; N out of M combinations, requiring a minimum quorum to recreate/recover

Split into independent components for storage, using Shamir secret sharing, shards are geographically decentralized and securely stored

Shamir secret sharing or equivalent method - so that keys can still be recovered if a shard is lost or damaged

Pre-contractually agreed resolution process, using an independent third party; requester/retriever are different parties

Recovery seeds are written down and stored offline in a secure location, which should be separate from the location of the hardware wallet; multiple parties should be involved in storing and accessing the recovery phrase to ensure that there is no key person risk

For DeFi Considerations

Given the nature of interactions with decentralized exchanges (DEXs), custody is applied differently.

Funds typically interact with DEXs and DeFi protocols directly using MPC providers and/or MetaMask Institutional (MMI). Copper offers a DeFi solution that is gaining acceptance, and Fordefi has designed its services to make DeFi more accessible with institutional-grade security.

MetaMask Institutional allows access to assets in cold storage without first transferring assets to a hot wallet (i.e., using a browser extension).

For Copper, Copper offers its own version of the software, similar to MetaMask, that integrates with Copper’s custody library.

Service Providers

The crypto space offers a growing number of options in terms of key service providers, including fund administration, auditing, legal counsel, and corporate services. This section will focus on these service providers, as they are essential to starting and managing a Crypto HF, just as the custodians described in the previous section. This section ends with a summary of other services in the space, which are numerous and, as mentioned at the beginning, it is beyond the scope of this article to provide exhaustive coverage of all of them. The use of other services depends largely on the investment strategy, the skills available to the manager, and economic factors.

Many established service providers in the traditional finance (TradFi) space are expanding their service offerings to serve the crypto space – especially audit firms with global operations. However, their experience and expertise in digital assets is still developing. In fund administration, the options are more limited, with only a few relatively established firms serving the space. The most important factors in selecting a service provider are their accumulated experience with digital assets, fund accounting systems, technical expertise, reputation, and customer service.

It is natural to rely on the advice and expertise of a service provider – but managers must also take responsibility for their own processes, as the guidance provided by service providers is not always correct and the severity of the consequences can vary. The lack of competition in the space itself presents risks that managers need to be aware of.

Fund Administrators

Fund administrators are arguably the most important third-party service provider, and the one with the fewest high-quality options. Fund administrators effectively sit between investors and funds and are independent by definition. After the fund administrator has been vetted and hired, the onboarding process and initial phase of the relationship after launch (i.e., up to 4–5 months) requires significant oversight and management, so it is important to have experienced operations staff or hire these separately.

Fund Administrator Functions Include:

Valuation and Pricing: The fund administrator calculates and verifies the net asset value (NAV) of the hedge fund. This involves the valuation of the fund’s assets, which may include a wide range of financial instruments, cryptocurrencies (spot and vested), derivatives (such as perpetual contracts, futures), equities, liquidity pools, private agreements, returns on staked assets, interest-bearing and non-interest-bearing stablecoins.

Accounting and Financial Reporting: Maintaining the fund’s accounting records, including tracking income, expenses, gains, and losses. The fund administrator generates financial statements and reports for investors, ensuring compliance with accounting standards and regulatory requirements.

Transfer Agent: Verifies and manages the allocation of fund units.

Investor Services: Interact with investors, process subscriptions, redemptions and transfers, and provide support for investor enquiries, calculate investor share values and prepare investor statements for distribution.

Compliance and Regulatory Reporting: Assist in ensuring that the fund complies with relevant regulations, including Anti-Money Laundering (AML) and Know Your Customer (KYC) requirements, as well as AEOI (Automatic Exchange of Information). They prepare and submit reports to regulators as required.

Reconciliation: Reconcile the fund's records with those of brokers, counterparties and other service providers to identify any discrepancies in transactions, settlements and cash positions.

Fee Calculation: Calculates management and performance fees based on the fund’s performance and fee structure.

Audit Support: Works with external auditors to provide documentation and data required for financial audits.

Technology and Reporting: Often provides access to software and reporting systems that enable fund managers to monitor their funds’ performance and policy compliance.

Data Management: Maintains and protects sensitive data, including transaction data, investor information and financial records.

It’s important to note that the reputation of a fund administrator is important, but it’s also useful to focus on the service team assigned to a fund account when conducting due diligence and managing the relationship, and consider the experience of fund investors from the perspective of receiving investor statements and formal communications from the fund – something that is often overlooked when opening an account for a fund administrator or transitioning to a new fund administrator.

Reconciliation

When dealing with crypto hedge funds, fund administrators often experience difficulties with portfolio reconciliation and pricing, which can result in a delay in providing formal NAVs to investors in a timely manner (typically within 30 days of the end of any given month). It is important that fund administrators are able to reconcile and price portfolios independently of investment managers. This requires accessing and processing data from the following sources:

Trading venues and counterparties

Custody providers

Banking partners

Blockchain

DeFi (decentralized finance) pools

As this data is not usually available in a uniform manner, and blockchain transactions read from the underlying chain (e.g., Etherscan and other block explorers) do not necessarily reflect discrete transactions, reconstructing the flow of transactions that led to the month-end balance of a wallet address can be complex. Doing this accurately, in a timely, scalable, and highly automated manner has proven difficult for even some of the most sophisticated fund administrators.

The lack of certain standards has led to accounting and auditing issues in the past, including:

There are no accounting standards specific to DeFi processing, which may create valuation issues.

Processing LP (liquidity provider) positions on DEXs (decentralized exchanges).

Recording staking rewards as capital gains vs. income.

DEXs do not provide API access for independent reconciliation, so block explorers must be used.

The conclusion drawn from this lack of standards is that managers must explain the nature of the investment strategy to fund administrators during the onboarding process and on an ongoing basis and ensure that the administrators' approach is consistent with audit standards, hence the need for input from the fund's auditors.

Some fund administrators have built in-house systems. Many use a tool called Lukka, a provider of technology and data services for mid- and back-office crypto asset processing. This is a crypto-native product that connects, standardizes, reconciles, processes and reports auditable information. It does this by automatically connecting to collect data from all exchanges, wallets, blockchains and accounts (e.g. bank accounts) that the fund interacts with.

Service Providers

The crypto space offers a growing number of options in terms of key service providers, including fund administration, audit, legal counsel and corporate services. This section will focus on these service providers, as they are essential to launching and managing a crypto hedge fund (Crypto HF), just as the custodians described in the previous section. This section ends with a summary of other services in the space, which are numerous and, as mentioned in the opening, it is beyond the scope of this article to provide an exhaustive coverage of all of them. The use of other services depends largely on the investment strategy, the skills available to the manager, and economic factors.

Many established service providers in the traditional finance (TradFi) space are expanding their service offerings to serve the crypto space - especially audit firms with global operations. However, their experience and expertise in digital assets is still developing. In fund management, the choices are more limited, with only a few relatively mature firms serving the space. The most important factors in choosing a service provider are their accumulated experience with digital assets, fund accounting systems, technical expertise, reputation, and customer service.

It is natural to rely on the advice and expertise of a service provider - but managers must also take responsibility for their own processes, as the guidance provided by service providers is not always correct and the severity of the consequences can vary. The lack of competition in the space itself poses risks, and managers need to be aware of this.

Fund Administrators

Fund Administrators are arguably the most important third-party service provider and the one with the fewest high-quality options. Fund Administrators effectively sit between investors and funds and are independent by definition. Once the Fund Administrator has been vetted and hired, there is a lot of oversight and management required during the post-launch onboarding process and initial phase of the relationship (i.e., up to 4-5 months), so it is important to have experienced operations staff or hire these separately.

Fund Administrator’s Functions Include:

Valuation and Pricing: Fund Administrators calculate and verify the Net Asset Value (NAV) of the hedge fund. This involves valuing the fund’s assets, which may include a wide range of financial instruments, cryptocurrencies – spot and vested, derivatives (e.g. perpetual swaps, futures), equities, liquidity pools, private agreements, returns on pledged assets, interest-bearing and non-interest-bearing stablecoins.

Accounting and Financial Reporting: Maintaining the fund’s accounting records, including tracking income, expenses, gains and losses. Fund Administrators generate financial statements and reports for investors, ensuring compliance with accounting standards and regulatory requirements.

Transfer Agent: Verify and manage the allocation of fund units.

Investor Services: Interacting with investors, processing subscriptions, redemptions and transfers, providing support for investor inquiries, calculating investor unit values, and preparing and distributing investor statements.

Compliance and Regulatory Reporting: Assists in ensuring that the fund complies with relevant regulations, including Anti-Money Laundering (AML) and Know Your Customer (KYC) requirements, as well as Automatic Exchange of Information (AEOI). They prepare and submit reports to regulators as required.

Reconciliation: Reconciles the fund's records with those of brokers, counterparties and other service providers to identify any discrepancies in transactions, settlements and cash positions.

Fee Calculation: Calculates management fees and performance fees based on the fund's performance and fee structure.

Audit Support: Works with external auditors to provide the necessary documentation and data required for financial audits.

Technology and Reporting: Typically provides access to software and reporting systems that enable fund managers to monitor their fund's performance and policy compliance.

Data Management: Maintains and protects sensitive data, including transaction data, investor information and financial records.

It is important to note that the reputation of a fund administrator is important, but it is also useful to focus on the service team assigned to the fund account when conducting due diligence and managing the relationship, and to consider the experience from the perspective of fund investors receiving investor statements and formal communications from the fund - something that is often overlooked when onboarding an account with a fund administrator or transitioning to a new fund administrator.

Reconciliation

When dealing with crypto hedge funds, fund administrators often experience difficulties with portfolio reconciliation and pricing, which can result in the inability to provide formal net asset values (NAVs) to investors in a timely manner (usually within 30 days of the end of any given month). It is important that the fund administrator is able to reconcile and price the portfolio independently of the investment manager. This requires access to and processing of data from the following sources:

Trading Venues and Counterparties

Custody Providers

Banking Partners

Blockchains

DeFi (Decentralized Finance) Pools

Reconstructing the flow of transactions that led to the month-end balance of a wallet address can be complex, as this data is not often provided in a uniform manner, and blockchain transactions read from the underlying chain (e.g., Etherscan and other block explorers) do not necessarily reflect discrete transactions. Doing this accurately, timely, scalably, and with a high degree of automation has proven difficult for even some of the most sophisticated fund administrators.

The lack of certain standards has led to accounting and auditing issues in the past, including:

There are no accounting standards for DeFi processing, which may create valuation issues.

Processing of LP (liquidity provider) positions on DEX (decentralized exchanges).

Record staking rewards as capital gains vs. income.

DEXs do not provide API access for independent reconciliation, so block explorers must be used.

The takeaway from this lack of standards is that managers must explain the nature of the investment strategy to fund administrators during the onboarding process and on an ongoing basis, and ensure that the administrators’ approach is consistent with audit standards, so input from the fund’s auditors is required.

Some fund administrators have built in-house systems. Many use a tool called Lukka, a provider of technology and data services for mid- and back-office crypto asset processing. This is a crypto-native product that connects, standardizes, reconciles, processes, and reports auditable information. It does this by automatically connecting to collect data from all exchanges, wallets, blockchains, and accounts (e.g., bank accounts) that the fund interacts with.

Compliance, Policies and Procedures

Regulatory risk is one of the biggest risks facing the crypto industry, which is rife with potential conflicts of interest and dubious or even bad actors who exploit crypto features for their own benefit to the detriment of investors and the public. Against this backdrop, managers in the crypto space must adopt an ethical approach that is institutionalized and transparent through a culture of compliance, as well as appropriate and well-documented policies and procedures. This will not only help the industry grow, but also make funds more attractive to institutional allocators. In addition, developing and adopting sound practices is also a means to improve efficiency and scalability.

From a US perspective, funds will not reach the asset under management (AuM) threshold required to register as a registered investment adviser (RIA) with the US Securities and Exchange Commission (SEC) for several years. However, given the intense scrutiny of cryptocurrencies around the world, it is recommended that investment managers adopt a posture as if they were regulated, or lay the foundation for registration with the SEC by implementing a sound policy framework.

Such a posture involves adopting a set of internal policies and procedures that clearly articulate the inherent operational risks associated with the fund’s investments and how those risks are managed. The rest of this paper sets out policy frameworks for custody, counterparty management and valuation, which are the basic starting points for policies covering all aspects of operations (see below).

It is unlikely that a newly established investment manager will need a compliance officer, but this is within the purview of the individual leading operations. Depending on the strategy and other unique characteristics of the investment manager, external legal counsel and compliance experts may be helpful. Cost is also a factor, and if such external advice directly benefits the fund, it may be a reasonable fund expense, otherwise such expenses are generally borne by the investment manager.

Policies and Procedures

For a newly established fund, creating a large mound of paperwork may seem redundant, but the goal is to truly reflect on the risks and complexities associated with operations and establish processes that promote good governance, efficiency and scale. Providing transparency to investors about the process is also critical to building trust and accountability.

A minimum set of policies should include:

Counterparty risk policy – includes exposure limits as described in the “Trading venues and counterparty risk management” section.

Custody policy – covers all matters related to all forms of custody, including self-custody, exchange custody, smart contract/multi-signature custody and third-party custody – as described in the “Custody” section.

Security policy – physical (office) security, network security, password management, background checks, disaster recovery and business continuity.

Compliance policy – covers personal account trading, insider trading.

Conflict of interest policy – covers outside business activities and relationships that could be interpreted as creating a conflict and aligning the interests of the investment manager and investors.

Valuation policy – the framework for determining how assets are valued – determined by the investment manager and implemented by the fund administrator. When a fund invests in illiquid assets (such as SAFTs held in side pockets), there are special valuation considerations given the potential for performance fees to be charged once the holdings become liquid. In addition, illiquid holdings may be valued upwards, increasing the basis for management fees. Valuation policies for illiquid assets and side pockets should consider the following:

Holding positions at cost until a verifiable catalyst occurs, i.e., completed financing round, OTC transaction, etc.

Applying a discount for lack of market liquidity – the illiquidity haircut.

Apply a discount for lack of market liquidity – comparable investments (e.g. same assets with different lock-up periods).

Exchange liquidity – to determine if there is genuine trading interest, review the 30-day average volume on trusted exchanges compared to the number of vested tokens.

Regulatory setup

Most funds are likely to face US offshore counterparties and will therefore execute trades through an offshore (i.e. Cayman Islands or BVI) master fund. However, offshore counterparties are becoming increasingly strict when opening accounts for funds with US ultimate beneficial owners (UBOs) somewhere in the structure, such as at the investment manager level. US-based managers must therefore consider structures that may involve a sub-advisor appointed by the investment manager, who is formally responsible for the management of the portfolio. This may involve hiring a third party to manage the sub-advisor and/or hiring someone locally (e.g. in an offshore jurisdiction) and potentially implementing some form of economic substance to create a structure that complies with strict anti-money laundering (AML) and know your customer (KYC) account opening requirements.

Typically, legal advisors and professional service providers are responsible for managing all local regulatory matters related to the establishment and registration of fund entities in their respective jurisdictions.

As mentioned in the Service Providers section, AML/KYC processes and representation are usually implemented by the fund administrator in accordance with local (jurisdiction) laws and may be performed by local representatives.

Systems

The systems that support operations in the crypto space are at different stages of maturity, and no system has yet become a universally adopted standard, but some interesting players have emerged. As mentioned in Section 7 Service Providers, the team planning to launch a fund usually has a high level of technical expertise.

The key data related to operations mainly concerns portfolio reconciliations, as mentioned in the section on fund administrators in the Service Providers section. When reviewing fund administrators, it is important to understand the tools they use and how they use them, with an emphasis on the degree of automation and systematization of processes and the implementation of quality controls. A high-quality fund administrator should have a qualified internal technical team that can interface with the counterparty API interface (if available), and is proficient in reading block explorers and using dashboards that interface with DeFi pools.

In traditional finance, there is usually an integrated technology stack, usually provided by a prime brokerage platform and supports some form of straight-through-processing. This stack usually includes:

Portfolio Management System (PMS)

Order Management Systems (OMS)

Execution Management Systems (EMS)

Data Aggregation Platforms (for operational, not analytical)

Integrated Accounting Systems

In addition, the quality of information provided to clients by trading venues and custodians varies widely, but is gradually improving.

In the crypto space, there are several platforms that offer different versions of PMS, OMS and EMS, typically focusing on liquidity aggregation through multi-asset trading infrastructure, connecting funds, brokers, OTC desks, lenders, custodians, exchanges and retail platforms, managing the entire trading lifecycle from price discovery to settlement, including:

Pre-trade process - price discovery, liquidity aggregation

Trading and execution - multi-dealer request for quotation (RFQ), order management

Post-trade - settlement integration

Analytics and reporting

Players in this space include Talos, CoinRoutes, Elwood and Liquid Mercury.

These platforms are excellent, but it is often difficult for new managers to justify their costs, and depending on the strategy, these platforms will only add value after the operation is truly scaled. Additionally, these platforms may be better suited for systematic strategies rather than strategies focused on fundamental asset selection.

New managers should also be aware of certain systems that service providers and counterparties use for onboarding and compliance purposes. These products include Chainalysis, TRM Labs, and Elliptic. These platforms have become infrastructure in the crypto ecosystem for customer verification, wallet anti-money laundering (AML), and transaction monitoring. New managers are unlikely to need these systems directly, but may be exposed to them indirectly when onboarding financial counterparties.

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