IASG Fund Service’s Brett Ladendorf participated in Sudrania’s Cryptocurrency Webinar Series last month. A transcript of Brett’s Q&A is provided below.
A Cryptocurrency Webinar Series: Investor Perspectives: Regulation and Oversight
September 16th, 2020
Lisa Vioni, CEO, Hedge Connection
- Mitchell Dong, Managing Director, Pythagoras Investment Management
- Brett Ladendorf, Managing Director, IASG Fund Services
- Jason Urban, CEO at DrawBridge Lending
- Nicole Kalajian, Attorney, Stradley Ronon
- Nitin Somani, Co-Founder, Sudrania Fund Services
Overview: Even as crypto is rising in interest as an investment, the confusion over how custody, auditing, and valuation are done presents a stumbling block. This panel looked at how technology and fund structuring know-how is being put to work today in easing investors’ concerns over fund managers’ effectiveness in creating and maintaining an institutional-grade portfolio.
The following questions were posed to Brett Ladendorf:
- What are common concerns investors have with putting money into crypto funds?
- What can investors do to learn about the industry and ecosystem in cryptocurrency?
- What are managers doing to build cryptocurrency platforms and why should investors care?
What are common concerns investors have with putting money into crypto funds?
A 2020 Fidelity institutional investor survey polled 774 parties to find top concerns or obstacles for digital asset adoption. [i] At the top was price volatility with concerns for market manipulation a distant second. Myriad concerns followed closely behind market manipulation. It is important to note that the percentage of respondents that named concerns for volatility and market manipulation fell 13 and 6 percentage points respectively from 2019 levels.
We spent much time researching custody service providers as initial contacts have conveyed concerns in this area. Pinpointing asset location, on or off exchange, at any given time of the day is critical for security and administrative reasons. An owner may need to liquidate. A fiduciary will need to have a net asset value struck by the fund administrator. Technologically advanced custody solutions may be difficult for anyone to understand. However, from an investor standpoint, it will become easier to control what company performs this service. In the Fidelity survey, this concern has declined as independent technology providers in the marketplace have focused on this node in infrastructure since 2015.[ii]
Volatility and market manipulation may remain top obstacles. Marginal entrants into a digital marketplace may stay away because of these and other reasons listed in this highly referenced survey. The top issues are common to traditional markets where IASG has conducted business for nearly 30 years. Intermediaries may self-deal, not adhering to ethical standards established and enforced in the commodities, equity securities and fixed-income markets. Concentration of large holders in some currencies may have large-order effects on price with misaligned incentives that stifle the development of stable markets with orderly structure.
Managed accounts are a way for qualified investors to become familiar with a new asset class, an alternative strategy, an investment style, or an emerging manager. With a managed account an investor can access an investment manager that trades commodities. In the commodity futures markets, managed accounts give investors control of their capital, better liquidity, and control of leverage. On the flipside, managed account investors have unlimited liability and leave investors responsible for vendor relationships and administrative duties that are normally handled by the manager or general partner.
From months of research, we are not sure managed accounts can be executed in the cryptocurrency markets to the same extent they are administered in the traditional markets. There are technologies that allow for subaccount classifications in the name of the investor, but more clarification is needed to determine whether assets are segregated and not commingled once managers post margin on trades.
The costs to run a managed account are also much higher than what they are to administer in traditional markets. We have found that most managers will only consider a managed account at the US$1 million starting point while more managers who have longer track records and larger AUM will request a minimum of US$5 million. In crypto or traditional markets, managed accounts are not popular outside the United States.
Finally, concerns for regulatory classifications have been trending up for investors. Managers and market participants such as service providers have referenced the lack of regulatory clarity and principles for guidance. In a sign of a market structure that wants to mature, institutions recognize the importance of the emergence of self-regulatory organizations (SRO) and associations. Market participants are looking for guidance and an SRO or similar association targeting global membership can do that. These types of organizations hold members accountable for their market behavior and provide methods for dispute resolutions such as arbitration. This may allay concerns by investors when they recognize a manager is looking to transact with “good actors”. As a signaling mechanism, a membership to such an organization demonstrates that a manager is not just an asset trader but a business owner.
What can investors do to learn about the industry and ecosystem in cryptocurrency?
Education is an essential pursuit for investors looking to put money in digital assets and cryptocurrencies. Investors who have come to us asking about managers in this space have spent years accumulating knowledge on these markets as well as traditional markets. These investors still go to other parties to triangulate knowledge. Confirming or disconfirming their own comprehension of a new product or process is a common pursuit. Relying on the expertise of others will continue.
Since IASG has one foot in traditional alternative investments, the company is familiar with advising qualified investors on what to expect when investing with a professional commodities trader or a professionally managed hedge fund. The company has been compiling the track records of such traders and trading operations for nearly three decades. While providing marketing and consulting services to these managers, company members, acting as an intermediary, transfer knowledge of these managers to prospective investors. Such an intermediary receives compensation for attained expertise. These experts perform operational due diligence and estimate expected returns as well as the volatility of strategies. Members of IASG must take exams from a self-regulatory organization to be compensated for expertise. These agents acquire knowledge from continuing studies, from conversing with and consulting to managers and from experience staking capital in these markets. We see this happening in these newer markets as well.
If investors prefer to do their own research, databases are a good starting point. Cryptocurrency investors have, through our experience, spent considerable time researching these nascent markets. By researching return streams, risk management parameters, performance statistics and additive value to portfolios, investors can compare professionally managed funds across traditional alternative markets. We are trying to do the same in the cryptocurrency markets. An online database of professional cryptocurrency trading strategies would provide similar information. The traders using are effectively various arbitrage or relative value strategies to trade cash market crypto that are essentially commodities. A web site will provide disclosure documents to prospective fund investors performing their own research. This is a further push for transparency in a market that is currently opaque.
What are managers doing to build cryptocurrency platforms and why should investors care?
A good question concerning a second order of questioning into what managers are doing to build infrastructure. Institutional investors care about vendor selection, particularly for those managers in the emerging classification. Most individual professional investors will not care. Right or wrong, the institutions care about brand, often dictating to a manager what company the managers select as an auditor or as a fund administrator. Though we think some of this to be flawed, it is a habitual form of box checking.
A manager’s operational process, whether it be security selection or algorithmic creation, is important to investors. From our experience, a professional investor finds comfort in consistency. This can translate into other good normative habits such as marketing strategy, investor outreach, volatility reduction or risk management. The closer a manager can match performance returns with expectations ex-post, the fewer concerned phone calls he or she will field. That goes for us as well.
A cryptocurrency manager must choose between outsourcing an infrastructure activity and developing it in-house. We believe this kind of recognition is a skill in and of itself. If the activity is core to the firm’s value proposition and thus inherent, the manager or partners decide to capitalize the activity to the firm and its balance sheet. If the manager or partners agree that it is noncore, the activity is expensed through the income statement. Functions such as fund administration should not be done in house. Though fiduciary responsibilities ultimately reside with the management company, Know Your Customer / Anti-Money Laundering (KYC / AML) functions as well as striking a net asset value (NAV) are responsibilities best left to a third-party service provider.
A common misconception about the digital markets is that the blockchain allows for complete transparency for an investor and, therefore, pooled funds are just as transparent. That is not the case. Pooled funds are considered securities by the SEC and therefore are under their jurisdiction[iii]. Pooled funds are also just that: investor resources commingled in a vehicle where administration and Treasury rights are contractually managed by a management company of the fund or pool. That fund has asset and liabilities that belong to the investors. The fiduciary responsibility lies with the manager of that company. Therefore, it is important to know with whom you are investing. The regulatory bodies in the traditional markets are there to regulate these managers, but transparency into the value of the fund or into what that fund invests cannot be assumed. The cryptocurrency and digital asset markets are no exception.
Finally, investors should care about the people running these businesses. They should care about industry standards and best practices because that implies these stewards of capital have the long term in mind when seeking to create and increase enterprise value in their companies. Managers are responsible for hiring and firing persons. They are responsible for contracting third parties that store data, serve audits, provide execution, and offer general administration services. Investors place trust in firms that manage or have access to data. Investors trust that these firms follow operational procedures consistently.
At this stage of the cryptocurrency markets, where market structure and transaction principles are extremely dynamic, investors and managers alike will benefit from the emergence of a self-regulatory association that progresses along with the ecosystem.