“I love paperwork, trading inefficiencies, regulatory hurdles, and ever-rising compliance costs,” said no fund manager ever. To do away with these bottlenecks, asset managers and their clients may soon have the option to run investment funds as smart contracts on a blockchain. Mona El Isa, co-founder of Melonport and founder and president of the Multichain Asset Managers Association (MAMA), introduced the concept of the Technology-Regulated and Operated Investment Fund (TROIF) at a special event at the Zurich offices of the law firm MME on June 6, 2018. Mona also introduced the vision of MAMA, its key performance indicators, and first pilot projects with Base58 Capital or JTC Group.
Regulation for crypto funds is improving in several jurisdictions, but operating a fund onshore and offshore is still a long way from a natural fit with the cryptoasset class. Many crypto funds try to fit into traditional legislation, risking to miss some of the advantages the cryptoasset class offers to managers and investors. Mona begins her presentation with explaining the TROIF. “This is a new concept to most people,” says Mona, “because anyone in the asset management space knows there isn’t much technology there at the moment, especially when it comes to administering and operating a fund.” The industry standard is that many processes are still manual and rely on intermediaries, making operations costly and slow. Trading an asset in the traditional space, say, an equity, can take three days to reach the buyer. Several risks can occur during these three days, and when they do, they have huge implications. An example is Lehman Brothers in 2008, when the t+3 settlement period trapped many investors who lost their assets as a result. With immediate settlement, this risk would be much lower.
Blockchains introduce a new way of doing things peer-to-peer with an inherent, built-in accounting system. Several ideas exist that use blockchain technology and smart contracts for operating an investment fund, and fund managers have an almost full suite of asset management projects available to them. This promises them almost immediate settlement with a similar or better degree of security at a lower cost.
Operating a fund on the blockchain in four steps: Setup, asset universe, risk management, KYC
Mona introduces technology-regulated and operated funds in four steps. The first step is setting up the fund. Fund managers can pre-select or pre-define parameters such as a management and performance fee. The existing framework of fund management needs a written contract and a fund administrator calculating payments. With a fund running on a blockchain, a smart contract handles both the agreement and the payout of fees in a transparent way.
The second step is defining the asset universe. Fund managers can predefine this in code rather than prospectuses with human beings looking over positions at the end of each day to verify that a manager stayed within the risk limits. This step also includes defining trading exchanges: On which exchanges does the manager have permission to trade? Finally, the smart contract includes risk management. One of the things that make asset management and its operation so expensive is regulation and the ensuing risk management and processes. As it is today, a fund manager can buy an asset, and it settles in their book three days later. But if somebody fails to book the trade for any reason, a risk manager has no idea the trade happened until three days later. Having an almost immediate settlement time has many advantages. Finally, the last step is predefining the blockchain addresses that may invest in the fund, which allows a compliance manager to do KYC and AML automatically. Going through these four steps, fund managers get the full suite of tools to operate and manage a fund and can start to connect the rest of the ecosystem of the fund.
“Defining the code is one part of the equation,” says Mona. “The other part is letting the code administer your fund, transfer the assets and take care of the custody.” The blockchain is in itself a custodian of assets. With a smart contract running the fund, the blockchain enforces all of its parameters, and the transactions have finality. Trying to break the rules is impossible on blockchains, because the code and the blockchain will enforce the rules that the manager has to abide by. People need to shift their trust from the intermediaries to the code. For that reason, it is important for the blockchain ecosystem to write secure code, which is why most of the projects in this space tend to be open source, so as many eyes as possible can inspect the code.
Another important point is audited track record. Managers can build credible track record on-chain, and nobody can dispute it. In the traditional world, it’s almost impossible to launch a successful fund and survive with less than $300 million of assets under management. “A TROIF costs about $25 to launch, and it will build track record over time that nobody can dispute, because it’s credible and audited by the blockchain”, says Mona. Auditors and other intermediaries are no longer necessary. Fund managers just need to show that they can trade or invest in a way that makes continuous returns.
Challenges in traditional asset management today
Several challenges exist in asset management today, and Mona breaks them up into challenges for traditional managers and crypto asset managers. Funds trading traditional assets, such as equities, bonds, and FX, three major issues exist. The first is a high barrier to entry. “Nine out of ten funds fail within their first year,” Mona says, “unless they have above $300 million assets under management.” There are several reasons for this, and most of them come down to intermediaries. With such high barriers to entry, the largest incumbent funds survive instead of the best funds. Young managers with an amazing track record but little funds have no chance in this environment, because investors say, ‘If you don’t have $300 million, I already know you’re going to fail within the first year. That’s what the statistics say, so why should I seed you?’ Because of this chicken and egg situation, many fund managers never break through the threshold. Instead, established fund managers keep getting more and more market share, because people invest with them according to the mantra ‘bigger is better’, and not ‘better performance is better’.
Asset concentration among hedge funds is a serious challenge. “95 percent of hedge fund assets are invested in 500 of the largest hedge funds,” Mona says. “This is really sad if you think about how many other talented managers must be out there.” The biggest funds can absorb high operating and compliance costs because of their scale, but established hedge funds have average returns of only six to eight percent gross. After subtracting fees, two percent on average, the average investor gets four to six percent of return. This is rather unimpressive in comparison to funds in the crypto space in the last year.
Finally, the lack of systematic accountability, monitoring, and governance are additional challenges. It is all too easy to misrepresent one’s positions within their own internal operation, to a fund administrator, or even by incorrectly booking a trade that will only show up in the fund manager’s books until settlement. Many of these may be innocent mistakes, but transparency is poor in the existing traditional asset management space.
Challenges in crypto fund management
Cryptoasset managers face additional challenges setting up their funds. MAMA identifies several of those in their vision paper. The first challenge is the requirement by law to have a custodian of assets and a fund administrator. With cryptoassets this makes little sense, because the safest way to store cryptoassets is on the blockchain, holding on to one’s private keys. Ironically, forcing a crypto fund manager to hold assets with a custodian has no benefit for the investor, but introduces new risks. Most managers revert to two or three custody options that are available today, all of which with their limits. Custodians usually store bitcoin, and some of them started to store ether. The fees for storing these assets are high, and the barrier to entry in this space is high as well, so the competition will remain small. Custody solutions solve a regulatory issue that exists mostly for different asset classes, which has a negative consequence for cryptoassets.
Risk management and accounting pose additional challenges for crypto funds. Proving that a fund really holds the assets they disclose in their portfolio is hard even when they have a fund administrator or a custodian. How do we know wallet addresses are correct? How do we know they really are in possession of the keys to that address? All of this is easy to manipulate. Unfortunately, many crypto funds have by design no other option than using exchanges as custodians. Centralized exchanges have in the past failed to be secure ways to hold cryptoassets. Managing regulatory uncertainty is also hard because the classification of tokens is uncertain. Is a fund dealing in securities or utility tokens, and which law applies to define that? The law is different in every country, and most countries don’t even have blockchain law, which adds to the confusion.
Trading infrastructure and best price execution are problems that are just beginning to show. The exchange space in cryptoassets is highly fragmented. Just in bitcoin alone, four hundred exchanges exist, and the largest exchange has only six percent market share. Giving best execution to investors is an important concept in finance, and it will be equally important in cryptoassets. However, providing proof of best execution is a challenge, especially when markets are fragmented. Amalgamating prices over on all four hundred crypto exchanges is challenging, but it will improve over time. Until today, most investors were happy with the performance of their crypto investments, because almost every crypto fund was up triple digits in 2017. But in more challenging markets, investors may begin to ask for best execution, which is currently hard to prove.
The final challenge is banking. Perhaps less for a pure crypto fund, but if a fund is investing in tokens and those tokens have companies behind them that own assets, they need access to a fiat bank account. The banking industry is currently unable to service crypto clients with few exceptions. Bank Frick in Liechtenstein, Hypothekar Bank Lenzburg in Switzerland, and only few other banks in the world currently take on crypto clients as fiat customers.
The case for technology-regulated and operated investment funds
Technology can solve many of the challenges that cryptoasset management face. Protocols like Melonport and others automate fund operations and risk management. Decentralized exchanges are on the rise, which offer a peer-to-peer way of exchanging assets on-chain. The cryptoassets space needs an exchange environment with more security, transparency, and efficiency. Decentralized exchanges remove central intermediary risk, although they face their own challenges with low liquidity.
Keeping the custodianship in the hands of the investor is another very important concept. “Until other solutions emerge where fund managers have secure ways of holding assets or keys,” says Mona, “it makes most sense if investors to keep custody of their own assets.” They may still give a copy of their private key to a custodian, which could allow them to have one key for all of their assets, because their assets will be in a fund. The alternative is holding, say, ten different assets on ten different chains with ten keys to worry about.
Transparency is an inherent feature in blockchain technology. Fund managers can use the same accounting that underpins Bitcoin in a fund with just a few formulas in a smart contract. Smart contracts may automate taxes, which are cumbersome and require paperwork. Price discovery and best execution will emerge as volume picks up on decentralized exchanges. This will go hand in hand with more transparency for the pricing of both the funds and the assets.
MAMA believes in twenty years from now, half of the world’s $80 trillion asset management industry will run on blockchains. “We measure if we are on track with three key performance indicators,” Mona says. One indicator is how many jurisdictions by GDP will be enabling on-chain asset management tools. The second is how much overhead fund managers save through on-chain solutions. The third is the share assets under management of cryptoasset funds as a percentage of the assets under management of the entire asset management industry.
Pilots of funds on the blockchain
Mona concludes her presentation with early pilots of technology-regulated and operated investment funds. “We decided to start with the following jurisdictions: Malta, Liechtenstein, Gibraltar, Jersey, Switzerland, and the UK,” she says. Base58 Capital, an asset manager from Switzerland who submitted the first application for a cryptoasset investment fund to the financial regulator in Malta, plans to launch a fund on the blockchain together with MAMA, Melonport and MME. Another pilot is in planning in Jersey withJTC Group. Additional projects include one in Gibraltar later in Q3 2018 and a project in Liechtenstein with Bank Frick. In Switzerland and the UK, the discussions are more preliminary, because the jurisdictions have more layers to work through.
It will be exciting to follow these early pilots to understand better how blockchain technology and smart contracts can help improve cryptoasset managers and more traditional investment funds in years to come.