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Crypto Funds 101: Fund Classification and Compliance Operations (Part I)

Author: Yixuan Huang, BD Director; Phil Yang, Head of BD

Prelude: From Traditional Funds to Crypto Funds

Broadly speaking, a fund is a pool of capital allocated toward a specific purpose.

Common sources of capital include trusts, sovereign funds, insurance firms, and various types of foundations. However, investment decisions are made by fund GPs, who are professional asset managers aiming to generate higher returns by allocating fund capital into both primary (venture capital, private equity) and secondary markets.

Crypto funds have been developing for years. From 2014, when crypto funds first emerged, to 2021, when the first U.S. Bitcoin ETF launched, a growing number of hedge funds and family offices have invested in crypto assets.  The bull market in 2020-2021 further increased the total market cap of crypto funds to over $62 billion. [1] Today, more and more traditional financial institutions (and even non-financial institutions) are stepping into the cryptocurrency business by having their first allocation toward crypto-related assets.

Although crypto funds are similar to traditional funds in fund structure and basic portfolio classification, the decentralized blockchain infrastructure makes crypto assets different from traditional financial assets like stocks and bonds, and face more variety and greater number of asset types/instruments, trading venues and strategies, and more advanced IT requirements. Besides, there are many worth-noting nuances on risk control, fund KPI calculation and fund audit.

As an experienced veteran in crypto trading and front to back-office infrastructure development, 1Token team has prepared a series of articles to share experiences and insights in managing crypto funds. This article will serve as an opening introduction, covering typical types of crypto funds in today’s increasingly regulated crypto market.

Key points in fund management and operations for various fund types, managers and third parties, as well as in-depth analysis on the feature of each will be covered in future articles.

 

I Classification of Crypto Funds

Crypto funds can be categorized into primary market funds and secondary market funds.

Primary market funds (like VCs, Seed /Growth Funds etc.) mainly invest in blockchain-related projects, including pre-ITO (Initial Token Offering) projects, post-ITO projects that have not yet been listed on the mainstream exchanges (Binance, FTX, Coinbase, etc.), as well as Non-Fungible Token (NFT) projects.

Secondary market funds, on the other hand, focus on investments in cryptocurrencies and their derivatives, which can be traded directly on exchanges or over the counter (OTC). Besides classifications by public / private , open-end / closed-end funds like traditional funds, crypto funds can be classified by investment strategy, trading frequency and source of capital. Depending on the specific fund type, different levels of infrastructure and IT resources are required in daily fund operations.

 

Crypto Fund By Investment Strategy

l  Typical strategies include Beta (passive), Neutral / Alpha (high frequency and delta neutral), Active (actively managed) and Yield (fixed income).

n  Passive strategy: returns are benchmarked against overall movement of the crypto market. Typical strategies includes tracking performance of one specific or a basket of mainstream coins (BTC and ETH)

n  Neutral / Alpha strategy: returns are gained from market volatility, utilizing derivatives hedging to keep long-term Delta at zero. Typical neutral strategies include arbitrage and market making.

n  Active strategies returns are determined by managers’ subjective judgment on price movements (for instance, long when price is low and short when high). Positions are adjusted according to the difference between market price and subjective price, gaining additional alpha vs. beta return generated from market movement.

n  Yield strategy: Although currently there is no standard crypto bond market, a yield fund may invest into “non-standard bonds” (like OTC lending and prime brokerage), which are popular models that generate fixed returns similar to bonds by gaining net interest income from back-to-back loans. Yield fund operations generally require stricter risk control given drastic fluctuation of crypto-denominated collaterals (like Luna and UST at May 2022). Another common strategy for Yield fund is to participate in DeFi financial activities based on smart contracts on the blockchain that have fixed-income properties. For example, yield farming on DeFi smart contracts (not applicable in traditional financial markets) enables fund managers to lend, borrow or stake coins to earn interest and speculate on price swings.

 

Crypto Fund By Trading Frequency

l  Typical strategies include low frequency (manual trading), mid frequency (semi-algo trading), and high frequency (quant trading).

n  Manual trading: orders are placed by hand on exchange websites/apps/brokers, or through OTC, or through trading terminals by IT infrastructure providers.

n  Semi-algo trading: orders are placed by setting the total amount of order by hand, and executed by pre-set programs (TWAP, VWAP, PEG, etc.).

n  Quantitative trading: orders are placed by programs, which connect to exchanges via API.

 

There are several major distinctions between trading in crypto market vs. traditional financial market:

  1. cryptocurrencies can be traded 24/7

  2. same coin pairs (e.g. BTC / USD Spot) can be traded in multiple venues (exchanges / OTCs). There are in total hundreds of centralized crypto exchanges (Binance, FTX, Deribit, OKX etc. ) and decentralized crypto exchanges (Uniswap and Pancakeswap etc.) worldwide

  3. crypto funds can directly get free market quotes and place orders via exchanges (even HFTs) rather than having to trade through brokers

These three distinctions result in more arbitrage opportunities for Alpha strategies in the crypto market (e.g. cross-exchange arbitrage). In typical cases, fund managers will adopt different trading frequency based on their return target, trading strategy, and IT capability.


Crypto Fund By Source of Capital

l  Typical fund types include proprietary fund, managed account fund, regulated private fund, and public fund.

n  Proprietary fund: as the name suggests, do not raise money from external LPs. Common types include institutions’ internal treasury, or family offices.

n  Managed account fund: a managed account refers to a trading account that is owned by an investor but managed by someone else like fund managers. Managed accounts are commonly given by high-net worth individuals or institutions that provide margin financing like shadow banking in traditional markets, to a group of various fund managers.

n  Regulated private funds: these funds are regulated by local authorities like SEC / MAS / SFC, raise money from external professional investors, and must meet standards such as having a fund entity, licensed fund manager, external fund custodian, and submitting reports backed back external fund admin / audit firms.

n  Public funds are defined the same as those in the stock market. Most public funds follow passive strategies, and track NAVs based on open / close window subscription and redemption. Public crypto funds usually deposit assets with an authorized third-party custodian, whereas retail or institutional investors trade fund shares on the secondary market. Market makers can provide liquidity to public funds like to exchanges.

 

The rich variety in crypto fund categorization, from both capital and asset perspectives, presents different advantages and challenges in fund management and operation, such as risk control, fund valuation, and settlement. Extensive discussions for each particular type of funds will be covered in subsequent articles. This article serves as a high-level synopsis for financial institutions to take a glimpse of crypto investments, as well as to invite industry players to resonate in sharing their thoughts and experiences.

 

1Token’s One-Station Financial Software for Crypto Institutions

1Token is the all-in-one financial software for crypto institutions, supporting 20+ Blockchains, 100+ Defi protocols, and 80+ CeFi & traditional trading venues.

Currently, 1Token software supports all crypto assets in CeFi and DeFi, including spots, futures, options, fixed / variable income products, SAFT, POW/POS mining, staking/yield farming, NFT etc., as well as traditional assets such as stocks / FX / ETFs etc.

1Token’s institutional clients spread across all verticals of crypto-finance, including buy-side institutions in asset management, fund / FoF / MoM, foundation / exchange treasury, fund admin, audit etc., and sell-side institutions in lending, margin trading, prime broke, retail brokerage, spot OTC, derivative OTC etc.

For each specific business vertical, 1Token provides an end-to-end solution that supports front-to-back office technology in sales & trading, OEMS, portfolio and risk management, pricing / product structuring, accounting, clearing & settlement etc., and multi-department usage for sales / trading / risk / operation / finance teams all at once.

Today, 1Token serves 40+ large global institutions, with top profiles like Algorand Foundation, Amber Group, Animoca Brands, FBG Capital, Matrixport, Metalpha, Pintu, Zipmex, and 4 of the Top 7 CMC exchanges etc., which in total exceed $20+ bn asset managed.

For buy side institutions, the system provides comprehensive end-to-end support across front-to-back office operations, including

l  Investor management: LP subscription / redemption and NAV reporting; Settlement of complex fund structures (feeder-master, structured funds etc.) and transfer

l  Portfolio management/risk management: 360° view of real-time balance sheet and exposure of all assets; Customizable pre-trade/ on-trade/ post-trade risk & collateral management, margin call & liquidation; Portfolio mark to market return, PnL and sensitivity analysis

l  Trading: Single/multiple account order execution; Manual / algo trade execution on aggregated CeFi liquidity (exchanges, OTCs, custodies / banks, FX…)

l  Accounting/reporting admin: Automatic reconciliation of all asset and cash flow movements (trades / transactions / transfer); Customizable generation & delivery of audit, tax, and compliance reports (internal & external)

The system is institutional operation oriented, supporting on-premise local deployment and exchange-grade data security, various roles and permissions for departments/user groups, as well as 24/7 IT support, offsite data backup and business continuity plan.

 

 

Reference

[1] Crypto Funds Explode in Boom Year Marked by First U.S. Bitcoin ETF. https://www.bloomberg.com/news/articles/2021-12-21/crypto-funds-explode-in -2021-led-by- proshares-Bitcoin-strategy-etf-bito

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