-by 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. 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.
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
Typical strategies include Beta (passive), Neutral/Alpha (high frequency and delta neutral), Active (actively managed) and Yield (fixed income).
- 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)
- 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.
- 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.
- 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
Typical strategies include low frequency (manual trading), mid frequency (semi-algo trading), and high frequency (quant trading).
- Manual trading: orders are placed by hand on exchange websites/apps/brokers, or through OTC, or through trading terminals by IT infrastructure providers.
- 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.).
- 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:
- cryptocurrencies can be traded 24/7
- 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
- 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
Typical fund types include proprietary fund, managed account fund, regulated private fund, and public fund.
- Proprietary fund: as the name suggests, do not raise money from external LPs. Common types include institutions’ internal treasury, or family offices.
- 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.
- 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.
- 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.
Regulated Crypto Fund Case Study
In this section, we will present three representative cases of regulated crypto funds: one Cayman hedge fund, one Hong Kong hedge fund, and one U.S. regulated public fund.
AnB is a regulated crypto SPC registered in the Cayman Islands. Currently, the SPC has two running funds:
- One multi-strategy fund that includes all of the firm's strategies and generates greater returns by undertaking higher volatility and greater market exposure
- One delta-neutral fund that contains only delta-neutral strategies. This fund generates steady returns by keeping minimal volatility and market exposure.
The SPC manages a total AUM of USD $50 million, with allocation split among various investments in cryptocurrencies and DeFi. In combination, the SPC aims to gain alpha from the crypto market's volatility and market inefficiencies. Strategies include directional algorithmic trading, arbitrage, yield farming, etc. Subscription and Redemption are available each month with a minimum investment of $100k. Fund revenue includes an annual management fee of 2.4% and performance fee of 20% upon reaching high watermark. Fund expenses include costs of strategy development, trading, risk management, operation, legal and audit related fees and human overhead.
Huobi Asset Management (Huobi AM)
Huobi AM is a regulated asset management firm registered in Hong Kong, holding both Type 4 (Advising on Securities) and Type 9 (Asset Management) licenses issued by the Hong Kong Securities and Futures Commission (the "SFC"). Huobi AM runs multiple SFC regulated funds, including two BTC and ETH index funds, and one actively managed multi-strategy fund. These funds are only open to subscriptions from SFC approved professional investors. Similar to AnB, Huobi AM also adopts an SPC structure where its assets (both traditional and crypto) are held by a third party custodian that complies to SFC regulations. Having established trading activities with a large number of exchanges and counterparties, Huobi AM devotes heavily into IT and human resources to optimize investment research, internal and external operational analysis, trading data collection and aggregation, and risk management. The company also hires multiple external fund admins to generate and deliver fund compliance reports (like fund valuation) on a regular basis.
ProShares is a regulated public fund registered in the U.S. It runs BITO Fund, the first regulated ETF in the U.S. This fund does not directly hold BTC spot (currently not permitted in the US), but indirectly tracks BTC movements by holding BTC futures. Like traditional public funds, BITO shares can be traded in the secondary market. In BITO's fund operation, the firm hires third parties including external fund admin, fund accounting agent, custodian, transfer agent, and distributor. Compared to private funds, regulated public funds are available to all public investors, and thus face stricter regulations, more frequent disclosure requirements (e. g. daily iNAV), and as a result, higher operational overhead costs.
How to Run a Regulated Crypto Fund
In general, buy-side firms refer to the various models of funds and asset managements. Two key aspects of running any crypto buy-side firm can be categorized into a) portfolio management and b) operational and compliance management. In most cases, portfolio management is handled by a team of investment professionals who focus on determining asset allocation, and the firm's overall strategy. In some cases, external trading teams can be outsourced to take care of part of the investment decisions. Operational and compliance management, on the other hand, is handled by a collaborative effort involving both internal teams and external service providers like fund administrators and auditors, etc.
Below is a breakdown of key workstreams for running a crypto buy-side firm from the perspectives of funds' internal team and external third-party service providers.
- Obtaining a license:
Depending on the location and local regulatory requirements, compliance thresholds can vary for issuance of fund operating licenses. Some regions present a very high compliance threshold--for example, in Hong Kong, firms must apply to the SFC for virtual asset management license and fund distribution license for crypto asset management and distribution. However, in offshore areas such as the Cayman Islands and BVI, the compliance threshold for license is much lower, and hence become popular choices for crypto funds. License applications are usually handled by professional fund admin and law firms.
- Determining your fund statement
Like any traditional fund, a crypto fund registration, as required under regulations, must provide a detailed statement including investment scope, trading strategies, opening frequency, management fees and performance fees and relevant third parties (custody, administration…) etc.
Mainstream crypto funds are generally USD-denominated (fund NAV is calculated in USD). For any USD- denominated crypto fund, investors can subscribe into the fund using USD or stable coins such as USDT/USDC. In other cases, crypto funds may also be denominated in cryptocurrency with good liquidity, such as BTC and ETH. Usually, crypto funds accounting are done in single denomination, either in USD or the denominated cryptocurrency. However, for FoFs/MoMs that invest into multiple crypto funds via managed accounts, the portfolio can be accounted in mixed denominations, say both USD and BTC. For regulated funds, external LP's funds will be secured and kept by a third party custodian. In many cases, crypto exchanges can provide custody services directly. In recent years, separate professional custodians emerged as well especially for DeFi trading purpose).
- Managing Daily Operations
Daily operations of a fund include but not limited to: investor subscription and redemption (various frequencies), trading execution of strategy, risk management of positions and collaterals, calculation of income and expenses, compliance reporting, etc.
- Investor subscription and redemption management: main workstreams include recording and calculating each investor subscription, redemption and settlement for single or mixed denomination funds, as well as the corresponding fund NAV adjustment.
- Trading execution: main workstreams include setting pre-trade risk thresholds, determining trading strategies and keeping records of all trading activities. For trade execution, to minimize the overall cost and reflect the true market price, institutions often adopt algo trading strategies like TWAP or VWAP, trade through OTC, or develop in-house quantitative strategies.
- Risk management: main workstreams include determining key risk metrics and closely monitoring and revising each. Common risk control metrics include NAV, drawdown, exposure, LTV/liquidation alerts, stress test, VAR, etc. Different trading strategies put different focus on specific risk parameters. For instance, active strategy requires close monitoring of drawdowns, whereas risk-neutral strategy requires fund exposure to be kept around 0. For lending fixed yield strategy, ratios like LTV (Loan to Value) are applied to monitor collateral value during price fluctuation. For DeFi fixed yield strategy, it is crucial to obtain real-time contract information to monitor risks accordingly.
- Calculations of income and expenses: main workstreams include calculating expenses (accrual, non-accrual, and amortized), and income for investors and managers including but not limited to dividends and profit share, management fees, and performance fees (per individual high-water mark). These income and expenses are calculated and reported to investors by third party fund admins, and internal fund operation team is mainly responsible for data verification.
- Compliance reporting: crypto funds are required to reveal fund performance and submit risk reports regularly. Common metrics include fund valuation, NAV, drawdown, volatility, etc. In addition, funds are required to provide detailed operation data such as account deposit and withdrawal, transaction and trade history etc. for audit trail and reconciliation.
- Fund Termination: main workstreams include final settlement of trading and custody accounts, and clearing of both capital and investors' shares.
Third-Party Service Providers (e. g. Fund Administration, Custodian, and Audit Firms)
Confirming service scope: typically, common services provided include investor management, account management, fund accounting, administrative compliance management, fee calculation, and audit assistance, etc.
- Investor management: main workstreams include investors' KYC management, fund subscription and redemption, and investor shares management.
- Trade reconciliation: main workstreams include keeping track of balance snapshots, deposit and withdraw records, transaction and transfer records, and all trading records for all accounts under various funds, as well as performing account & fund level trade reconciliation on a daily/weekly/monthly basis.
- Calculation of fund-related expenses: main workstreams include calculating management fee, performance fee, operating expenses, etc.
- Reporting: main workstreams include preparing fund performance report for investors with fund NAV information, normally on a monthly basis. Others include preparing and delivering quarterly, semi-annual, and annual income statements, balance sheets and cash flow statements.
In addition to understanding the key workstreams for funds' internal team and external third-party service providers, it is also important to understand the key responsibilities of various internal and external roles.
Key Responsibilities for Internal Team
Typically, the internal team of a crypto buy-side firm consists of roles like portfolio manager, trader, risk controller, operation and compliance officer. Based on unified data source and data pipeline criteria, (e. g. get market feed via APIs, setting risk factors calculation rule), the internal team work together under both internal and external regulations.
- Portfolio manager: main responsibilities include multi-dimensional data tracking and data analysis of the fund. The scope of data tracking and analysis covers all counterparties related to the fund, all instruments (including centralized and decentralized) individual or combined positions, PnL, KPI, and so on. Portfolio managers are also responsible for generating customized reports externally for investors, or internally for the management board, which would require additional cleaning and transformation of raw data.
- Trader: main responsibilities include efficient and stable order executions and fund transfers. The scope of such includes monitoring market conditions, trading processes (e.g., TWAP algorithmic mandate execution), and relevant risk metrics.
- Risk Controller: main responsibilities include setting risk control rules, monitoring and reporting risk in real-time. The scope of such includes market-level, fund-level, account-level, and instrument-level monitoring, alert checking and record keeping.
- Compliance Officer: main responsibilities include information bookkeeping and disclosure according to internal and external regulations. The scope of such includes trading approval, report preparation, periodic disclosure, regulatory data submission, etc.
- Operation Officer: main responsibilities include data integration and coordination between internal team and external service providers (normally with fund admins). The scope of such includes fund subscription and redemption, NAV calculation, expense management, fund valuation, reconciliation, historical data tracking, and data analysis.
Key Responsibilities for Third-Party Service Providers
Fund admins: main responsibilities include provision of accurate and timely ((weekly or even daily) NAV calculation. Like traditional funds, crypto funds may see variances in the accrual of performance fees, based on factors such as investor category, fund category, investment amount, holding time, fund performance, etc. With increasing number of investors or frequency of subscriptions and redemptions, manual calculation of NAV would become extremely labor-intensive and time-consuming. Strong IT infrastructures that standardize and facilitate data processing and calculation can be key in improving efficiency and differentiating the quality and speed of service delivery for crypto fund admins.
Auditors: main responsibilities include reconciling the changes in account balances to 100% matching the net movement of deposits and withdrawals, transfers, funding and trading activities. Thus, it is necessary for auditors to support reconciliation for all types of crypto assets (spot, derivatives, DeFi, etc.), and be familiar with all 'rabbit holes' regarding data collection. For example, in many cases, incompletion or errors in transaction history can be caused by exchanges not being able to provide historical balance snapshots, not having exact instrument lists to generate trading history, or keeping special fees like maker rebate separately. An efficient solution to such common pain points is to streamline reconciliation with an IT system, taking regular balance snapshots, collecting all asset movement data and conducting automatic reconciliation.
Custodians: main responsibilities include authorizing transfers to be restricted to authorized addresses and accounts. Pre-transfer control (monitor and alert) and approval are necessary to ensure investors' asset security.
Market Opportunity for Third-Party Service Providers
From 1Token's many prospective clients, feedbacks are showing that there is a growing need for crypto-specific reporting services:
- Higher reporting frequency: most fund admins can only provide NAV by manual process, which does not satisfy crypto funds and investors in this 7*24 volatile market. To be able to generate daily/weekly, fund admins/auditing firms require an IT system for operational scalability.
- Accounting reconciliation for complex trading strategy: quant trading, especially high-frequency trading, can generate thousands and tens of thousands spots and derivative orders per day, causing a big challenge for fund admins to ensure correct reconciliation output. Fund admins/auditing firms require a robust IT system that perfectly addressed such complexity.
- Diversified crypto asset class: crypto funds can contain various types of assets, including spots, derivatives, DeFi, loans, etc. To maximize well-roundedness, crypto fund admins and auditing firms need a comprehensive portfolio management software that supports and evolves quickly with all crypto assets.
- Data security: for institutional clients, it is crucial that vendors (fund admins/auditing firms) comply to data security and confidentiality, which are commonly ensured by 1) technical solution like on-premises local deployment and 2) process audit like SOC 2 certification.
 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
 ProShares Trust Form N-1A REGISTRATION STATEMENT.
 Statement on the Regulatory Framework for Virtual Asset Portfolio Managers, Fund Distributors and Trading Platform Operators.