This article aims to provide guidance and reference from an operational perspective for launching institutional-grade crypto hedge funds (“Crypto HFs”). Our intention is to hope that this will assist teams planning such launches and serve as a resource in their journey.
Cryptocurrency is still an emerging asset class, and so is its servicing infrastructure. The goal of establishing a robust operating framework is to enable trading and investing while ensuring technical and legal security and control of fund assets, and providing appropriate accounting treatment for all investors.
The information and opinions contained in this article draw on L1D’s experience as one of the most active investors in crypto hedge funds since 2018, as well as our team’s long-term performance 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 aftermath, our team has learned many lessons and applied them to investing in crypto hedge funds.
As a guide and reference, this article is long and explores multiple topics in depth. 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 experts. 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 strong infrastructure that is constantly evolving, and new startup managers have many options to choose from. The scope of this article is not particularly focused on an exhaustive review of the infrastructure available in the space, which is well covered by other publications.
The goal here is to review processes and workflows in detail, identify operational risks, and come up with best practices for managing risk in the context of starting 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 venue and counterparty risk management
5. Financial Management — Fiat Currency and Stablecoins
6. Hosting
7. Service Providers
8. Compliance, Policies and Procedures
9. System
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 to do the right thing for their investors, but their negligence 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 traditional finance (TradFi) backgrounds 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 the right 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 considering redundancy in areas such as banking partners. As a rule of thumb, setting up a typical fund can take between 6 and 12 months. 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 realized on day one. This also means that investment managers must consider a certain expense burden when preparing for launch, as revenue 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 diagram below 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 is ultimately reflected 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.
Fund structure, terms and investors
The structure of a fund is typically 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 U.S. and non-U.S. 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 potential negative outcomes for investors and outright failure.
The diagram below illustrates a typical Cayman Islands based master-feeder (also known as master-feeder or parent-child) 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 Types – Institutional, Qualified Investors vs. Non-Qualified Investors, Qualified Purchasers
Number of investors and minimum subscription amount
ERISA (US pension plan)
Transparency and reporting requirements
Policy Capacity
Release Documents
The following matters 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.
Place of Registration
Institutional funds often choose the Cayman Islands as their primary domicile, or less often the British Virgin Islands. These domiciles allow the fund entity to have counterparty facing – to trade with offshore counterparties.
The choice of the Cayman Islands as a preferred jurisdiction is the result of traditional financial hedge funds being established here, and a system of service providers has formed around it, including legal, compliance, fund management and audit, with a good track record in the alternative asset management field. This advantage also extends to the crypto field, as many of the same well-known service providers have now established businesses in this field. Compared with other jurisdictions, the Cayman Islands is still regarded as the "best choice", which is also evidenced by the strengthened 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 has the highest costs and time-consuming legal set-up, leading many managers to consider the British Virgin Islands. The British Virgin Islands is continuing to establish itself as an accepted jurisdiction and is becoming increasingly comparable to the Cayman Islands as more high-quality and reputable service providers offer services there. The premium paid for selecting a well-known jurisdiction is often justified over the life of the fund.
Fund Entity - Master Fund and Feeder Fund
According to the above structure diagram, there are usually master funds and feeder fund entities. The master fund holds investments, participates in and executes all portfolio investment activities, and distributes financial returns to the underlying feeder funds.
The master fund is usually a Cayman limited company (LTD) that issues shares.
Feeder funds for offshore investors are usually Cayman limited companies that issue shares, while feeder funds for U.S. onshore investors are usually 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-feed 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 usually driven by the fund manager’s tax considerations and how they wish to be compensated for performance fees, which usually apply at the master fund level.
Cayman Limited Company (“LTD”): A separate legal entity from its owners (shareholders). The liability of shareholders is generally limited to the amount invested in the company.
LTDs typically have a simpler management structure. They are managed by directors appointed by the shareholders, and day-to-day operations may be overseen by senior executives – usually investment managers.
Shares in an LTD are transferable, 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.
An LTD typically elects to be treated as a corporation from a U.S. tax perspective and therefore pays taxes at the LTD level and does not pass them through 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.
LP involves general partners (“GPs”), who are responsible for managing the partnership. GPs have unlimited personal liability, while LPs enjoy personal liability protection.
Cayman does not tax foreign limited partnerships.
LPs have a different structure, with limited partners typically contributing capital but not having the same flexibility in terms of share classes.
Delaware Limited Partnership (“LP”): The choice between implementing a Delaware LP or a Cayman LP can be nuanced and is often related to the tax and governance preferences of the investor. The most common for onshore funds is a Delaware LP.
Delaware's LP laws define governance and investor rights.
For tax purposes, it is a "pass-through entity", meaning that LPs/investors pay their own taxes.
Through the fund’s governance documents, flexibility is provided for defining the relationship between the parties.
Delaware LPs are generally cheaper and faster to form.
Investment Manager/Advisor/Sub-Advisor/General Partner (GP)
An entity that has portfolio management decision-making power and is compensated through management fees and incentive fees.
The entity that holds decision-making power and collects the fees generally depends on the ultimate beneficial owners (UBOs), their respective nationalities and tax preferences.
Typically formed as a Limited Liability Company (LLC) to take advantage of limited liability protection since the GP (General Partner) has unlimited liability.
Asset holding structure
Investments are typically held at a master fund level, but other entities may be established for certain assets/holdings, which may be driven by tax, legal and regulatory considerations.
In certain special cases, investments may be held directly by the fund for the same reasons as above, and the ability to do so must be clearly set out in the fund's legal documents.
Share Class
A fund may offer different share classes with different 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 provide certain preferential terms to early investors to support the growth of the fund in its early stages.
Special categories may be created for special situations, 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.
cost
The market standard for charging management fees is to align with the fund's liquidity - 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 within 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 value above the HWM during the performance fee period.
Some funds may prefer to settle and charge performance fees on a quarterly basis - this is not considered best practice, nor a market standard, is unpopular with investors and is less common.
Performance fees are not collected on assets held in the side pocket until they are realized and until they are transferred from the side pocket back to the liquidity 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 strategy and underlying liquidity. Lock-up periods can vary, with 12 months being fairly common, but can be longer. Lock-up periods 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 to other share classes.
Side pockets – see below.
Gates – Funds may impose gates at the fund or investor level – gates mean that if more than a certain percentage (e.g. 20%) of fund or investor assets request redemptions during any redemption window, the fund may 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.
Limits are often associated with illiquid assets because the impact of large redemptions may affect the actual price of the asset when it is sold/liquidated to raise redemption cash, a feature that does protect investors.
The choice of whether to impose restrictions at the investor or fund level is driven by liquidity structure and the concentration of AUM in the investor base. However, more often, 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 eliminates any incentive or possibility for large investors to game the system and receive unintended preferential treatment in terms of liquidity.
cost
The Fund may charge certain operating expenses to the Fund, which are actually paid by investors.
Best practice is to charge to the fund those expenses that are directly related to the management and operation of the fund and that do not create a conflict between the fund and the investment manager. Remember that the manager is paid a management fee for its services, so operating and other expenses related to the management company and entity should not be charged to 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 run 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”).
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 shouldering certain start-up and ongoing operating expenses. This demonstrates a long-term commitment to the sector, with the expectation that the AuM growth from such commitment will compensate the manager for this investment and discipline.
Good expense management can also further align managers and investors by mitigating potential conflicts of interest. There can be a grey area between what directly benefits the fund and what benefits the manager more than the fund – industry presence at conferences and events, and the associated expense 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 true fiduciary approach to fee policies is critical to enabling institutional investors to invest in cryptocurrencies.
Accounting
In order to properly track the high water mark that investors use for 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 have 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 high watermarks 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 main classes and series at the end of the year, while 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 balanced method (“EQ”) accounting, all shares of a fund have the same NAV. When new shares are issued/subscribed, they are subscribed at the total NAV, and investors receive a balancing credit or debit depending on whether the NAV is above or below the high watermark. Investors who subscribe 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 they subscribe 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. Balanced method accounting is considered to be quite complex and places an additional burden on fund administrators that many are not competent to perform. The same is true for the fund manager's operational and accounting staff.
Neither approach is superior, as investors are treated equally in both cases, but series accounting is generally preferred because it is more straightforward and easier to understand (with the disadvantage that many series are produced that may not always be aggregated into a master series, so there may be many different series over time, which increases the administrator's operational and reporting effort).
First In, First Out (FIFO) - Redemptions are usually processed on a "first in, first out" basis, meaning that when an investor redeems, the shares redeemed belong to the series they subscribed to first. This is more beneficial to the manager because if these (older) shares are above their high watermark, such redemptions will trigger the settlement of the performance fee.
In some cases, a manager may choose to leverage a strategy through an accounting mechanism rather than through 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-stage protocol investments, may not be liquid. Such investments are often held outside of the regular portfolio and segregated into side pocket categories 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, usually with restrictions in terms of percentage of AuM and with certain defined liquidity catalysts such as IPOs. However, as a result of the global financial crisis, a larger portion of the previously liquid portfolio became illiquid and placed in side pockets, and such funds experienced large 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 implementing them requires careful consideration. Side pocket investments have the following characteristics:
They should only be created if there is a genuine need to protect investors.
Ideally it should be limited to a certain percentage of the fund's AuM.
Cannot be redeemed during normal redemption intervals.
Should (must) be held in its own legal share class and not just separated through an accounting mechanism.
There is a management fee but no performance fee - 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 – generally, 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 constructing side pockets:
Offering documents – should clearly state that side pockets are permitted and intended; if the fund is structured as a principal-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 – for example, no management fee, no performance fee, no redemption rights.
Accounting structures within the fund structure - side pockets are typically created when illiquid investments are made and/or existing investments become illiquid; only investors who are already invested in the fund at the time the side pocket is created should have exposure to the side pocket, and such investors typically subscribe to that side pocket class. When assets in the side pocket become liquid, they are typically redeemed from their class and then placed into a liquid share class, and investors with that exposure then subscribe to the newly created liquid class - this ensures accurate tracking of investor exposure and high watermarks. If the fund structure is 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 funds.
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:
Migration from side pocket to liquid category – There should be a clear policy for when assets become liquid enough to be moved from the side pocket to the liquid category. This policy and rules are usually 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 the side pocket may be valued upwards, but must adhere to clear and realistic valuation guidelines. One approach could include applying a marketability discount (“DLOM”) based on the asset’s recent large transactions (e.g., a recent financing at a valuation above the fund’s original cost).
Reflection in investor statements – Investors should have a clear understanding of their liquidity in the fund and therefore the side pocket categories should be reported separately from the liquidity categories (each liquidity category should also be reported separately) to ensure that investors know the number of their shares and the net value per share that can be redeemed under standard liquidity terms.
Example side pocket configuration
The example structure diagram below reflects a common version of how investors 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 fund invests in the Master Fund's share classes and is a shareholder of the Master Fund.
Investors in the Feed Fund receive shares of the Feed 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. Investors in the Feed Fund share the performance of the Master Fund portfolio through changes in the value of the Feed Fund's investment in the Master Fund's shares, and the corresponding increase in the value of their Feed 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 liquid and eligible for redemption according to the terms of the fund. Their Feed Fund shares' performance will be 100% based on the performance of the Master Fund shares, which ultimately derives from the Master Fund's portfolio (specific performance is accounted for at the series level).
In Figure 1 below, the master fund only holds liquid investments in January, the entire performance will be distributed to the feeder fund investors, all feeder 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.
Figure 2 shows a master fund portfolio that determined that 10% of its portfolio was illiquid in February.
When certain portions of the Master Fund portfolio are illiquid, those assets cannot be sold to satisfy redemption requests from the Feed Fund investors. There are two main reasons why assets may be illiquid—either certain assets become illiquid due to some distress, or the Master Fund invests in illiquid assets because of special opportunities. In either case, only the Feed Fund investors who were invested when those illiquid assets entered the Master Fund portfolio should have exposure to those illiquid assets—from both a fee and performance perspective, and from a change 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 subscribe 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 – i.e., 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, i.e., the Master Fund SP Shares. This is to ensure proper accounting and liquidity management to match the Master Fund’s liquid 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 category is necessary to ensure that value is fairly allocated.
In this structure, investors in the offshore feeder fund receive corresponding 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 can be sold at the master fund level to raise cash to pay redemptions at the feeder fund level.
Investors in offshore-fed funds will receive investor statements reflecting their liquidity category and side pocket category so that they know what their total capital is and which capital is available for redemption.
This accounting treatment and appropriate structuring design 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 the 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 operational experience and expertise who can add value in dealing with complex operational issues – such individuals can also provide value in an advisory capacity rather than as a formal director.
Independent boards are becoming more common for new crypto funds, 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 forth in the fund’s offering documents. Side agreements should generally be reserved for large, strategic and/or early stage investors in a fund. Side agreements may include provisions relating to information rights, fee provisions and governance matters.
Regulatory status
Funds are typically regulated by local corporate or mutual fund laws in the jurisdiction in which they are located. In the United States, even if a fund is exempt from SEC registration 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 an ERA (Exempt Reporting Adviser), which has much lower reporting requirements. In the US, 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 of investable assets and entities with $25 million of investable assets). Many new funds choose to be 3(c)(1) because of the lower reporting requirements. However, managers must recognize that due to the limited number of investors allowed, they may not want to accept small subscriptions in order to manage this investor "budget" in terms of the number of investors the fund can accept.
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 typically requires hiring legal counsel in each jurisdiction, making appropriate filings, and ongoing maintenance and compliance.
Physical subscription and redemption
The Fund may choose to accept subscriptions from investors in cryptocurrencies (physical).
In some cases, funds may be permitted to pay redemptions in kind – this is generally not ideal and can create regulatory and tax issues as investors may not have the technical capabilities to custody the assets or may not be permitted from a regulatory perspective to hold crypto assets directly.
Physical subscriptions may raise valuation, tax and compliance issues. Typically, physical subscriptions only accept BTC or ETH to avoid valuation issues. From a tax perspective, in the United States, physical subscriptions may trigger a tax event for investors, which needs to be considered. In terms of compliance, physical subscriptions will be wallet-to-wallet transactions, so fund administrators and fund agents 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 physical subscriptions from investors, then when that investor redeems, from an anti-money laundering perspective, best practice is to pay the redemption amount equal to the physical subscription amount in kind, and any profits in cash.
Key Person Risk
Key person clauses allow investors to redeem outside the normal redemption window if a key person (such as the 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 fund structures, and as reflected in offering documents, can lead to adverse or potentially disastrous outcomes for investors. These choices are understood to have been made with the best intentions of the respective managers, often to achieve operational and cost efficiencies.
Side pockets
A fund provides side pocket exposure to investors without creating a legally separate side pocket and only records the side pocket exposure for accounting purposes.
The intentions of the manager and the fund were clear and the accounting treatment was correct.
However, because no legal side pockets are created, investors in the fund can theoretically and legally 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 received investor statements that did not reflect the side pocket category (because none was created) and therefore may have believed that their entire reported net asset value (NAV) was 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 putting the entire fund at risk of collapse.
Eventually, this was rectified with clear definitions provided in updated fund legal documents, creation of formal and legal side pockets, and proper investor reporting.
It is worth noting that 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 that L1D intends to invest in is actually a share class of a larger fund (the “umbrella fund”) that offers various strategies through different share classes. Each share class has its own corresponding fee terms and redemption rights.
The umbrella fund is a standard master-feeder fund structure.
On the surface, this appears to be a way to scale various strategies through a single fund structure to save on costs and execution fees. However, one of the stipulations in the “Risks” section reads:
Cross-class liabilities. For accounting purposes, each class and series of shares will represent a separate account and will maintain separate accounting records. However, this arrangement is binding only among shareholders and not on external creditors dealing with the fund as a whole. As a result, all of the fund's assets may be required to satisfy all of the fund's liabilities, regardless of whether such assets or liabilities are attributable to any separate portfolio. In practice, cross-class liabilities will generally only arise in the event that a class becomes insolvent or otherwise exhausts its assets and is unable to satisfy all of its liabilities.
What does this mean? It means that if the umbrella fund is liquidated, the assets of each share class will be treated as assets available to creditors of the umbrella fund, potentially wiping out the assets of each share class.
What happened? The umbrella fund ultimately failed to manage risk, leading to its collapse and liquidation, and the assets of each share class, including the specific share class that L1D considered as an investment opportunity, were 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.
Risk management failures at the investment level led to blow-ups, 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 huge losses for investors in a stress scenario. The risk was actually 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 trying 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 offers both leveraged and unleveraged versions of its strategy through share classes within a single fund.
The fund is a single pool and all collateral is in a single legal pool with the fund’s counterparties – all gains and losses are attributed to the entire fund and the manager allocates gains and losses on an accounting basis based on leverage across share classes.
The fund’s strategy and corresponding risk management processes changed without notifying investors, coinciding with a major market event that effectively wiped out the fund’s collateral with its counterparties, leading to large-scale liquidations.
Based on the leverage ratio defined at the share class level, investors in the non-leveraged share class would have expected a larger loss, but not a wipe-out. Similarly, the cross-class liability risk expressed in the PPM communicates this risk, but is not well understood by investors in the non-leveraged share class.
The fund’s failure was the result of a confluence of events – unannounced strategy changes and poor risk management, coinciding with tail market events, coupled with structural choices that meant investors intending to gain unleveraged exposure were still subject to the application of leverage.
Net Asset Value (NAV) reporting delays
See Service Providers section, Fund Administrators.
Operations 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 stock trading.
In crypto trading and investing, trading venues and custody form the core infrastructure as their combined functionality forms a parallel architecture to the traditional financial settlement and prime brokerage models. As these entities are at the heart of all trading, all processes and workflows are developed around interacting with them. The following diagram 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 in custody (e.g., lend securities to other clients of the prime broker).
While prime brokers play a key role in managing counterparty risk, they are themselves the fund’s primary counterparty 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 with underlying assets sitting 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 a clear 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 will not be 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 broker 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 the space, much or even most expertise should be expected to be in-house, with the manager’s own domain knowledge being critical.
The operational stack of a crypto hedge fund
The following are the main operational functions in a Crypto HF. It is still important to maintain a certain degree of separation between operations and investing/trading, which is usually applicable to the signing policy involving the movement of assets.
Middle/back office: Fund accounting, trading and portfolio reconciliation, net asset value (NAV) generation – often overseeing and managing fund administrators.
Financial management: managing cash and equivalents, collateral on exchanges, stablecoin inventory, and banking relationships.
Counterparty management: Conduct due diligence on counterparties including exchanges and over-the-counter trading desks, open accounts with counterparties and negotiate commercial terms, establish asset transfer and settlement procedures between fund custody assets and counterparties, and set exposure limits for 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 performing due diligence on third-party custodian providers.
IT and Data Management: Data systems, portfolio accounting, backup and recovery, cybersecurity.
Reports: internal reports, investor reports, audits.
Valuation: Develop and apply valuation policies.
Legal and Compliance: Manage external legal counsel, internal policies and procedures, and handle 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 fund administrators.
Operational Role
Given the above operational functions and responsibilities, when considering the appropriate skills for an operations staff member (typically a Director of Operations and/or 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 required experience generally falls into two categories:
Accounting and auditing – Applicable to all funds, but particularly critical for funds with high turnover, numerous projects and complex share structures (e.g. side pockets).
Legal and structural – applies to funds trading structured products and strategies that contain tax and regulatory components, often some form of arbitrage.
In both cases, if there are gaps in the 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 oversight 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 managing this process.
As a best practice, the investment manager is able 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.
Asset Lifecycle
The flow of assets from fund subscription, trading to redemption demonstrates the functionality of the operational stack. The following generic life cycle indicates the key nodes of the operation:
Investors' subscriptions are transferred to the fund's bank account
Investors' 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 a fiat on-ramp (exchange or OTC) and converted into (usually) stablecoins; typically, the fund administrator must act as a second signatory to transfer fiat currency out of the bank account.
Stablecoin balances may be held on exchanges and/or in third-party custodians.
Investment Committee/Chief Investment Officer (CIO) decides on transactions/investments
Pre-trade approval for compliance (e.g. personal trading policy) and/or risk management purposes.
Traders source liquidity from a counterparty – exchange or OTC – and specify an order type such as market, limit, stop, and possibly an execution algorithm such as TWAP (time-weighted average price), VWAP (volume-weighted average price).
Interact with counterparties via APIs, web portals, or chat tools like Telegram.
If listed assets are traded on an exchange, 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.
If it is a perpetual contract transaction - you need to maintain a collateral balance on the exchange and pay funding fees 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, custody, bank), prices, volumes, price references, calculates portfolio profit and loss; publishes internal reports.
At the end of the month, provide transaction documents and reconciliation information to the fund administrator
Fund administrators independently verify assets and prices with all counterparties, custodians, banks – often manually, via APIs, getting support from OTC desks (e.g. Telegram chats), and/or using third-party tools (e.g. Lukka), applying fees and expense provisions.
The investment manager works with the fund administrator to resolve differences in the reconciliation and calculate the final net asset value (NAV).
The fund administrator applies an internal quality assurance (QA) process to calculate the fund's NAV and investor's NAV.
The fund administrator provides the final NAV information to the investment manager for review and signature and issues the investor report.
Investors submit redemption applications
The invested assets are transferred from the custodian to the exchange/OTC, converted into fiat currency, and sent to the fund’s investor bank accounts.
After the NAV is approved
The fund administrator authorizes the payment of redemption proceeds to redeeming investors.
Summary of counterparty funding flows
This chart reflects the flow of funds depicted over the life cycle of an asset.
Trading venue and counterparty risk management
Since the FTX debacle, funds have reevaluated their 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) where 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 agreements with OTC desks provide for delivery versus payment (DVP), whereby clients pay before assets are delivered. Furthermore, these agreements typically provide for such assets to be commingled with other client assets, rather than being segregated or bankruptcy remote. Therefore, there remains the risk of an OTC counterparty defaulting before assets are delivered. During the FTX collapse, certain OTC desks themselves had unsettled client trades with FTX. These OTC desks became creditors of the FTX estate, and despite having no obligation, chose to fully reimburse clients from their own balance sheets. Formal underwriting of exchanges and OTC counterparties has been difficult, as financial statements are not necessarily available and may be of limited use, although transparency is improving.
Counterparty risk management approach
In order to appropriately manage counterparty risk, investment managers should develop policies that are compatible with their investment strategy. This may/should include defining:
The maximum exposure permitted to any counterparty.
Maximum exposure allowed to any counterparty type – exchange, OTC, custodial.
Maximum exposure permitted to any sub-category – qualified custodians vs. other.
The maximum time limit for a trade to settle - usually measured in hours.
The proportion of a fund's assets that may be outstanding at any given time.
Other measures can be taken to monitor the health of counterparties, including regularly "pinging" counterparties for small transactions to test response times. If response times are outside normal ranges, managers may move exposure away from that counterparty. It is well known that fund managers continuously monitor market activity, news, and wallets of major players to identify unusual activity, respond in advance to any potential defaults, and transfer assets.
Considerations for DeFi
Decentralized exchanges (“DEXs”) and automated market makers (“AMMs”) can complement a fund’s counterparty universe and, under certain conditions, serve as substitutes. When certain centralized players experience distress, their DeFi counterparts perform relatively well.
When interacting with DeFi protocols, funds transform counterparty risk into smart contract risk. Generally speaking, the best way to underwrite smart contract risk is to size exposure in the same way as you define counterparty exposure limits (as described above).
Additionally, there are access and custody considerations when interacting with DeFi protocols, which are covered in more detail in Section 6 — Custody.
Tripartite Structure
To manage counterparty risk associated with exchanges, several service providers have developed innovative approaches that implement a tripartite structure. The solutions detailed below have 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 - an entity that manages the collateral in the transaction, usually 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 (usually 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 occurs.
As part of the process, excess collateral is posted or returned in response to 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, through its ClearLoop product, enables over-the-counter settlement or in-custody settlement. 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 the 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, funded by financing trades for clients. HRP reduces its risk by setting risk limits and requiring partial collateral to be posted in advance. Clients can then hedge their positions between trading venues.
In this framework:
The Fund is not required to post collateral to an exchange or trading partner.
The counterparty risk is transferred to the HRP's balance sheet.
Trades are recorded under ISDA and standard prime brokerage agreements.
Clients can margin trade their portfolios in various 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 investors' subscriptions are accepted, funds are usually converted into stablecoins through a fiat currency entry (exchange or OTC counter). The considerations for the financial management function are as follows:
Banking Partners
Stablecoins
Banking Partners
Given that most activities are conducted in cryptocurrencies, usually stablecoins, Crypto HFs typically maintain very low fiat currency balances. Nevertheless, all Crypto HFs need to establish banking partnerships to accept investor subscriptions, fund fiat-based payouts and pay service providers. The number of banking partners willing to work with crypto clients continues to increase, but from an anti-money laundering (AML) and know your customer (KYC) perspective, the account opening process can be cumbersome and often takes months to complete.
Given that banks’ willingness to work with crypto clients may change based on their respective risk appetites, funds should work with at least two banking partners to ensure redundancy. When Silicon Valley Bank, Signature Bank, and Silvergate Bank failed, many funds lost their banking partners and were unable to reliably conduct certain operations, including funding redemptions that had been submitted and accepted prior to the failure of these banks.
The account opening process requires a lot of documentation, either through a portal or by direct submission. 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 (e.g. directors) and the investment manager. 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.
Below is the standard set of documents required for the onboarding process at a US bank. These documents are fairly standard, but they themselves may contain up to 100 basic questions related to the fund's operations, investment managers, all service providers, and potential investors. In addition, once an account is successfully opened, there is usually ongoing/annual compliance work that may amount to a re-opening of the account.
Bank partner account opening document requirements:
Account Application Form
Due Diligence Questionnaire
Certificate of Incorporation – usually requires notarization or certification
Private Placement Memorandum
Articles of Association or Limited Partnership Agreement
Financial Statements
Register of Directors
Commercial register extract
Form W-BEN-E
FATCA ID - Global Intermediary Identification Number (GIIN)
US Tax ID Number
Passport/driving license of the account signatory and authorized user
Proof of ultimate beneficial owner
Passport/driving license/residence certificate 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 an integral part of conducting crypto transactions. 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 happened). Therefore, it is wise to diversify your stablecoin inventory into multiple stablecoins.
Bank partners typically do not impose minimum monthly balance requirements, but also do not typically offer a full suite of services to small fund accounts, including the ability to purchase and hold U.S. 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 present their own risks, and the structure of each stablecoin product should be subject to due diligence to properly understand these risks.
Hosting
In the crypto space, the term “custody” is a metaphor because there is no physical representation of the asset, such as a stock certificate.
In traditional finance (TradFi), custody is identity-based, where the custodian acts as an agent for the ownership of assets of individuals and corporate entities. In cryptocurrencies, the custodian acts as an agent for access and control of private keys.
There are many types of custody available for cryptocurrencies, and the appropriate form of custody is often determined by the investment strategy for the asset being traded and the frequency of trading. It is likely that more than one type of custody will be implemented simultaneously.
Where policy permits, the use of third-party custodians 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.
Hosting Policy
It is important to understand the technical differences between the various types of custody, and the products of the top custodians each implement several industry-standard security architectures. The track record of existing crypto custodians is quite good, with no major losses, either systemic or individual, and they have withstood various crises unique to the industry. In fact, custodians have benefited from these crises because investors now pay more and more attention to 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:
Trading 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 require keeping 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 typically apply to allocations 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 the best approach on behalf of its investors.
Internal resources: For teams whose strategy requires the use of self-hosting, these teams should have the necessary technical expertise and/or access to establish an appropriate operational security program 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 recovering 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 appointment of a third-party legal agent to act on the fund’s behalf 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 the assets are legally segregated and belong to the fund, as well as 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 overseen 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 elsewhere 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. Opening and maintaining an account with a third-party custodian involves a certain amount of overhead and cost that may not be worthwhile for a newly started 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 trading frequency 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.
Here’s a breakdown of the pros and cons of the four main hosting categories:
Self-Hosting
Browser-based, software, cold wallet/hardware/offline.
Broader asset support, greater control.
Secure, but requires a very good framework with multiple layers of redundancy, coordination, and technical knowledge.
Typically 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 users (e.g. EVM’s Safe, Solana’s Squads).
More suitable for low turnover strategies rather than strategies with higher transaction frequency, as moving assets between wallets is more operationally complex.
May involve the use of hardware to access a non-custodial wallet.
escrow
Institutional level.
Clearly defined functions and controls.
May have certain compliance/lightly regulated statuses, such as qualified custodian, and be subject to SOC audits; others (such as Anchorage) have been placed under the supervision of the U.S. Office of the Comptroller of the Currency (OCC); may be insured to a limited extent.
Assume responsibility for assets, services, and management of complex technologies.
With sub-custody, institutional investors can outsource custody operations to a custodian in a pooled account or segregated account setup (where the custodian is unaware of the end investors).
This can be a warm wallet, hot wallet, or cold wallet (see below).
The following table provides a high-level overview of the characteristics of each wallet type.
Third-party custodian
These custodians are usually the most technologically advanced, providing complete custody infrastructure and corresponding workflows. A third-party custodian is 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 shards to sign transactions. MPC is used when a client wishes to hold portions of a private key (“shards” or “shares”) 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 keys. MPC implements a custody solution where the multi-signature requirement replaces the need to store private keys offline. Shards are geographically and architecturally decentralized.
Hardware Security Module (HSM)
An HSM is a piece of hardware that allows for secure and controlled decryption of private keys. The private keys are generated on the device and cannot be extracted without destroying the device - they are never exposed, even to the device holder, and cannot be copied or hacked. 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 an HSM is that the keys are kept 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 pros and cons of MPC vs. HSM when choosing a third-party custody provider. To date, both have been relatively well-tested and have demonstrated adequate security. In fact, MPC custodians can store each shard in an HSM module, so the technologies are complementary.
Open 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 custodian and investment manager's policies 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 platform. This may involve creating strong passwords, enabling two-factor authentication (2FA), defining access controls for authorized personnel, enabling biometrics and video call-back.
Test and Validate: Test the deposit and withdrawal process with small amounts of funds to ensure everything goes smoothly before processing larger holdings.
Security training: Custodians may provide training on how to use their platform safely, 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 whitelisted address, specify the types of transactions allowed. Common permissions include:
Deposits: Allows funds to be deposited into whitelisted addresses.
Withdrawal: Allowed from white name
