Digital asset fund managers face substantial risk in the disclosure of their investment fund strategy and have limited precedent in preparing those disclosures. As an emerging asset concept, distributed ledger technology presents a myriad of potential regulatory considerations, technological complexities, and market uncertainties with few analogous instruments. As with any fund offering disclosure, digital asset fund managers are advised to err on the side of thoroughness and caution in disclosing the breadth of the investment strategy and its potential risks.
Digital asset technology is fast-moving and highly interdependent, with market intermediaries that are quickly evolving and frequently updating core business functions. Offering documents quickly become outdated due to technological advancement.
Digital assets on a distributed ledger present unique cybersecurity risks relating to the physical security of the asset. Unlike equity, debt, and futures instruments, which are representatives of an underlying asset and typically cannot be “stolen,” digital ownership of assets is based on encryption techniques that generate units independent of a centralized repository of ownership, represented by access codes, which can be misappropriated or lost in ways that can be unrecoverable. Exchanges, custodians, and various hardware and computer programs have made strides towards mitigating the risk of loss, but the fundamental cybersecurity risk of trading and holding digital assets remains a critical risk facing funds and their investors.
A hedge fund relies heavily on custodians to execute trades on behalf of the fund manager and to safely hold custody of assets on behalf of the fund. For a traditional hedge fund, the custodian holds fund assets through all stages of the investment cycle in an unbroken chain, from trading to liquidation, with a strong structure in place, built on decades of precedent and industry evolution. For digital asset funds, holding custody of investor assets presents significant risks for investors, as well as regulatory concerns with the satisfaction of the SEC’s custodial provisions required by registered investment advisers. Unlike traditional liquid markets, there are no prime brokers for virtual assets, a role generally played by an investment bank, to facilitate the trading and safeguarding of crypto assets.
Regulatory uncertainties surrounding blockchain and distributed ledger technologies abound. Because global and national standards are far from being fully established, fund managers face the heavy disclosure obligation to not only disclose existing regulatory considerations but the potential outcome of various regulatory issues that have yet to be decided. The comprehensive regulation needed to facilitate institutional investment will require the coordination of global standards, particularly for the exchanges. For U.S. governance, regulatory standards will likely be set not by a single authority, but by a combination of state, national, international and industry bodies, judicial precedent, international agreements, and industry associations.
Moreover, digital assets investments are inherently global. Even for fund managers drawing on an investor base solely located within its home country, regulatory issues across the world can have direct and indirect impacts on the investment portfolio. Crypto exchange platforms, custodians, counterparties, and (for centralized exchanges) token issuers are rarely all located within a single jurisdiction.
For further information on hedge fund risk disclosure, see our blog posts, “What’s in a Private Placement Memorandum” and “Hedge Fund Documents.” Likewise, for additional discussion on Hedge Fund Prime Broker/Custodian, see our blog post here.