Due Diligence for Crypto Investing
With the exponential increase in the adoption of cryptocurrencies such as Bitcoin (BTC) or Ethereum (ETH), more and more fund allocators are choosing to invest in digital currencies through fund managers to take advantage of the new wave of growth and the advantages that blockchain technology offers.
Due to the crypto space’s decentralized and unconstrained nature, these digital assets have become the key to decentralized financial services (DeFi) and open crypto markets outside of a single jurisdiction.
Even so, this ecosystem brings its risks. In addition to the volatility of these crypto-assets, their decentralized and open nature can facilitate money laundering and other malicious activities.
This is why an increasing number of venture capital companies and institutional investors are entering into this alternative investment with the help of Operational Due Diligence (ODD) on any fund managers facilitating these investments.
What is Operational Due Diligence?
Operational due diligence is the process of monitoring and operational oversight of investment managers and funds. This process considers the operational process, supply chain and logistics, human resources, workforce strategy, cost optimization, and risk management.
Unfortunately, the decentralized and risky nature of cryptocurrency adds another layer of complication to operational due diligence.
ODD is a critical process for anyone investing in hedge funds that are dabbling in cryptocurrencies because operational risks, which include things like fraud and theft, are heightened when it comes to this new and unstable asset class.
Why is ODD Important for Crypto Investing?
A skilled fund manager who recognizes an underutilized venture with high potential might make significant profits, but there must be operational guardrails in place to ensure that any funds invested are properly managed and secured due to the high-risk nature of cryptocurrency.
For example, in 2014, One Coin collected millions of dollars in investment funds with managers having collected little to no details about its technologies while making huge claims and flashing jargon.
Soon after, its investors realized they were in a four-billion-dollar Ponzi scheme, and the now-super-rich creator, identified as “Doctor Asia”, vanished.
Without proper ODD, it is difficult to spot the red flags associated with the management of these types of investments which can lead to catastrophic losses.
Another recent example of this threat was the case of Michael Ackerman, who pleaded guilty in September of this year to wire fraud.
As the hedge fund manager of a cryptocurrency investment, Ackerman raised more than $37 million by falsely touting monthly returns of over 15% and doctoring numerous account screenshots used to communicate with investors.
As a result, Ackerman pleaded guilty to one count of wire fraud, agreed to restitution of at least $30,667,738.79, and agreed to the forfeiture of $36,268,515.
Yet another example is the YAM protocol, which gained traction in the DeFi space as a purely decentralized DeFi project that allowed holders to deploy a decentralized governance model.
But in August 2020, Yam co-founder Brock Elmore announced the protocol had a bug that crippled its governance system.
Nearly 24 hours later, almost $500 million of capital was locked in the Yam protocol, and while no assets were lost, the value of Yam itself dropped to zero.
5 Key Considerations For Crypto ODD
Before investing in hedge funds that are investing in cryptocurrencies, performing a due diligence process is essential to ensure the viability of funds management.
With crypto, you have all the typical risks associated with investments, plus additional risks associated with the uncertain nature of crypto assets that require an additional level of due diligence, according to the Standards Board for Alternative Investments.
Investment Strategies & Trade Processes
First, you need to have a firm understanding of what strategies and trade processes are being used by fund managers to invest (i.e. arbitrage, token appreciation, etc) and what risks are associated with those strategies.
You also must identify where the custody of assets is being held. There are numerous risks associated with asset custodianship because of the newer nature of this type of investment.
Often assets are encrypted with keys but it’s important to understand how those encryption keys function and whether assets are being held privately or through a third party.
Accounting Practices, Including Valuation and Asset Verification
Additionally, you’ll want to audit the fund managers’ accounting practices and how the assets are valued and verified.
Some tokens aren’t associated with US dollars so there needs to be a clear, documented monetary conversion and verification system in place for the security of investment funds.
Conflicts of Interest
It’s also important to identify any potential conflicts of interest that could arise with the fund manager. This can include anything from prior business relationships to undisclosed personal investments in related or unrelated crypto assets.
Regulatory & Protocol Risk
Finally, ODD professionals should assess any regulatory risk associated with fund managers to determine if they are in compliance.
In the U.S., for example, this typically includes ensuring that any SEC-registered investment managers or advisers who manage funds investing in crypto assets only use securities that fall under the appropriate exemptions.
Additionally, Layer 1 and protocol risk should be considered. Layer 1 blockchains are the platforms themselves (like Ethereum, Solana, Terra, etc.) while protocols are the dApps built on them (for example Sushiswap, Yam was a protocol, Uniswap, etc.).
Both have risks associated with bugs present in the code, so you must make sure they have gone through independent code audits.
For example, Solana has gone down several times in the past year due to bugs and issues with scalability. In essence, you want to know in what protocols and Layer 1 blockchains your hedge fund managers are invested in, how much is being invested, and include this in your ongoing due diligence.
How ODD360 Can Streamline Your Crypto ODD
Managing all these aspects when entering a market as volatile as crypto-assets can be a complicated task, so automating the ODD process can be the best decision for such cases.
ODD360 is a multi-party operational due diligence software that Investors and Managers employ to create a superior operational due diligence process experience.
ODD360 offers a highly intuitive user interface, extensive automation, and analytics. It provides Managers with a straightforward, clear, and fast approach to reply to DDQs or RFIs.
ODD360 improves productivity dramatically and helps consultants to give a greater solution to their clients, allowing them to maintain, earn more business, and differentiate themselves in the market.
To learn more about how ODD360 can help you optimize your operational due diligence, schedule a demo today!