Part V - Towards An Onchain Crypto Hedge Fund
We concluded our previous Part of this Fund Special by identifying some of the key frictions in setting up and managing a crypto hedge fund the analog way. In this last Part, we look at the future.
Here is the vision:
A web3 site that lets Subscribers to an onchain Fund connect with their wallet and prime it for purchase of Shares in the Fund.
Before they proceed, Subscribers are given the onchain tools to whitelist their wallet by attesting to their real-world identity.
Alternatively, they can whitelist their custodied wallets by linking their account on for instance centralized exchanges who have already performed KYC.
By proceeding, they accept all the terms of the analog Subscription Agreement by scrolling down an online form and clicking for agreement at the bottom, the same way we are asked to agree to the terms of any new software update.
Any further information Subscriber currently provides by filling out tedious analog forms would be harvested online by way of an elegant UXUI served up via the Fund’s Web3 site.
All shares in the Fund are tokenized and their smart contract prevents transfer unless approved by the Manager, as per the Terms. This would avoid the emergence of a parallel marketplace for the Fund’s tokens e.g. on decentralized exchanges and prevent price divergence and arbitrage between the Fund’s NAV per Share and the price of its tokenized Share in the open market.
This NAV per Share is automatically and real-time calculated since all underlying positions in the Fund are marked-to-market 24/7/365.
As a result, liquidity in the Fund - if the Managers wish so - could be compressed to the time it takes for a transaction on blockchain to confirm. Signing such transaction would have legal equivalence with submitting an analog redemption notice.
The role of a Fund Admin would be entirely taken over by blockchain:
Subscriptions and Redemption are pushed via the Fund’s online front-end and confirmed on a decentralized ledger;
The NAV of the Fund is an aggregator of each of the Fund’s positions at any given moment in time.
KYC/AML checks are done at the wallet level and could be augmented. by onchain analysis tools such as Chainanalysis.
Custody would be by way of multi-sig wallets, if necessary with third-party crypto custodians as a signature party.
Can it be done?
We recognize that the above vision would need significant development time to implement however from a technical point of view this can be built.
The reason we concluded Part IV stating Otonomos would need seven lives before we start building this vision is that it would require a change of mindset with not only regulators but also with service providers including lawyers, fund admin, custodians, and auditors.
Legal service firms are still ensconced in walled garden thinking instead of open-sourcing their documentation, hiding behind possible legal liabilities from the free use of their documents (which can easily be contracted away using available licensing models. Also, what legal firm has ever been sued for giving wrong advice? If you know cases please email us!). We await the day that legal firms accept that documentation is a commodity knowing that what will always be in demand is their brain trust.
Reactionary thinking when it comes to crypto, including by legal services firms who refuse to be involved with the setup of crypto hedge funds that take subscriptions and make redemptions in crypto. This reactionary thinking is part the result of general conservatism in the legal profession, part a lack of understanding of the technology, and part regulators’ fault.
The latter stems from regulators increasingly imposing liabilities and penalties on service providers, including legal firms and corporate service providers, which over the years has lead to everybody being asked to police everybody else. However, it is not the role and neither could legal firms and corporate service providers practically verify if a transaction in crypto to subscribe for Shares in a Fund they documented or incorporated could come from a wallet that contains criminal proceeds. Because they can’t, they prefer not to touch funds that take crypto since there is potential reputational risk and their respective regulators could punish them by taking away their professional license.
Fund admin and auditors do have an explicit compliance role in a fund setup. However in a decentralized world that acts as a ledger of wallet addresses and calculates and performs calculations on such wallets’ contents, the role of a fund admin and auditor will only remain mandated because regulators lack imagination, not because their services are still relevant, in the same way that notaries live by the grace of the outdated rituals they have been given under the law.
Can’t be bothered won’t be bothered?
The above shows that putting Fund formation onchain and seeking to automate it is quite tiresome, the economics may not be all that good and life generally is perhaps too short!
However, as has become our house style, if Otonomos were to develop an onchain Fund product, we would probably develop it first for an in-house Fund and then white-label it.
In this context, we are having internal discussions about launching a Fund ourselves that would let each of our clients invest in each other client.
Conceptually, this could be rather powerful since it would mean that becoming a client of Otonomos means you get funded by the Otonomos Client Fund.
Practically, we already hold KYC for all of our clients on file.
In addition, we have first dibs on projects given that they come to us in a very early stage, typically even before they have their legal stack sorted.
We also get to know the teams and get a good sense of whether they’ll be able to execute and if they’re genuine about decentralization.
Finally, we have both the technical and legal engineering capacity, which we believe gives us a leg up.
So we may just make an announcement in 2022.
Meantime let us know your thoughts and help us spec an onchain, automated Fund product via our growing Otonomos Intel Swap Telegram channel.