Cryptocurrency Fund 101: Fund Classification and Compliance Operations

Original title: "Cryptocurrency Fund 101: Fund Classification and Compliance Operation"

Original author: Huang Yixuan, Phil, 1Token

As more and more traditional financial institutions and even non-financial institutions enter the cryptocurrency fund business and allocate cryptocurrency-related assets, it becomes more important to operate cryptocurrency funds in compliance. Based on 1Token's years of experience in the cryptocurrency industry and fund-oriented software services, this article introduces the types and characteristics of cryptocurrency funds with different strategic attributes, trading methods, and sources of funds, the operation cases of medium and large-scale compliance funds, and the operation process of cryptocurrency fund business. And the key elements of compliant operation of cryptocurrency funds.

From traditional funds to cryptocurrency funds

A fund in a broad sense refers to a certain amount of funds established for a certain purpose. It mainly includes trust investment funds, provident funds, insurance funds, retirement funds, funds of various foundations...the common feature is that the investment is managed by a dedicated manager (asset manager), thereby creating higher investment returns, and these funds can be invested in Primary market (venture capital, private equity) and secondary market.

Funds have also been developed in the Crypto field for many years. Since around 2014, cryptocurrency funds have quietly emerged, followed by private equity funds and private financial management. By 2021, the first Bitcoin ETF in the United States will be established. With the bull market in 2020-2021, the size of cryptocurrency funds will exceed 62 billion US dollars by 20211. More and more traditional financial institutions and even non-financial institutions have begun to enter the cryptocurrency business and allocate cryptocurrency-related assets.

Cryptocurrency funds have both the attributes of traditional financial products and the attributes of cryptocurrency decentralized technology, so the development path is similar to that of traditional funds while reserving differences. The same point lies in its classification and form, and the difference lies in the unique asset types brought by cryptocurrency, blockchain technology and decentralized finance (DeFi). Due to the large number of investment targets, numerous trading venues and diverse strategies, fund management There are relatively high requirements for people's IT capabilities, and there are also some points worth noting in terms of daily risk control, fund index calculation, and fund auditing.

This article is the beginning of the 1Token cryptocurrency fund series, based on 1Token’s years of experience in the cryptocurrency industry and fund-oriented software services , which mainly introduces the various classifications of cryptocurrency funds and the key elements of operating a cryptocurrency fund business. According to the characteristics and business models of different types of funds, 1Token will launch a series of special introductions in the future.

Classification of cryptocurrency funds

By Investment market classification, cryptocurrency funds can be divided into primary market funds and secondary market funds. Among them, primary market funds mainly refer to investment in blockchain-related projects, including projects that have not yet issued coins and projects that have issued coins but have not landed on mainstream trading platforms (the definition of mainstream trading platforms here is relatively vague, usually referring to the ranking of trading volume Leading trading platforms such as Binance, FTX, Coinbase, etc.), and non-homogeneous Token (Non-Fungible Token, NFT) projects that are gradually emerging. The main investment targets of secondary market funds are various cryptocurrencies and their derivatives, which can be traded on the trading platform or OTC outside the trading platform.

Secondary cryptocurrency funds have a richer classification. Similar to traditional funds, they can be classified according to the source of fundraising (public offering, private offering), redemption mechanism (closed, open), etc.; however, the classification method with more characteristics in the Crypto field is based on strategic attributes, transaction methods and sources of funds Classification. Corresponding to the infrastructure and functions required for business development, this classification method is more in line with the business model in the Crypto field. The following is a brief introduction to the common classification methods of secondary funds in the   Crypto field.

- According to strategy attributes: the most mainstream There are Beta (passive), Alpha (high frequency, neutral), Beta+Alpha (active), fixed income, etc. The income earned by the passive strategy is the income generated by the rise of currency prices. In the field of Crypto, it is mainly reflected in tracking the overall performance of several highly liquid currencies (such as Bitcoin, Ethereum, etc.).

Neutral strategy through long-short hedging, using derivatives and other tools to hedge against market fluctuations (Delta), will long-term The overall risk exposure is controlled at around 0, and the pursuit of absolute returns has nothing to do with the rise and fall of currency prices. Common arbitrage and market-making strategies are all neutral strategies.

Active strategy thinks that there is a target price through a certain analysis model or prediction, and trades around the target price, if If the current price is lower than the target price, go long. If the current price is higher than the target price, then go short. Adjust the position according to the difference between the current price and the target price. The income comes from both the market situation (Beta) and the excess of subjective judgment. Earnings (Alpha).

Fixed income funds mainly obtain income through "bonds". Although there is no standard bond in the Crypto field, there are a large number of Over-the-counter lending is non-standard bonds, which earn interest by lending or earning interest difference in lending. Similar to traditional fixed-income funds, the income is relatively stable, but in actual operation, strong risk control is required (such as collateral management) capabilities. DeFi is a financial activity based on smart contracts on the blockchain, which has certain fixed income attributes. Among them, yield farming is a unique financial asset in the Crypto field, which obtains interest and other income by providing liquidity. We have previously written an article introducing "Under the DeFi tide, how asset management institutions should make stable gold mining" 2, interested readers can read it for reference.

- According to the transaction method: according to the order The method level can be divided into manual trading, algorithmic entrusted trading, and quantitative trading. Manual trading in the Crypto field refers to manually entering the quantity and price directly on the trading platform to place an order, or conducting over-the-counter transactions (OTC) through financial service providers, or trading through the counter system of technical service providers. Quantitative transactions in the Crypto field are placed by connecting to the trading platform API.

Between quantitative and manual trading, there is also algorithmic order trading (TWAP, VWAP, PEG, etc.). In terms of trading methods, there are two main differences between the Crypto field and traditional finance: the first is that cryptocurrencies are usually traded 24 hours a day, and the second is that the Crypto field can trade the same target (such as BTC/USD spot) in more For venue transactions, there are hundreds of centralized trading platforms worldwide, as well as decentralized trading platforms such as Uniswap and Pancakeswap.

Traditional finance can only obtain market quotations and place orders through the quantitative trading interface/speed trading software provided by securities companies, while Crypto Investors in the Crypto field can directly connect to the trading platform to obtain free quotes and place orders at high frequency, which also makes Alpha strategies in the Crypto field more arbitrage possibilities (such as cross-exchange arbitrage). Different institutions will choose different trading methods according to their own profit expectations (obtaining Beta or Alpha income), combined with trading capabilities and technical capabilities.

- By Funding Source: divided into Business funds, wealth management on behalf of customers, compliant private equity, public equity funds. As the name suggests, self-operated funds do not raise funds from outside, such as prop trading firms, or family offices that operate in a low-key manner. Wealth management on behalf of customers is the use of other people's trading platform accounts with funds, which is similar to traditional financial off-site fund allocation, and most of them are ultra-high-net-worth large households and institutions. Compliant private placements have fund entities, managers, external fund administrators (fund admins), fund auditors, and local compliance supervision that are registered in the regulatory framework. Public offering funds mostly adopt passive strategies. The fund issuer only provides subscription and redemption, and implements the established trading strategy according to the subscription and redemption situation. It is hosted by a third party, and there will be market makers to provide liquidity. The outstanding shares can be circulated in the secondary market. .

In the actual operation and management of cryptocurrency funds, different types of funds are actually operated due to differences in capital and asset The main points and difficulties are also different (such as the risk control of the fund, valuation, liquidation, etc.), and will be dismantled and analyzed one by one in the follow-up series of fund articles. People in the field think and discuss together.

Common cases of compliant fund companies

This article lists three representative cases of cryptocurrency compliance funds: offshore private equity funds, Hong Kong compliance private equity funds, and US compliance public offering funds.

- AnB Investment (offshore compliance private equity fund)< /b>: It is a separate investment portfolio company (SPC) registered in the Cayman Islands. It operates two funds, a quantitative multi-strategy fund and a neutral strategy fund. The main investment targets are cryptocurrencies and DeFi, and it mainly earns Alpha income brought about by market fluctuations. The total AUM of the fund is US$50 million, and the minimum investment for a single investor is US$100,000. Both funds are open for subscription and redemption on a monthly basis. The source of income for the operating fund is management fees and performance sharing. According to AnB Investment's promotional materials, the management fee is 2.4%, and the performance share is a high-water mark of 20%. The main expenditures of the operating fund are strategy, transaction, audit, operation, risk control, legal related systems and human expenditure.

- Huobi Asset Management (Hong Kong Compliant Private Equity Fund) : It is an asset management company registered in Hong Kong, holding the No. 4 license (securities consulting) and No. 9 license (asset management) of the Hong Kong Securities Regulatory Commission. It operates a number of private virtual asset funds that comply with the relevant provisions of the Hong Kong Securities Regulatory Commission, including currency price tracking (Bitcoin and Ethereum) and active multi-strategy. As a fund manager, Huobi Asset Management only provides services to professional investors. The actual operation is similar to that of offshore private equity funds. It adopts the SPC structure. Funds (including traditional and virtual funds) are hosted by a third party that complies with the relevant provisions of the Hong Kong Securities Regulatory Commission. The transaction involves multiple trading platforms, and the third-party fund administrator is responsible for product valuation. Daily affairs such as reporting, data integration, and risk control are completed jointly by the system and manpower.

- ProShares (US compliant public offering fund): It is a compliant public offering fund company registered in the United States. It operates the first compliant ETF fund in the United States - BITO Fund. This fund does not hold bitcoin spot (currently there is no compliant public offering fund that holds bitcoin spot), but tracks bitcoin price trends by holding bitcoin-related futures contracts. Consistent with the traditional financial market, public funds can be circulated in the secondary market. In addition to the custody of legal currency and encrypted currency and fund administration, the actual operation also has a TA fund account (Transfer Agent) and a fund sales team 3. Compared with private equity funds, compliant public equity funds face stricter supervision, more frequent disclosures (public equity funds disclose net worth every trading day), face a wider investor group, and have higher operating costs.

How to operate a cryptocurrency fund

raising Subjects receiving funds such as fund companies and trust companies are collectively referred to as buyers. As can be seen from the previous classification and cases, the buyer’s operation of cryptocurrency funds, especially compliance funds, mainly involves two categories: investment management of funds and compliance operation management of funds. Among them, the investment management is mainly carried out by the buyer internally (there is also the possibility of hiring an external transaction team to invest, but the buyer still needs to be responsible for the actual operation of the fund),  Compliance operation management is usually carried out by the buyer and the hired third party (fund administration, auditing) company) are jointly responsible. The following describes the business process and key points of operating the fund buyer and the third party respectively.

Buyer business process:

1.  Obtain operating license: Depending on the place where the fund is issued/regulatory requirements, different licenses are involved. In places with higher compliance thresholds such as Hong Kong, you must apply to the SFC for a special Virtual asset asset management and fund distribution license4, while offshore regions such as the Cayman Islands and BVI have become popular choices for funds due to their relatively low compliance thresholds, and professional fund administrators and law firms are generally used to apply for them.

2.   Determining Fund Elements: Similar to traditional finance, according to regulatory It is required to make a fund contract: including the investment scope of the fund, investment strategy, opening frequency, related expenses such as management fees, accrual methods and ratios of performance remuneration, etc.

3.   Fundraising: The mainstream Crypto funds are generally in US dollars Standard fund (the currency used to calculate the net value of the fund is USD), but the specific purchase funds can be legal currency, stablecoin USDT/USDC, or even cryptocurrencies with better liquidity such as Bitcoin and Ethereum. Usually, the same fund has only one standard currency (single standard), such as the common US dollar standard, or the currency standard that the "coin party" is keen on. In the scenario of agency financial management, there may be multiple assets such as USD and Bitcoin at the same time. As an initial input (mixed standard). The funds raised will be stored in escrow accounts (most funds in the Crypto field directly use trading platforms as custodian institutions, and professional custodian institutions have gradually emerged in recent years).

4.   Daily Operation: Mainly includes redemption management, transaction, Risk monitoring, dividend and expense accrual, compliance reporting.

a)   Redemption management: including the redemption and liquidation of various standard funds, in the redemption, liquidation Afterwards, adjust the net value of the fund accordingly

b)   Trading: Set pre-event risk control before trading, retain risk control modification and trigger Record. Fund institutions usually use algorithms such as TWAP and VWAP to entrust, or seek third-party OTC to execute on their behalf, or develop quantitative strategies by themselves to minimize the impact of strategies on the market.

c)   Risk control: general risk control indicators include net worth, retracement, exposure, liquidation risk, Stress testing, VAR monitoring, etc. Different asset attributes correspond to different risk control strategies. Subjective trading strategy risk control mainly needs to monitor and deal with drawdowns. Neutral strategy risk control mainly monitors whether the strategy risk exposure is kept near 0. The risk control of the lending strategy is mainly to ensure the safety of the principal, which is specifically manifested in the valuation and liquidation of the collateral of the borrower when the fund is the lender (usually the fund pool is the investor's assets). The risk control of the DeFi strategy is mainly to obtain contract information in a timely manner, and the specific monitoring indicators vary according to different contract types.

d)   Dividends and expense accrual: fund expense accrual and amortization, regular dividends, management fees and For the accrual of high-water mark performance remuneration, the general third-party fund administration will issue calculations and report to investors, but fund managers are obliged to verify the data to ensure accuracy.

e)   Compliance report: Funds with various strategies/asset attributes need to calculate various operational indicators , to describe fund performance, such as fund valuation table, net value, drawdown, volatility, etc. Compliance funds usually also require regular (daily, weekly) risk control reports, transaction reports, etc. In addition, it is also necessary to cooperate with external audits to provide detailed data such as deposits and withdrawals of accounts involved in the fund, transaction flow, etc., for reconciliation.

5.   Fund termination: similar to daily redemption management , Fund termination includes the liquidation and withdrawal of investor shares and funds. Settlement of trading and custody accounts

Third party (mainly fund administration, custody, auditing companies) business process:

1.   Connect with investment institutions and clarify service methods: usually provide investor management, account management, fund accounting, administrative compliance management, and cost calculation , Assist in auditing and other services.

2.   Investor management: including investor KYC management, fund redemption, investor share Management, etc.

3.   Raw data reconciliation: For various assets and transaction accounts under the fund name, obtain Accurate asset snapshots, fund transfers, deposits and withdrawals, and transaction flow data. Complete account level reconciliation.

4.   Calculation of fund-related expenses: including calculation of management fees, fund operating expenses and other expenses and performance commissions.

5.   Issuing regular reports: usually a monthly fund investor report (including fund net value, Valuation profit and loss, etc.), calculate accurate fund net value and other related data. In addition, he will also be responsible for completing quarterly, semi-annual, and annual financial statements, etc.

The various roles surrounding the operation of the above funds involve The following operational key points

Buyer business key points:

The daily operation of the buyer involves multiple business roles, mainly including fund managers, traders, risk control posts, operation posts (domestic securities firms and asset management companies are also called comprehensive management posts or comprehensive posts), compliance post. Each business role is based on a unified underlying data source (market data, mainly obtained through an API connected to the counterparty) and data calculation standards (fund data, mainly obtained through a calculation method that meets internal operations or external audit requirements), within the company and Under the common management framework of external supervision, each business has its own focus.

- Fund Manager: Responsible for multi-dimensional funds data tracking and analysis. Including all counterparties involved in the fund, individual or combined positions, profit and loss, KPI, etc. of all investment targets (including centralized and decentralized). Fund managers in the Crypto field are also responsible for the preparation of customized reports such as investor reports, which require integration and processing of underlying data.

-Trader: Responsible for efficient and stable execution of transactions and transfer of funds. Including the monitoring of market conditions, the transaction itself (such as the entrusted execution of the TWAP algorithm), and related risk indicators.

- Risk Control Post: Responsible for monitoring risk control indicators and report. Including indicator monitoring at the market, fund, and account levels, multi-gradient alarm processing mechanism, risk control operations and risk trigger records, etc.

- Compliance Post:Responsible for related funds The traces and disclosures of internal compliance and external regulatory compliance. Approve traders' transaction applications, and cooperate with risk control and operation posts to complete report preparation, regular disclosure, and regulatory data submission.

- Operation Post: Responsible for a series of data integration and internal collaboration in fund operations . Including fund redemption management and corresponding net value restoration, fund expense management (accrual and amortization of management fees, calculation of gradient performance compensation), fund valuation, reconciliation, historical data records, and internal data statistics required for operations and analyse. Some fund companies will also work with third-party fund administrators to complete fund operations.

Third-party business focus:

- Fund administration (Fund admin) requires the calculation of the net value of the fund: Similar to traditional financial private equity funds, the withdrawal of management fees and performance remuneration may be based on the type of investor, the amount of participation, the type of investment fund, Set the corresponding fee gradient for holding time, fund performance, etc. When there are a large number of investors and high water levels are involved, it is necessary to accrue expenses for a single transaction/person, relying on purely manual or rudimentary system calculations will require a large amount of resources to ensure accurate data. An efficient system needs to embed commonly used rules, and only need to manually set the corresponding parameters (such as accrual method, frequency, ratio) to quickly integrate customer and fund data and output results.

- Auditor requested transaction reconciliation: Reconciliation requires that the change in account balance at the end of the period compared with the beginning of the period can completely correspond to the account’s deposit and withdrawal, transfer, transaction flow, etc. records during the reconciliation period, so it must cover all asset types (including spot, derivatives, DeFi, etc.), Familiar with the trading platform and underlying rules, and support all trading scenarios. For example, the trading platform basically does not provide historical asset and position snapshots. When obtaining transaction history from some large trading platforms, it is necessary to subdivide the query of transaction targets, so that the targets with infrequent transactions are easy to be missed, or some trading platforms provide market makers with maker returns. commission. An efficient solution is to use the system to automatically and regularly obtain account assets and positions, automatically complete data acquisition and verification corresponding to the flow, and automatically complete a large number of account transaction reconciliations.

-The custodian bank requires account security: the transfer is set to a white list, and the limit can only be authorized Transfer between accounts and cannot be transferred to external accounts to ensure investor confidence.

- Fund customers require stronger data processing capabilities: Most of the current funds The administration provides monthly reports. If you want to further expand business capacity, realize higher frequency data requirements (such as weekly reports) or support data analysis of tens of thousands or even 100,000 transactions per day, you need to be familiar with the fund Business, experts who are familiar with the rules of each trading platform, and a robust technical framework to achieve a professional fund PMS system.

1Token provides one-stop system solutions for various buyer financial institutions