Digital Asset Governance – Perspectives for Fund Boards

Unlike traditional asset classes, many of which were created by financial institutions before retail investors could participate, the reverse has been true for digital assets, as institutions catch up with emerging technologies.  As demand for crypto investments and the new layer of opportunities, including stablecoins, tokens and non-fungible tokens (“NFTs”), has increased, the greater commitment seen by institutions suggests crypto is here to stay.  This means fund boards need to ensure that proper and appropriate governance is in place and that the right questions are being asked at the correct time.

RISK FACTORS, QUESTIONS AND MITIGATIONS

Portfolio Assessment

As has often been the case, it is not uncommon for investors to chase the latest trends, which has created pressure for managers to open their portfolio to digital assets.  Conversely, as managers look to make stronger returns in an increasingly competitive market, the performance of digital assets can be enticing.  The key question here for fund boards is whether a move into digital assets really fits the profile of the portfolio.  To make an appropriate assessment, directors should discuss the following points with managers:

•  What are the risk parameters of the portfolio and would adding digital assets fit these parameters?
• What is the risk appetite of the entity and would digital assets be appropriate?
• Do the entity documents make it clear that digital assets are an investment class that can be part of the portfolio?

Service Providers

The digital asset sub-industry is incredibly fast moving and constantly evolving.  Fund boards should be inquiring if the service providers involved are experienced in this space and ensure that appropriate (and continuous) due diligence is being performed.

• Do service providers have the technical background (and the right technology) to perform their duties?
• Do service providers have adequate controls and procedures in place, specifically to service digital assets?
• Do service providers have a deep enough bench to tackle new issues that will inevitably come up in an ever-changing environment?As with any asset class, fund boards should consider if the service providers are up to the task; however, in the case of digital assets, boards should also be continually assessing if these organisations are able to adapt to this rapidly changing technology.

Custody

Perhaps the most concerning issue tied to digital assets, is custody.  Many digital assets were specifically designed to have no central control authority within decentralised blockchain systems.  In other words, these assets were designed not to be governed.  As a result, transparency of custody should be a major focus for fund boards, with the safekeeping of investor assets paramount.  Fund boards should be asking:

• Is hot storage being utilised, which can provide stronger evidence of custody, but leaves more vulnerability to online attacks?
• Is cold storage being utilised, which can be quite secure, but leaves doubt as to ownership and segregation of duties?
• Is there potential for key-person risk and / or lost / stolen passwords?
• What control processes are in place for transactions and reconciliations?
• How susceptible is the setup to possible fraud, theft and manipulation?

Fund boards need to address such concerns at the initial stages, which may help to build a custody framework that can be adopted.  As the complexity of this sub-industry continues to grow, traditional custody solutions and controls that have historically been used may no longer be appropriate.

Cybersecurity

Closely tied to the custody of digital assets, is cybersecurity, which has grown in prominence over the last few decades to become one of the largest risks for the financial industry.  With vast amounts of assets stolen each year at an alarming rate through malware, hacking, scams and phishing attacks; the very nature of digital assets introduces an exceptional degree of cybersecurity risk.  Fund boards exploring the crypto space are well advised to understand management’s approach to the following questions.

• What controls / systems are in place to secure the assets?
• What steps has management taken to ensure robust safeguards for not only the digital assets, but for the fund as a whole?
• Are the cybersecurity standards adopted by the other service providers sufficient for digital assets?
• Have there been security audits and expert reviews of the code, especially if open source?

As blockchain-based transactions are irrevocable by design, there is a risk that assets could be lost forever if a security breach occurs.  While new mechanisms have emerged to assist in recovering stolen digital assets, the reputational damage of falling victim to a hack or other form of crypto theft can linger long after the digital assets have been returned.  It should also be remembered that no matter how secure a system is, the biggest threat often rests with individuals, especially as hacking and infiltration via social engineering remains a popular exploit.

Valuation

Crucially, where digital assets are concerned, the valuation policy of the fund must be both clear and transparent.  If traded on an open exchange, digital assets can be readily valued; however, valuation questions will arise when this is not the case.  This issue can be exacerbated by the fact that many digital assets are only traded on decentralised platforms, with some even on social media websites.  The fact that some NFTs, for example, have seen extreme fluctuations in price, means serious thought must be given as to what realistic valuations should be reflected, including:

• What sources are being used to value the digital assets?
• Are these sources standard within the crypto sector and will they be accepted by the auditor?
• Due to the volatile nature of digital assets, have different valuation methodologies been discussed?
• Fund boards should consider the instability and volatile nature of valuations for digital assets and how this could detrimentally affect investors.

As the digital assets sub-industry continues to progress, fund boards need to be aware of developments in industry standards for valuation policies, as well as best practice.  Fund boards should consider having conversations with auditors on accepted valuation standards, as well as the most recent accounting pronouncements.

Liquidity

Looking back, a controversial lesson for investors from the Great Recession of 2008, was that governments demonstrated a willingness to intervene, in order to prevent systemically important institutions from failing.  Digital assets, and specifically cryptocurrencies, however, do not have this back-stop to support and stabilise their value.  The issue is compounded because there are no governing bodies to set standards or limitations on what digital asset providers and exchanges can do, once they receive deposits, as there are no statutory liquidity ratios to adhere to.  Key questions from a fiduciary perspective, relating to liquidity of crypto assets, centre on the following areas:

• Has management assessed the liquidity risk of the digital assets within the portfolio and compared that to the liquidity being offered to investors?
• Do the digital assets heavily rely on a small number of key stakeholders, which could presage a liquidity crunch if they were to withdraw?
• What degree of transparency exists in regard to the use of cash and customer deposits by each particular digital asset venture?

It is clear that the current lack of regulatory oversight in the digital asset sector, while allowing for some incredible innovation and wealth generation, has resulted in high volatility, increased liquidity risk, money laundering concerns and the potential for significant wealth destruction.

Regulatory Framework

The regulatory landscape for digital assets is evolving, but not as quickly as the changes taking place in the crypto sector.  With an absence of definitive legislation, we are seeing regulatory bodies often leveraging their existing authority for digital asset oversight and enforcement.  The extreme volatility and lack of guidance in the sector, coupled with recent failures of certain cryptocurrencies and exchanges, which has cost investors billions of dollars, certainly seems to have galvanised regulators to establish frameworks in order to protect investors, guard against illicit activity and ensure financial stability.  Against this dramatic backdrop, fund boards should be focused on a number of key areas:

• Has management assessed regulatory changes and their impact on a fund’s investment strategy?
• Has the risk of regulatory infractions been assessed amid changing regulatory guidance?
• Are all of the required regulatory disclosures and reporting requirements being adhered to?
• Do parameters need to be established within the portfolio, in order to adhere to changing regulations?

Essentially, fund boards need to be constantly monitoring updates to regulations, across jurisdictions, and always questioning if managers and service providers are doing the same.  Of all asset classes, it is quite conceivable that digital assets will be subject to the most significant regulatory updates in the coming years.

Anti-Money Laundering

While many of the above issues discussed are relevant to digital assets from an investment perspective, fund boards must also be aware of entities engaged in token issuance.  This activity can present additional risk, relating to tracking the ultimate beneficial owners of the issuing entity, resulting in significant issues for Anti-money Laundering (“AML”) / Know Your Customer (“KYC”) compliance and potentially breaching regulatory requirements.  Furthermore, the risks associated with in-kind subscriptions and redemptions, can further blur transparency of ownership.  Drilling further into AML compliance for funds engaged in token issuance, there are some more key questions for vigilant fiduciaries:

• Does management have a method to consistently and accurately track the underlying investors?
• Is the technology sufficient to provide constant transparency of ownership?
• Are all token transactions being monitored and reconciled to ensure AML / KYC requirements are being met?

In a world where AML / KYC standards are ever increasing and where anonymity represents a key feature of digital assets, fund boards will need to be equipped with sufficient expertise to ensure appropriate supervision and technology is being utilised by both the manager and service providers.

Business Risk

As with any new industry, investment managers can be established with certain niche experience and expertise on the portfolio product, but little to no experience in actually running a business (let alone managing someone else’s money).  Overall, this dynamic significantly heightens the risk of all the factors previously discussed, which may result in fund boards requiring more oversight into operational activities.  In this regard, directors would be expected to consider the following questions:

• How experienced is the investment manager in running a business and managing money?
• Has the investment manager previously engaged with regulators and do they fully understand the requirements?
• Have positions within the investment management team been staffed with people who are experienced and appropriate for the roles?

As the financial industry has repeatedly seen, while an individual may have specialised and in-depth knowledge of a particular asset class, they may not necessarily be able to run a fund management business.  Fund boards would be well advised to take a step back in these circumstances and assess if the investment management team is really well-rounded enough to tackle all aspects of the business.

FUTURE TRENDS

When it comes to digital assets, one certainty is that with no real general guidance or protocols, fund boards are unable to rely on historical best practice.  The crypto environment is evolving rapidly, amid fresh advances in technology and this trend only seems to be accelerating.  Looking ahead, fund boards must be actively aware and anticipate changes in both regulations and industry practice.  Just as digital assets are considered to be highly disruptive technology, fund boards should be constantly questioning how risk can be mitigated and if more can be done to protect investors.  As the digital asset sub-industry continues to mature, the entities best suited to take on these challenges will be ones with management and governance that can readily adapt, learn and grow.