Digital Assets Fund

Business Plan

Principle

Jan 23, 2023 — 9 min read

This is a blueprint for a fund's business plan. It discusses how a fund would go about setting the scope of its investment strategy, its asset allocation, benchmark, and key risks.

Table of Content

Purpose

The fund's purpose is to invest the capital provided by the members to achieve a positive rate of return for its members. The fund invests in crypto assets, a relatively new type of asset, and there is a considerable chance that the investment will go to 0.

Risk Profile

The fund will invest in crypto assets. These assets have a higher risk profile than most equity investments. The crypto market trades at around 5 Beta to the US stock market, meaning it is about five times more volatile than equity. This view is, however, historical, and the volatility of crypto markets has been decreasing as more asset managers enter the market.

The volatility of the largest crypto asset by market value against USD is around 70% annualized and has seen volatilities as high as 120% throughout 2021 and 2022. Comparatively, the volatility of the EURUSD FX rate is normally around 10% and the volatility of the US equity market (as measured by the VIX Index) is rarely above 30%

Therefore investing in crypto assets is a risky endeavor, and there is a non-zero chance that all investments can be lost

On the other hand, there is also a possibility of high returns as shown by recent history, where between 2019 and 2023, some of the assets have risen multiple times their original value. Bitcoin rose from around 5 000 USD in 2019 to around 22 000 USD in 2023. Many smaller crypto assets market size has seen even more spectacular gains.

The fund will not employ leverage for trading. The risks of liquidation is high when using leverage and in those cases, the loss can be 100% of the assets invested. This happens when collateral is pledged for leverage trading and is sold at fire sale prices during liquidation. Given the lack of maturity of crypto markets and, at times, questionable behavior of market participants, there is always a chance of a market down gap where collateral thresholds are hit intentionally to force liquidations.

Many funds defaulted during 2022 due to these funds employing leverage (e.g. 3 Arrow Capital, Alameda …). After liquidation, the game is over for these funds and they don’t participate in the recovery when the markets eventually turn around.

Scope

The fund will invest primarily in crypto assets. The fund may, from time to time, invest in other assets such as equity, bonds, and real estate; this will be limited to a maximum of 20%

To manage the fund's cash position the fund may hold part of the fund's value in cash and liquid cash equivalents

The fund may also use FX derivatives to hedge currency risk

The funds accounting currency is USD. Most of the liquidity in the crypto markets is against the USD, this is also where most of the trading takes place. For regulatory reasons, the fund might need to report its asset value in currencies other than the USD. When converting to other currencies this is done at the spot FX rate of the conversion date.

The fund will only hold tokens issued by exchanges to the extent needed to pay for exchange fees. There is a substantial risk these tokens are designated as securities and the exchange is sanctioned for issuing these to retail investors. The largest of these tokens by market capitalization is BNB, issued by Binance and is part of the top 10 crypto assets by market cap.

Benchmark

The fund will be benchmarked against the Credit Suisse Hedge Fund Index. The Credit Suisse Hedge Fund Index is compiled by Credit Suisse Hedge Index LLC. It is an asset-weighted hedge fund index and includes only funds, as opposed to separate accounts. The index uses the Credit Suisse Hedge Fund Database, which tracks approximately 9,000 funds.

The fund holds a substantial amount of stablecoins and engages in market making, which reduces its risk as compared to the bitcoin price alone, therefore it is more appropriate to benchmark it against a broad index rather than a crypto-only index

Fees

The fund has a standard fee structure of 2/20

The administrator charges 2% of assets per year, charged monthly, and 20% of profit, charged at the end of each year. The profit fee is subject to a high watermark of the fund value at inception - the performance fee is only charged if the value of the fund is higher than what it was at inception.

Redemptions

The fund invests in assets that might have limited liquidity during a market downturn. This can happen for several reasons, of which the most common are:

Trigger of stop-losses. In crypto markets, retail investors often trade using leverage. They borrow money to invest. This creates a condition where when markets are falling, the lenders are forced to take hold of their collateral and sell on the market, thereby creating additional selling pressure in the market, and causing the market to fall even further
Lack of liquidity from market makers. Institutions that stand to buy and sell crypto assets at all times might disappear from the market due to regular concerns, or lack of capital from suffered losses.

The fund might limit redemptions from members to protect the asset value of the fund.

Withdrawal requests need to be made 30 days in advance. The fund will endeavor to satisfy the withdrawal request as soon as possible

Asset Allocation

Asset allocation determines the logical risk buckets of how the fund’s capital is invested. At inception, the fund is divided into five buckets with increasing levels of risk. This allocation might change from time to make use of opportunities in the market. A change by more than 10% of fund assets to any risk bucket must be communicated to fund members at least 30 days in advance.

Stablecoins

20% of the fund is held in stablecoins (USDT, USDC, BUSD, and other stablecoins tied 1:1 to the USD). The majority of stablecoins in the market are in USD. The fund may also invest in stablecoins of other currencies. The stablecoins will be lent out on decentralized lending protocols to generate a stable yield. The yield varies between 0% and 20% per year, depending on market conditions. High yield is usually achieved in rising markets when there is high demand for leverage trading.

Cash and Carry Arbitrage

10% of the fund will be invested in cash and carry arbitrage on futures exchanges. The cash and carry trade involves buying crypto assets on the spot market and selling them in the futures market. The futures market usually trades at a premium to the spot market. The return exists as speculators want to bet on the direction of the market without providing the full capital for the trade (use leverage) and are willing to pay a premium for this. Premiums tend to vary between 0% and 30% per year. The largest premiums are usually available during rising markets.

Automated Market Making

30% of the fund will be used to make markets in 4 of the largest blockchains: Bitcoin, Ethereum, Cardano, and Polygon, with the following allocation. The allocation will be rebalanced quarterly.

Bitcoin (BTC) 5%
Ethereum (ETH) 10%
Cardano (ADA) 10%
Polygon (MATIC) 5%

Automated Market Making is one of the greatest use cases of a blockchain. It allows for retail investors and funds to provide liquidity to other traders and investors looking to trade in crypto assets and receive a fee for this service. This is similar to the role of financial institutions when they stand ready to buy and sell securities to their clients. This strategy has historically generated between 10 to 60% in fees and performs best in volatile and rising markets. The main risk of the strategy is a falling market. In a falling market, the investors will tend to sell to the liquidity provide the asset that is losing in value. Therefore the inventory value that the liquidity provider holds will lose value in USD terms in a falling market. The strategy can lose more than an equivalent investment in the asset without engaging in providing liquidity.

Holding of Core Crypto Assets

30% of the fund will be held in crypto assets that are part of the top 10 by market value: Bitcoin, Ethereum, Cardano and Polygon. The asset needs to have spent most of a year in the top 10 to be considered. Those assets that provide staking returns will be staked. Staking returns vary between 0 and 7% per year. The main risk in this investment is market direction. These assets lose value in a falling market and gain value in a rising value. The allocation will be rebalanced quarterly.

Bitcoin (BTC) 10%
Ethereum (ETH) 10%
Cardano (ADA) 5%
Polygon (MATIC) 5%

Alternative Investments

10% of the fund will be invested in crypto assets with smaller market capitalizations that are not part of the top 10 and into non-crypto strategies. This part of the portfolio will be rebalanced frequently to capture emerging opportunities in the market and will be the riskiest bucket.

Risks

Blockchain and crypto assets are a fairly recent invention. There still needs to be more regulation. Fraud and market manipulation are not uncommon. Investing in crypto is a risky business, with the potential for full loss of capital.

The most common risk factors:

Blockchain Failure as an Industry

the blockchain industry has been heralded as the next big thing in finance, with the potential to revolutionize financial institutions by making them more efficient and bringing their tools to retail traders. This comes with the risk of a crackdown by regulators, central banks, and governments as they see their influence diluted. Central authorities can limit users' ability to interact with certain blockchains, making them unusable by large portions of the population, even if not being able to block entirely. A concerted effort by central authorities could cause a significant drop in the value of crypto assets.

Smart Contract Hacks

the power of blockchains is also their weakness. Smart contracts are codes that, once deployed, are guaranteed to be executed. At times, developers of smart contracts make mistakes in their code and malicious actors can use that to their advantage by stealing assets locked in those smart contracts.

Operational Error

transactions on the blockchain are irreversible, so there is no way to undo errors. There is a risk that a fund member sends the crypto assets to the wrong address, or misplaces their password, or the operator makes a mistake when executing a transaction.

Volatility

Price volatility is the potential for the prices to go u, or down. The volatility of crypto assets is relatively high by investment standards. Bitcoin, the largest crypto asset by market cap, is about 3 to 5 times more volatile than the Nasdaq 100 equity index and about 10 times more volatile than FX rates. So on a day when the equity market moves by 1%, the crypto market might move by between 3 and 5% and at the same time, the FX market might move by 0.2%.

Protocol-Specific Risks

Each of the investment strategies also involves some risk. The key risks of each are described in the Asset Allocation section

THERE IS A HIGH CHANCE OF RECOVERING LESS THAN THE ORIGINAL INVESTMENT

Custody

Crypto custody means securing the private key held within your crypto wallet. In traditional banking, all custodians are financial institutions, as required by law. With crypto, however, holders can become their own custodians. Using gold bars as an analogy, you can either store them under your bed to keep them safe yourself or pay a third-party custodian to lock them in a vault protected by security guards.

Self-Custody

Self-custody is when you hold the private key to your own wallet. This means you are the only one who can prove ownership of your funds and access your holdings. Being your own custodian means having complete control over your wallet, but it also means you also bear all the risks. If you lose access to your physical device (cold wallet) or forget the private key, your crypto will most likely be gone forever.

Pros:

You own the keys and have direct access to the crypto assets. Only you have access to the account;
No counterparty risk. There is no third party between you and the crypto assets. Defaults of crypto exchanges do not affect you directly.

Cons:

Losing the keys means losing the crypto assets, and the assets are not insured
Risk of exposing the keys to hackers, which can lead to loss of funds

Third-party Custody

Those who do not want to take the responsibility of managing their own accounts or find it too intimidating to deal with the tech might want to turn to a third-party custodian. These are registered, regulated financial institutions that have acquired a state-level or national license to act as a custodian.

This type of crypto custodian holds clients’ private keys to their wallets in a safe manner and ensures the security of their holdings. From the user's point of view, it is similar to having a checking account with a bank. When you register to open an account, you must undergo know-your-customer and anti-money laundering checks. When you store crypto with a third-party custodian, you’ll be expected to complete the same sort of checks to make sure your cryptocurrency was not acquired through illegal means.