The Top 3 Trends in Private Funds That Deal in Digital Assets
MG Stover custom tailors fund administration for hedge, private equity, VC and digital asset firms. Here are the top three trends they see in digital assets.
- Funds might encounter great difficulty in satisfying anti-money laundering (AML) rules. This isn’t a problem when it comes to traditional assets because bank accounts are linked directly to their owners.
- DeFi involves its own set of challenges. Clients have to be very mindful of where they’re putting their assets due to their fiduciary responsibility.
Private funds in the digital asset space face a set of unique challenges. Many of these challenges stem from the fact that crypto is still a new asset class with little to no industry wide regulation or standardization. There’s also no standard system established to handle the necessary accounting.
Several trends have been emerging in response to these challenges. Those within private funds have no choice but to come up with innovative solutions to adapt their business structures to the rapidly growing and increasingly in-demand world of crypto.
In particular, there are three important trends developing in private funds that work within the digital asset space:
· The unique structures of both venture capital and hedge funds
· Using “in-kind” transactions
· Demand for DeFi services and NFTs
These bullet points might seem vague or confusing to those unfamiliar with the topic, so let’s dive into the details.
The MG Stover team lends their expertise
To gain professional insight into these matters, we spoke with several members of the team at MG Stover, the leading digital asset fund administration firm. They had some interesting things to say regarding what they’re seeing in private funds that invest in digital assets and how the industry is evolving in response.
VC and hedge fund uniqueness
Seth Altman, senior director of blockchain and digital assets, started off by noting that “the original methodology or platform for a lot of these crypto funds was originally [that of a hedge fund].” He went on to say that many of these funds struggled to determine what type of structure would be best to use. Digital assets sometimes seem more like illiquid assets that might turn liquid at some point, and could therefore “fit better inside of a venture capital, closed-end type structure more than an open-end.”
This makes things complicated because these funds, “still want to have a trading strategy; they still want to have this liquid portfolio of trading assets inside of a venture capital fund, which is more like a hedge fund,” Altman added.
CEO Matt Stover then mentioned that closed-end funds have different accounting systems than open-end funds, and that closed-end funds typically don’t see high trading volume. This leads to a situation that “creates the need for us to build systems and processes that can accommodate these hybrid funds.”
All of this leads to a great challenge. The goal is to try and “make sure that the allocations to all the investors are correct and a lot of the standard normal practices that would exist in each type of fund now really morph together,” said Altman.
As for the topic of in-kind transactions, Michael Monroe, general counsel, shared his thoughts: “When someone invests into a pooled investment vehicle like a private fund, they typically do so by sending in a wire transfer,” he said.
But an in-kind transaction involves transferring assets of the same kind, rather than making a purchase or sale. This is common among traditional funds due to the tax benefits. Monroe explained: “So, the subscription into the vehicle through non-monetary means is what we would call in kind. It’s tax terminology and the typical reason why someone would do that would be to defer taxes; you don’t sell your asset contributed in-kind.”
According to Monroe and his colleagues, there has been a massive uptick in demand for in-kind transactions for digital asset funds. The reason has to do with not only tax benefits but also the unique aspects of investing in crypto. Since digital assets are typically fungible and therefore easily transferable, in-kind transactions are easier to complete with digital assets than with traditional assets. But this presents its own set of pitfalls.
For example, funds might encounter great difficulty in satisfying anti-money laundering (AML) rules. This isn’t a problem when it comes to traditional assets because bank accounts are linked directly to their owners.
With blockchain-based assets, however, “you can’t trace back what’s called the source of funds, it’s really difficult. You could go on to the blockchain, and you can see which public wallet address it came from. But as a blockchain doesn’t reveal the owner or the controller, there is a large level of anonymity that exists there,” said Monroe. This factor “creates a real challenge with these in-kind transactions,” he added.
Monroe also stressed the fact that even though the demand for this type of transaction has increased, it doesn’t mean many of them are actually taking place. Successfully facilitating in-kind transactions requires “an extraordinary amount of diligence” on the part of both a fund and their clients, he noted.
DeFi and NFTs
What about DeFi and NFTs (non-fungible tokens)? Are private fund investors interested in these more exotic types of digital assets?
According to Altman, the answer is yes. The interest is there, but he explained that “there aren’t a ton of our clients who are investing in [NFTs]. We do have one fund dedicated to NFTs, but thus far, [NFT investing] seems to be more popular as a venture capital investment.”
As far as DeFi (decentralized finance) is concerned, “there is a ton of interest, and it’s ranging from people dabbling in it, either using it to just do some DEX trading, or others are a lot more heavily involved in entering into liquidity pools, staking, lending and borrowing,” and so on, he said.
Altman went on to say that while not all of their clients are active in the DeFi space, those who tend to be “pretty heavily involved.”
Again, DeFi involves its own set of challenges. Clients have to be very mindful of where they’re putting their assets due to their fiduciary responsibility. For MG Stover, one of the main obstacles involves “keeping up with all the different protocols and making sure that we’re able to integrate [them all] from a programmatic standpoint,” since people might be entering into liquidity pools on one protocol, yield farming somewhere else, staking on yet another platform and so on.
This leads to the topic of data standardization, which will be covered in a forthcoming article. As regulations and expectations continue to shift, MG Stover is working out the many complexities that arise as private funds expand to investing in crypto.