The governance around hedge funds has changed dramatically since the introduction of the mutual funds law in Cayman 25 years ago. Even eight years ago, fund directors were either conflicted because they came from the administrator of a fund or they had only limited investments and securities experience. Today, the demand for independent oversight is growing, not least in response to investor and regulatory pressure.
The same demand also exists for funds dealing with crypto assets but regulatory uncertainty and lack of knowledge about the nascent industry means that most requests for independent directors to serve on the boards of crypto funds are being denied, panelists at the Campbells Fund Focus conference in November said.
“When we look at crypto funds, we are seeing demand for independence,” said Yolanda Banks McCoy, director at fund governance firm HighWater. But there are only a limited number of service providers in the space and it is still a learning environment for many of them.
As a result, she said, independent directors, who must assess their own personal risk, are very selective in terms of the types of funds they can work with.
For John D’Agostino, global head of Investor Engagement at DMS Governance, the crypto space is often incorrectly seen as riskier than funds investing in other types of assets. Many directors, for instance, had no issues sitting on the boards of cannabis funds, even though cannabis is still technically illegal in the U.S. at federal level, or they are directors to funds that deal with highly complex derivatives, he said.
“Because this asset exists in code there is this information barrier,” D’Agostino noted. “Our strategy is to be at the center of the ecosystem, so we can be picky as to who to take on.”
Despite the massive interest, he said, for every 50 managers that approached the fund governance firm, it had taken on only one or two as clients. Those that qualify must fit into a specific risk matrix. Investments and redemptions must be made in regular fiat currency rather than in kind with other cryptocurrencies; they have to trade on a white list of exchanges; and deal with a white list of crypto assets.
Paul Byles, founder of consulting firm FTS, noted that crypto assets are undergoing the same evolution as other new industries and asset classes.
In the current environment, where the crypto space is “far from settling down” and “regulators are not fully on board,” he said independent directors must make their own judgments about what they believe is risky.
When considering directorships, they will look at the types of services providers that are involved with the entity, such as the administrator, the custodian and the auditor. These need to be credible and may give an indication of whether someone else has carried out due diligence on the principals and their business.
The qualification, reputation and track record of the principals are also important, as are the types of assets they deal with and the types of exchanges they trade on.
“There is a great need for independent directors,” he said, and “directors are willing to do it, but the acceptance rate is very low for good reason.”
Traditional KYC was already flawed and failing, Byles noted, but dealing with crypto assets raised a very complex system of new issues. At the same time, crypto assets are much more volatile.
This means directors need more information and better reports more frequently to carry out their fiduciary duties. And to get better reports, they must develop an even closer relationship with the other services providers to the fund.
Banks-McCoy agreed that communication becomes even more important in the crypto environment and issues such as valuation and liquidity must be discussed more regularly.
Beyond that, and provided directors can make an informed risk assessment, they should not be influenced by their personal opinion of crypto assets, argued D’Agostino.
“I can sit on the board of a fund that has an underlying asset class that I personally would not invest in. It is not my job to tell these qualified purchasers what to invest in,” he said. “Complex derivatives may have no intrinsic value. But unless there is a fraudulent underpinning to the market, who am I to judge?”