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Launching the first cryptoasset fund in Malta vs. Cayman Islands

Panel participants:

Panel participants agreed that the current state of regulation is in its infancy in all onshore jurisdiction. At the same time, Malta has several characteristics that position it well to become a haven for cryptoasset investment funds. As a hub for online gaming, the country has a strong ICT infrastructure. Its membership in the European Union gives UCITS and AIF funds with a Maltese domicile passporting rights into the EU. Finally, the Malta Financial Services Authority (MFSA) adjusted its existing framework for alternative investments around the professional investor fund (PIF) to fit virtual currencies, instead of creating entirely new legislation. A PIF allows cryptoasset managers to run a fund with a high degree of flexibility on asset selection and custody of up to 100 million Euro under management with the ability to switch into a AIF vehicle when AuM exceed the threshold.

Of course, other jurisdictions are making similar advances into the crypto space, and Malta competes with other crypto-friendly jurisdictions in Europe, such as Gibraltar, Switzerland, and Liechtenstein. At the same time, they offer less flexibility overall for fund vehicles and cryptoasset managers. Gibraltar, for instance, has a Brexit risk, because it’s close affiliation to UK legislation. Switzerland has made great strides to become a Crypto Nation, but its restrictive fund regulation and inappropriate fund vehicles make life hard for cryptoasset managers. Liechtenstein has attracted more crypto funds, but their regulation requires a bank to serve as custodian. Using a bank custodian may restrict the fund manager from investing in a variety of cryptoassets due to technical limitation of safeguarding of less well-known cryptocurrencies and cryptoassets. Overall, Malta is a destination fund managers should look into. The country is in a good position to make its mark in the cryptoasset space.

For more in-depth information about the event, read the full transcript of the panel below.

Fabio Federici: The short version is: It was slow, and I hope soon. We started the process back in September when we first met with the MFSA. Back then, they made it clear that they are not ready to accept an application for a crypto fund, mainly because they had regulation in the pipeline around professional investor funds intending to invest in cryptoassets. We provided some feedback and guidance on the upcoming rules. In January 2018, they published the feedback and then came out with the actual rules, which required us to set up a second meeting with the MFSA. We flew down to Malta two weeks after they released the rules and had another meeting, where we presented the strategy of the fund and the people involved in the whole setup, as well as the safekeeping and valuation topics that were a concern. In mid-March, we submitted the application, and now, we just had to supply some additional documentation. It’s a back and forth right now, but I hope we’ll get an answer soon.

Hansjoerg: Fingers crossed. Taking a step back again: Why Malta? Simon, with Crypto Finance, you focus more on Cayman, I think. Fabio, can you discuss some background on Cayman and the advantages and disadvantages in comparison to Malta?

Fabio: When I started looking into setting up a fund, I first wanted to do it in Switzerland. I spoke to some service providers here and it quickly became clear that this was not the route we want to go down. On the one hand, we wanted to find a fast and cheap way to get up and running with a startup-like approach. On the other hand, it is important that we can use our understanding of the space and our strong network, having been in the space for many years now. The value we can provide to investors is doing due diligence on new projects, being able to take positions others might not feel comfortable with because they don’t understand the underlying technology of the protocols. We needed to find a jurisdiction that allows us to implement that strategy. When we started exploring the professional investor fund structure in Malta, the open-minded approach to custody that allowed us to work with custodians that are not necessarily a bank was definitely a key criteria.

Simon Tobler: We started the company Crypto Fund AG to become one of the first regulated crypto funds out of Switzerland, and that’s still our aim. But if you deal with regulators, it always takes longer than you might hope in the beginning. We’re still taking on the challenge of bringing the first Swiss crypto fund to market, but in the meantime, we also realized we needed something else, a first product, we needed to go live with something. Cayman is one of the world’s offshore centers and we had some experience with them. People in our group had experience with setups there and connections, so it was an obvious decision for us to go with a Cayman fund.

Hansjoerg: In terms of service provider selection, what are your experiences? Have you approached those who are already familiar with crypto or have you educated existing ones?

Fabio: Ideally, you want to work with people who have experience, but the selection is thin. I think when we approached service providers like SGGG, we wanted to find somebody who is actually willing to take on that business. This comes with overhead, risks, and many unknowns. On the technical side, right now, there are mainly existing service providers that have been around for a couple of years. For storage and valuation, we’re exploring different new up-and-coming service providers, but most of them are still in the early phase, so there’s always a balance you need to find. One of the biggest challenges remains the banking side. We have Bank Frick that has been a pioneer in Liechtenstein, but I would love to see a little more diversity in that space.

Simon: We’re going to be in the crypto business not just for one or two years, but for the long term. It makes sense to build up everything from the very beginning in a way that is as regulated as possible, even if it is not necessary from the regulator’s perspective. You need to deal and work with professional counterparties, with professional partners. You can search for them if you find them, or you can take the approach we took and build them on your own. That’s why we founded Crypto Broker and Crypto Storage to bring professional storage to those markets, not only for our funds, but for all players in the sector.

Hansjoerg: Christophe, looking at it from an investor perspective, what are the key topics regarding jurisdiction, does it make a difference for investors if funds are onshore or offshore? How about the service providers?

Christophe de la Celle: In terms of jurisdiction, not really, I would say. Investors are quite open about jurisdictions of crypto funds. From the service provider point of view, what matters for investors is scalability. The chance for a crypto fund manager or any sort of hedge fund manager is, they are entrepreneurs. If you’re managing 50 million, you want to see that you can scale up to 500 million, and that’s quite a challenge. The good news is that, ten years ago, there was a stigma attached to outsourcing risk management, portfolio management, tracking, et cetera. Now that has been flipped on its head, and investors are pushing managers to outsource as much as possible. One reason is the cost advantages, but as a portfolio manager, you now have access to open architectures, and you can offload the tech development to providers. In the hedge fund business, there is the joke, ‘What are three P’s of marketing? Performance, performance, and performance.’ A lot of emerging crypto fund managers and hedge fund managers obsess about raising AUM, but ideally, you want to have a bit of a balance, where you focus on setting yourself up from an infrastructure point of view, so that you can really focus on trading, investing, and raising assets.

Hansjoerg: I would say, blockchain technology helps in that regard, you don’t have the high thresholds to set up, talking on-chain fund solutions in the future, it’s much cheaper, obviously, to launch and roll out smart contracts-type of fund structures rather than the need of having 50+ million to raise in a current fund structure.

Christophe: Definitely, there is disruption. If you look at the asset management industry as a whole, 90 percent of the assets are controlled by 10 percent of the traders. You look at that picture, and that’s obviously an industry that is ripe for disruption. It’s great that blockchain technology is lowering barriers to entry for a lot talented managers.

Hansjoerg: Exactly, because regulation, or over-regulation, bent the entire space in the opposite direction. Only the biggest companies survive with their entire banking and development and regulatory requirements.

Christophe: I would say, it’s a very interesting time for crypto fund managers to launch, from an investor’s perspective. If you’re an allocator, and let’s say a small pension fund in the UK, or even a bigger pension fund, there has been a big focus on brand name hedge funds. That’s changing now. We have a new generation of allocators that come on board, they have big data tools, and they have to go out and source actual alpha. Where is the alpha? Generally speaking, it’s amongst the smaller managers, and they’re interested in very niche strategies, so the timing for crypto is very interesting.

Hansjoerg: Coming back to the Malta PIF. Fabio, obviously, the security scheme is a hot topic. Can you tell us a little bit about the discussions with the MFSA, how they look on the security topic?

Fabio: There’s not that much that’s required by the PIF. Mainly a cold-hot storage mix, which is debatable if it has anything to do with the words we use in the industry for cold storage. It’s mainly about how many people can access the individual funds. I think multi-signature is one of the components. The way we approach it was basically to propose a multi-strategy approach depending on the underlying asset. If you look at something like bitcoin, you have service providers that range today from a bank to professional service providers to very professional self-custody solutions that allow you to implement very complex internal processes of how somebody can access those funds. If you look at some of the smaller cap assets, those solutions are not available yet. In some cases, they might never be available. Depending on the asset, we will identify the best solution to keep them safe. We need to keep in mind here that this is also going to depend on the strategy of the fund. Yes, if you’re long-only, then it’s going to be easy to store cryptoassets in cold storage. If you have an actively traded or day-traded strategy, there’s not going to be another way than to have the assets on the exchanges, where you have to take some counterparty risk into consideration. At the end of the day, it really depends on the underlying cryptoassets as well as the strategy of the fund.

Hansjoerg: I assume also Binance coming to Malta will play a vital role in that discussion with the regulator about cold storage, hot wallets, and everything.

Fabio: Yes, that is something exchanges need to handle. If there’s more checks around that maybe you will feel more comfortable leaving assets on the exchange. Even Binance, they’re just six months old. I’m pretty sure their infrastructure reflects the age of the company to some extent.

Simon: Next to hot or cold and all the buzzwords, it’s important to find good solution that can implement a corporate governance. You need to be able to build your operational framework into a custody solution, otherwise it will not fit. Whenever possible, or I would say, even for 100 percent of your assets, you need some kind of multiple controls. Multi-sig is just the first buzzword, but it doesn’t need to stop there. You could add multi layers of approvals, time delays, whatever is available to make sure that nobody is accessing your funds without the respective access rights. Then, another point not to forget is business continuity. What do you do if your whole team, if you have a multisig of four people, if your whole team was on the same plane and crashes? Disaster recovery, how do you handle the very improbable cases? You need to be able to recover your funds every time. Business continuity is a different topic. Then also, the mix between software and hardware security. Software is always a little tricky, you know. No code is perfect. We think the more hardware security you have in a solution, the better it is.

Hansjoerg: In terms of risk disclosures, in how far has the risk disclosures section of the prospectus increased for crypto-specific risks?

Fabio: We spent quite some time on adding specific risks, but at the end of the day, many risks are going to be similar. You have the safekeeping, things around the underlying technology itself that need to be added to the prospectus. Then, on the valuation side, it’s one thing when a cryptoassets is traded, and another thing if it’s a new project that is not traded.

Hansjoerg: Talking about trading, what about asset confirmation? Obviously it’s all very transparent, but how do you implement the trade confirmation and the interaction with auditors and valuation providers?

Fabio: On our end, we’re currently working with different service providers to evaluate the best and most viable solution, but it’s still early days in terms of the infrastructure that is available today. At the end of the day, you want to have a single system that consolidates all the different venues and trading partners, that’s where we’ll end up, I think. But there is no silver bullet as of today.

Christophe: I agree with Fabio. The funds we are working with seem to have their own approach. There is no general convention in the crypto space. Especially with assets that trade 24/7, it’s difficult to reset a timeline. Everybody is applying their own approach, working closely with auditors, taking a snapshot that depends on each partner.

Simon: The more you rely on existing professional solution, the better you’re off, I think. If you want to have an NAV for your fund, an official fixing from CME Futures might be a solution, or some indices that are run by professional index providers, not all those small crypto pages where everyone is setting up an index, but rather existing index solutions from experienced providers, such as the SIX CMI Crypto Market Index. There are some solutions out there, if you rely on those, you should be OK with all those discussions about NAV et cetera.

Fabio: I think the challenge then comes back to the strategy of the fund. If you invest in assets that have such a solution available, that’s great, but if you want to expand your investment universe, you will need to start in-house solutions as well, at least for the time being.

Hansjoerg: What about best execution?

Simon: The crypto space is not regulated in that regard, but we expect regulators to step in going forward, so we have some similar best execution requirements as in the traditional fund management market. The more professional players you have in the game, the better it is. As a fund, if you want to execute your orders, you might be better off in the future using a professional broker or your custody bank, if they serve that role. If you have a prime broker setup, he needs to make sure he trades on the platforms where the values and the prices are best for you as a client. Already today, you can get pretty close to that best execution requirement for MiFID or other regulations in traditional financial markets.

Hansjoerg: How I see this currently in the space, you’re really leading, spearheading, and shaping that adoption of the off-chain world, or the traditional world, and replicate that into the specific crypto trading and crypto requirements. I think it’s key in the beginning to really have professional players who are aware of that responsibility. If you get it wrong and don’t really care, and err a lot, then it’s the regulators who will much harder regulate the space than if you bring good examples and drive the space forward. Also, I think it could be beneficial in blockchain technology support, it’s the regulatory reporting. Have you had discussions with regulators how to set that up?

Christophe: Not yet, but it will come. Bouncing off what Simon said before about best execution, I think most exchanges aren’t mature enough to really handle complex orders. From a technology-standpoint, you can use an order management system (OMS) or an execution management system (EMS) for best execution. All that will evolve in parallel with regulation. As those regulations matures, the exchanges will mature. We’ll have tools to apply best execution.

Hansjoerg: Moving again to valuation, and the difficulties of not the big five tokens, but the valuation of pre-ICO investments, rather illiquid tokens. What are your thoughts on that?

Fabio: As we did with the safekeeping approach, we tier it into different types of investments. If there is something available like an official index from somebody like the CME, we will probably use that, but if not, we define a value-weighted average and we get the methodology approved, and the data itself comes from the different exchanges we trade on. That gives you very close price to something like the CME is doing. On the pre-ICO and ICO side, I mean, on the ICO side, I hope they start trading fairly quickly. If we’re talking about three to six months, I think it’s not going to be a big deal. The challenge is dealing with tokens that might be delayed for a very long time, you will fall more into a traditional venture capital type setup. There it’s going to be challenging to find the right valuations. What we can do is connect with different private OTC desks that might trade some of those assets and see what the current rates are. I think other than that, it’s still a little bit too early, also from an understanding point of view, to have a clear methodology or a go-to method where you benchmark against other companies that do something similar.

Hansjoerg: Moving from valuation to transfer agency functions and the investor onboarding. Obviously, we’re speaking about a normal sub-fund, but what are the specific requirements around KYC and AML, and maybe also about subscription timings? Could it be daily, weekly, monthly? Are there specific requirements and needs around redemption time, for example? Would that be possible with crypto with the regulation in Malta?

Fabio: Honestly, I don’t know. We do subscription in USD and Swiss francs. You’re very flexible in terms of what you can do. It’s then up to you to figure out how to do it and implement it. I think right now it would still be challenging to get subscription in crypto approved, so we stayed away from that for the time being. You see early experiments in Luxembourg with the guys from Bitstamp. I think it’s always going to be challenging. If you have this intersection of fiat and crypto, it’s always going to be a boiling pot for a very long time. As we see other crypto assets that might not be as traceable as bitcoin, even with bitcoin itself, I spent three years of building software to track it, and it’s impossible to have absolute confidence of where the money is coming from. The best way to buy bitcoin for you would be to go straight to a miner of, let’s say, the government is auctioning off Silkroad funds, that’s coming straight from the government, and that’s as clean as it’s going to get. As soon as you have one hop in between, it becomes probabilistic. Then, you always have a risk, and that’s going to be a big challenge when it comes to subscriptions in kind. I think redemption might be easier. For us, we try to keep it simple for the time.

Simon: If you go directly to a miner, even then you’re not a hundred percent sure. Your coin might be clean, but you’re not sure if the miner built up his mining facility with some darknet money or something else. Even there, you might have the duty to show that the miner is proper with his operations.

Fabio: One issue with bitcoin is that we have a public ledger of transactions, and regulators say, ‘Can we actually leverage that to put some more burden on the service providers, rather than less.’

Hansjoerg: In terms of investment strategy, what are the key topics around that point?

Simon: We see right now in the market out there that all those cryptoassets tokens are highly correlated. At the very moment it might be difficult to run an active strategy and find the correct positive outliers. I think the right approach at the moment is more on the passive side, but this will change going forward. It’s a question of when the tipping point occurs, in three months, six months, or whenever. It’s easier to attract institutional investors and new investors to invest in a passive fund with some basic beta exposure before going forward and adding some alpha. It’s similar like on a private base, you first buy bitcoin, and then you realize, there is more out there. It’s similar for institutional investors.

Fabio: I think for us, the reason why we run an actively managed fund is basically because we don’t like what we see in the top ten of cryptoassets all the time. I think we have a network and access to technical expertise to make decisions on what we want to have in our portfolio. It’s mainly centered around understanding which projects actually need a token, why they need a blockchain, if they need to be decentralized, and then making sure we have positions in the ones we believe will perform well. Not necessarily in the next month, because, as Simon said, everything is very correlated, but which will be the long-term winners in the space?

Christophe: The first vehicles that were launched in this space to get access to the asset class definitely face the same challenges we see on the traditional side. Pressure on fees, how you justify two and twenty when you have ETFs coming out, I think we already have a Swedish ETN Bitcoin Tracker. That’s going to be a challenge. We’re seeing now more active strategies, more hedge fund-type multistrat propositions. A few guys are launching more systematic-type strategies as well with crypto. It’s all very interesting.

Hansjoerg: What I hope is that we get active investor communication as well about the real value of the token universe and blockchain technology. Just last week I was on a hedge fund panel in London, where one manager who just started to trade crypto last year was so proud of his 1,200 percent annual return in 2017. But I could clearly say this guy will have the same excuses by the end of 2018 when it’s not going so well. He will come up with excuses like, ‘The markets aren’t performing that well.’ I think communication and education is key about this topic.

Fabio: It’s also still a very small and young market environment. As everything matures and volumes come up, there will be a lot of opportunities to go into different strategies with different approaches.

Hansjoerg: You just mentioned volume, and PIF is limited to 100 million we learned today. What about big tickets that will come in. You could trade the big five coins, but if you focus on pre-ICOs and other stuff, I guess you’re limited in terms of volume as well.

Fabio: Obviously, that will be reflected in the size of the positions when it comes to lowly traded assets. For us, we will have monthly redemption, so we need to keep an eye on liquidity anyway, so there is a component of bitcoin and ether in the fund, and the pre-ICOs and small caps will have smaller positions.

Simon: You need to make sure you’re able to tap into the existing liquidity. Where do you trade, with whom do you trade, do you have access to most of the more liquid marketplaces out there? The trading venues are still very fragmented. There are over one hundred crypto trading platforms out there. The easiest way is using a professional broker who has access to a vast majority of liquidity providers, not only order books on exchanges, but also OTC trading desks. Try to get into every channel you can to distribute your order. If it’s a big ticket, distributed it over as many venues as possible.

Christophe: It’s a nascent market, but you probably have seen that Goldman is launching their own crypto trading desk. They are starting to just trade bitcoin futures, but it’s definitely going to raise the liquidity profile of the asset class. On the exchange front, I expect to see consolidation going forward, and all that is going to add to liquidity.

Hansjoerg: Last but not least, in terms of cost structures, what do you currently see, and where do you see it going to in terms of service providers: Are they charging more or less for crypto than for traditional funds?

Christophe: From the technology side it’s definitely less. You have to be realistic, a lot of these crypto funds are small, if a solution provider has a good understanding of their business and an entrepreneurial mindset, the pricing structures are built in a way, where the solution providers can grow with the crypto funds.

Fabio: I think, traditional service providers are definitely not charging less. Most of the time, it ends up being more expensive because the first couple of hours, you pay for education until they can get to work. It’s the same in every new industry: Eventually, there will be more providers offering the same services and the cost is going to come down.

Simon: On the service side, we see higher cost than in the traditional financial world. The market is young and competition is small, and you have high development cost on the service provider side, they have to build new tools, new offices, and new teams. Everything is pretty costly as long as you have just a handful of clients. It’s expensive now, but costs will come down in the coming years, that’s for sure.

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