Establishing best practices for a crypto fund audit
For most new fund managers the concept of having to prepare for a financial audit is entirely novel. Knowing what is involved and how best to prepare, in terms of applying best practices, is a new discipline, yet it is one that is crucial to running a successful fund management business.
With respect to the meteoric rise of cryptocurrency funds, there are only a handful of auditors that really know what they are doing, in terms of supporting them. For these managers, therefore, choosing the right auditor is important. If not, and they run into difficulties because the appointed auditor does not fully understand the asset class, it could lead to delays and result in additional fees down the line.
“Doing that initial due diligence on service providers, so that managers have the confidence that their service providers know what they are doing in this space, is crucial,” says Ignacio Griego, Assurance Partner, BDO, speaking from the firm’s San Francisco office.
“There are a lot of people that don’t know what they are doing with respect to crypto funds as more and more service providers try to get into this space. The type of people launching crypto funds can include engineers without fund operational experience or traditional fund managers without the technical crypto background. Having a complimentary team with a foundation in both areas is a prerequisite to running a successful crypto fund business.”
There are a few areas that new managers should be discussing with their appointed auditor. One of the most important areas of discussion is the valuation policy. This is true, regardless of what the fund strategy is, but for cryptocurrency strategies it is crucial because of the lack of provenance in handling such funds.
“Many of the tokens or coins in these funds trade on exchanges but as we’ve seen in the last few weeks there have been some significant spikes in volatility. There are spreads across different exchanges so coming up with a solid valuation policy to determine how the manager arrives at a fair market price for each position is important. They shouldn’t be cherry picking one exchange over another in different scenarios,” advises Griego.
As reported by BBC News on 22nd December (citing Coindesk), Bitcoin’s price fell off a cliff, losing almost a third of its value as it dropped from nearly USD20,000 before recovering just north of USD13,000.
In Griego’s view, it is important that managers of crypto funds adhere to Topic 820 (Fair Value) under US GAAP. They should establish the valuation policy when the fund is established with the fund administrator and run that policy by the appointed auditor to check they are comfortable with it.
“This should all be done early, ahead of the financial year-end, so that there will be less of a likelihood that the manager will need to make any adjustments prior to finalising the year-end NAVs. This is good best practice for any new investment fund, be it a crypto fund, a hedge fund or a private equity fund.”
For funds investing directly in blockchain or cryptocurrency related companies, valuation can prove challenging if the company is not generating any revenue. Even for companies producing revenue, walking through the valuation concepts with the auditors is a helpful exercise. Many of these companies are highly specialised, so it is important to hold discussions on comparable companies and other unobservable inputs being used in the valuation. It’s about making sure everyone is on the same page prior to year-end.
“I foresee a lot of potential challenges in 2018 for teams who may have hastily put a launch together without assembling the right team and dedicating the right amount of resources to operations and service provider diligence. Equally, for many service providers it is the first time they’ve worked with such funds. It is a new era, in many respects,” says Griego.
Another key piece of the financial audit is thinking about the custody of the assets. In a typical hedge fund, this is all pretty simple. The assets will be held at a qualified custodian such as Goldman Sachs, to whom the auditor can send a confirmation that they are indeed holding the assets. Reliance can be placed upon reports received as these qualified custodians typically will obtain a SOC-1 report from an external auditor, which focuses on the custodians’ internal control environment.
However, with crypto assets the problem is that there are not yet many custodians in the market. If you want to buy and sell Bitcoin or other tokens there are plenty of trading options but when it comes to utilising a qualified custodian there are limited options. You can buy it on an exchange, but then need to determine the most secure location to store and if there is even the option of moving to a qualified custodian based upon the token type. In many instances funds are forced to self-custody tokens using their own hard disk ledger wallets.
“As an auditor we need to know what the custody position is for the fund, and if they do have a custodian, does that custodian generate any sort of report on their internal controls such as a SOC-1 report? Auditors need to go through such reports, if indeed they are produced, with a fine tooth comb to ensure the report covers the key internal controls.
“If the manager self-custodies, who has access to the cold storage? How are they protecting the encryption keys? What back-ups do they have in place in the event that the manager misplaces the hard drive ledger or it gets stolen?
“A lot of these are common sense questions but they tend to get overlooked,” explains Griego.
There are plenty of Bitcoin wallets available to use for self-custody. Some of the more popular include Ledger Nano S (a hardware wallet), Mycelium (an open-source Bitcoin wallet) and Exodus (a desktop-only wallet).
“At the end of the day, we want to be aligned with the right teams who have spent the necessary time developing not only their investing strategy, but their operations and infrastructure. We want to understand exactly what they are investing in, what their valuation and custody processes are and what key internal controls have been implemented,” emphasises Griego.
As for how an auditor thinks about cryptocurrency funds in respect of financial reporting under FATCA and Common Reporting Standards, this is a careful exercise because theoretically, if an investor were investing in a crypto fund using tokens rather than cash, how would the investment adviser know who that end investor was?
“The funds I’ve seen have not had any in-kind contributions and they still go through standard AML/KYC checks.
“While there may be instances where it may make sense for an individual or fund to utilise an in-kind contribution of securities or tokens, it oftentimes will result in a headache as the cost basis of these asset lots will need to be tracked separately and specially allocated to those contributing individuals, which can create additional headache, time and costs.
“While many of the legal documents will allow for in-kind contributions, funds should think carefully about the implications should they chose to go this route,” concludes Griego.