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STANDARDS BOARD FOR ALTERNATIVE INVESTMENTS

Operational Due Diligence of

Crypto Assets Toolbox

Introduction
Crypto assets were once the purview of retail investors, but more recently the asset class has gained
attention from institutional investors and asset managers. There are dedicated crypto funds specialising
solely in digital assets, however more traditional hedge fund managers are now allocating to this asset
class. In a Q1 2021 survey, it was identified that there are more than 800 crypto currency or blockchain
investment funds with just under half of these being hedge funds 1.

For a dedicated crypto fund, it will be obvious that crypto assets are included in the investment mandate,
but this is not the only place they can appear in an allocator’s portfolio. A 2021 study by PWC and others
identified that one fifth of hedge funds are investing in digital assets with an average exposure of 3% of
the portfolio. In addition, one quarter of hedge funds who have not yet invested confirmed that they are
planning to invest2.

Institutional allocators conduct operational due diligence (ODD) on the underlying managers and funds
that they invest in, including on elements such as counterparties, valuation, and conflicts of interest.
Crypto assets operate using different infrastructure than more traditional asset classes, therefore any
ODD must take account of certain risks that are more prominent within this asset class. The SBAI’s
Alternative Investment Standards help asset managers apply the required controls to satisfy an ODD
process and specific standards are referenced throughout this memo.

This SBAI Toolbox memo looks at:

• Key areas of ODD for crypto assets, including custody, trade processes, valuation and asset
verification, conflicts of interest, and regulatory risk.
• Other ODD considerations including a brief look at crypto assets and responsible investment.
• The appendices contain a list of ODD questions for investors to ask and a glossary of common
crypto asset terms3.

Crypto Assets can be a controversial topic and it is important to reaffirm that, at the SBAI, we do not endorse any
alternative investment strategy including crypto assets. Should allocators, after their own research and investment
processes, choose to invest in specific strategies or asset classes, our aim is to ensure they can do this in an informed
way whilst maintaining high standards within the alternative investment industry.

1
https://cryptofundresearch.com/cryptocurrency-funds-overview-infographic/
2
https://www.pwc.com/gx/en/financial-services/pdf/3rd-annual-pwc-elwood-aima-crypto-hedge-fund-report-(may-2021).pdf
3
Defined terms are highlighted in bold throughout the memo

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Investment Mandates
Most fund governing documents define the fund’s investment universe quite broadly meaning crypto
assets may not be excluded from the investment universe of traditional hedge fund strategies. Allocators
should explore this in initial and ongoing due diligence, particularly in macro or currency-based strategies.

It is important to discuss the scope of crypto assets that may be considered, this could include liquid
assets (and their derivatives) such as Bitcoin or Ethereum, Initial Coin Offerings (ICO), Simple
Agreement for Future Tokens (SAFT), or venture capital style equity positions in companies within the
crypto ecosystem. Asset managers of crypto funds could also be involved in Staking, lending, and
borrowing of crypto assets.

Investors should consider any investment restrictions for this asset class. Given high levels of volatility, it
is possible for small allocations to become much larger in a short space of time.

How the SBAI Alternative Investment Standards can help:

Standard 1.1 requires that asset managers have an appropriate level of disclosure and explanation of
the fund’s investment policy/strategy and associated risks included in the fund’s offering documents.
This should include:
▪ General details of the investments and instruments likely to be included in the fund’s
portfolio.

Custody

What does Custody of Crypto Assets Mean?

Crypto assets are digital bearer instruments that reside inside a digital blockchain database.
Custodians store the private key (password) that controls the ability to transfer the asset to other
people. Key custodial functions are the secure creation of the public-private key pairing and storing
the private key in a secure way.

Custodians may be independent third parties (typically the case for more liquid crypto assets such as
Bitcoin) or the manager may opt to self-custody assets where infrastructure does not yet exist or is not
yet mature enough for the specific asset class.

Third Party Custody:

Custodians of crypto assets are not typically the recognised names used for more traditional asset classes
requiting allocators to complete due diligence on the counterparties. Crypto asset infrastructure may not
yet be as mature as for traditional asset classes, but there is a minimum set of standards that should be
expected. Allocators should understand the minimum standards they require in advance of conducting
due diligence. As crypto is a bearer asset, security of the Private Key is an important area of focus
alongside more traditional custodian due diligence 4.

4
See Report on Institutional Digital Asset Custody for more technical details on due diligence of a digital asset custodian:
https://web.anchorage.com/anchorage-blocktower-whitepaper/

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Self-Custody:
Some crypto assets may not be supported by competent third-party custodians, meaning the manager
may hold the private key internally. How acceptable this is to an allocator will likely depend on the
rationale for self-custody and the safeguards put in place. Where there are available institutional third-
party custodians for the specific crypto asset, serious questions should be asked about why an
independent custodian is not being used.

At a high level, the ODD of a manager’s custody arrangements should be the same as that for a third-
party custodian. Some areas, however, will require increased scrutiny:

How the SBAI Alternative Investment Standards can help:

Standard 17a.4 requires that one or more third parties, independent of the manager, should be
appointed to be responsible for the safe keeping of the property of the fund.

Trade Process:
The system infrastructure supporting the crypto asset ecosystem is in its infancy and there can be heavy
reliance on manual processes.

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Crypto Asset Trade Flow Diagram

Trading of crypto assets can be through “voice trading”5, some exchanges offer electronic trading, but
this is not yet standard across the industry. ODD analysts should ensure that controls expected when
other asset managers trade via “voice” are in place.

Trade confirmations are typically emailed and should be provided simultaneously to the third-party
administrator for reconciliation purposes.

Trade settlement is typically faster than most traditional asset classes, but delays may occur at the point
of transferring fiat cash. For managers that hold assets in cold storage the retrieval process can be more
cumbersome; however, this is typically achieved in hours rather than days.

Valuation and Asset Verification:

There will be many similarities between the valuation of crypto assets and traditional asset classes, but
there are also some key differences:

Valuation:

Valuation processes for crypto assets vary depending on the specific asset class, but broadly:

Markets for most liquid crypto assets operate around the clock and as such valuation points could be set
at any specified time and are not reliant on a market close time. The valuation point for the fund must be

5
Trading completed on the phone or via other non-automated communication methods

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clearly documented in the valuation policy and be consistently applied without exception. Managers may
document this with a time stamp or audit trail within the fund accounting system.

Multiple exchange prices can be used to value liquid assets creating an average price. There have been
instances of incorrect prices on exchanges so, given the volatility of the asset class, the process should
be treated and evaluated in the same way as for broker quotes. Processes could include checks against
the high and low prices in the market that day, monitoring of outliers, and comparisons or back-testing
against traded prices.

Asset Verification

Independent parties such as auditors and fund administrators should be able to independently verify the
crypto assets in the portfolio.

When the asset is stored on a single blockchain address (i.e., not commingled with the custodian’s other
assets) there is a constant view of the existence of the asset and therefore traditional verification practices
can be used. These addresses, or wallets, also contain a hash for each transaction in addition to the
current wallet balance. Allocators should discuss who manages the list of wallet addresses to ensure all
assets are verified.

For self-custody, there are more processes and procedures required to make sure that the private key
is owned and exclusively controlled by the manager. Managers may, for example, demonstrate control
over the private key by using it to send encrypted messages over the blockchain to an independent
party.

How the SBAI Alternative Investment Standards can help:

Standard 7.1 requires that where a fund manager performs in-house valuations of hard to value assets,
valuation procedures aimed at ensuring a consistent approach to determining fair value should be
adopted and the procedures should be set out in a Valuation Policy. This should include amongst other
things:
▪ If using broker quotes (similar processes to this should be used when sourcing prices from
multiple exchanges):
o Making reasonable efforts to identify and draw upon multiple price sources (where
available),
o Specifying the acceptable tolerance ranges when multiple price sources are used
and the approach to handling “outliers”,
o Ensuring consistency and avoiding cherry-picking of favourable pricing sources by
using the same brokers at each valuation point, and
o Where the fund manager arranges the provision of broker prices (as opposed to an
independent third party) the manager should instruct the brokers to send the prices
directly to the administrator.

Conflicts of Interest:
Crypto assets are relatively new compared to traditional asset classes such as equities or bonds. Early
asset managers in this space needed to diversify revenue sources until more institutional interest was
attracted. In addition, the required infrastructure was either not available or not at the required standard
and many market participants had to fund the creation of this infrastructure.

This means that in the crypto ecosystem, there is a relatively high level of affiliated interests. Managers
may have their own service provider functions (e.g., trading desks) or equity investments in service

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SBAI Toolbox - Operational Due Diligence of Crypto Assets (November 2021)
providers. Service providers may also own exchanges or other related businesses. Affiliated businesses
and conflicts of interest that may arise should be discussed as part of the ODD process.

Similar conflicts of interest in traditional asset classes are not uncommon. For example, in structured
credit where there are affiliated loan originators and service providers 6. So, a framework for assessing
these conflicts already exists. Allocators should not hold crypto fund managers to a lower standard
because of the early-stage reasons detailed above. There should still be appropriate governance,
mitigation, and disclosure of these conflicts.

How the SBAI Alternative Investment Standards can help:

Standard 17j.1 requires that a fund manager should ensure that it has internal arrangements to manage
and mitigate conflicts of interest, and this should include documented compliance policies and
procedures. Conflicts of interest should be recorded and reported to senior management on a periodic
basis or, in the case of conflicts requiring the approval of senior management, escalated as soon as
reasonably practical. Where applicable, conflicts of interest should be reporting to the fund governing
body.

Regulatory Risk
The regulatory framework for the crypto asset ecosystem is currently undefined and unclear, which adds
heightened regulatory risk to the space. Regulators continue to express interest in a more regulated
environment and each jurisdiction is following its own approach. The focus of regulation so far has been
on ICOs, exchange activities, and AML and KYC 7.

For example, in the US the lack of clarity as to whether a crypto asset is considered a security or not
gives rise to regulatory risk. If underlying assets are classed as a security this can lead to actions by the
US SEC8 for unregistered security offerings as seen in the action filed against Ripple in December 2020 9.
This can mean that exchanges delist the asset resulting in reduced liquidity and an inability to trade.
Allocators should use these case studies to understand manager’s reactions and knowledge on this topic
(particularly for less liquid or newer crypto assets).

How the SBAI Alternative Investment Standards can help:

Standard 17g.1 requires that a fund manager should ensure that it understands laws and regulations
relevant to the securities in which it trades.

AML and KYC:

The use of crypto assets for money laundering or terrorist financing has been a concern for regulators
and some institutional investors. A crypto asset benchmarking study by the University of Cambridge
suggests that there has been some improvement, reporting that in 2020 approximately 13% of crypto-
asset only companies did not complete any KYC checks - down from 48% in 201810. Therefore, AML and

6
Covered in more detail in the SBAI Toolbox Memo on Conflicts of Interest in Alternative Credit:
https://www.sbai.org/toolbox/alternative-credit/
7
Anti-Money Laundering and Know Your Customer checks
8
US Securities Exchange Commission
9
https://www.sec.gov/news/press-release/2020-338
10
https://www.jbs.cam.ac.uk/faculty-research/centres/alternative-finance/publications/3rd-global-cryptoasset-benchmarking-study/

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KYC checks by the manager and service providers continue to be an important consideration during ODD.
Two main areas should be considered:

How the SBAI Alternative Investment Standards can help:

Standard 17c.1 requires that a fund manager should be confident that it understands the applicable
laws and regulations in the market in which it deals and has effective systems and controls in place to
enable it to identify, assess, monitor, and manage the risk that the fund manager might be used to
further financial crimes.

Standard 21.7 requires that regular reports on compliance with laws and regulations (in particular those
relating to AML) applicable to activities which are performed by the administrator on behalf of the fund
should be obtained by the fund governing body from the fund administrator.

Other Operational Due Diligence Considerations

The focus areas above are considerations above and beyond traditional ODD. Allocators will still need to
cover standard areas, several of which were highlighted in a recent SEC Risk Alert 11

11
https://www.sec.gov/files/digital-assets-risk-alert.pdf

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 How the SBAI Alternative Investment Standards can help:

Standard 14.1 requires that a fund manager has a process for setting up trading relationships on behalf
of the fund, including the assessment of credit worthiness and the setting of risk limits.

Standard 14.2 requires that the creditworthiness of a fund’s counterparties are monitored periodically
and risk limits adjusted where required.

Standard 17h.1 requires that a fund manager should adopt a personal account dealing policy for its
staff, ensure awareness of this, test compliance from time to time, and make a summary of the policy
available to investors upon request.

Crypto Assets and Responsible Investment

Headlines have highlighted the potential environmental impact of this asset class which should be
considered alongside any Responsible Investment objectives of the allocator.

Mining is integral to currencies that use Proof of Work to validate transactions. For example, Bitcoin
miners solve complex mathematical challenges to verify a transaction. This process is designed to
increase in complexity over time which requires more computer processing power and therefore more
energy. Whilst the use of renewable energy is becoming more common, a crypto asset benchmarking
study by the University of Cambridge shows that only approximately 39% of proof of work mining is
powered by renewable energy12.

There are alternative mechanisms that use less energy, for example Proof of Stake. Here miners are
required to have an investment in the designated crypto currency and the ability to mine is typically
proportionate to their stake. The incentive here is to increase investment rather than processing power.
There are also initiatives such as the Crypto Climate Accord 13 , where supporters sign up to help
accelerate the development of “greener” proof systems.

12
https://www.jbs.cam.ac.uk/faculty-research/centres/alternative-finance/publications/3rd-global-cryptoasset-benchmarking-study/
13
https://cryptoclimate.org/

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Appendix A: Questions for Investors to Ask
Investment Mandate

▪ Does the investment mandate exclude crypto assets as part of the investment universe?
o This might be explicitly excluded, or the investment mandate is defined well enough
that crypto assets could not be part of the investment universe.
▪ Does the asset manager currently invest in crypto assets, or has it done so historically?
▪ Does the asset manager intend to explore adding crypto assets to the portfolio at any point?
▪ How does (or would) the manager invest in crypto assets (e.g., derivatives, liquid assets,
ICOs, SAFTs, or VC style investment?
▪ Should the asset manager decide to allocate to crypto assets, does it intend to give
advanced notice to its investors?
▪ How will any crypto assets be reported to investors e.g., how will they appear in risk reports,
monthly newsletters, etc.? The Open Protocol Risk Reporting framework was updated in
2021 to include digital asset exposure data.
▪ Is there a restriction on the amount of exposure to crypto assets in the portfolio – if yes, what
is the restriction and how long is the cure period for any breaches given the volatility of the
asset class?

Custody

▪ Does the manager use third-party custodians for all assets? If no, which assets are self-
custodied and what is the rationale for this?
▪ What authorisations and licences does the custodian have?
▪ Does the custodian have insurance? If yes, what does this insurance cover, up to what value
is covered, and which firm is providing the insurance?
▪ Does the custodian have an external auditor produce a Type II SOC Report on its controls? If
yes, will investors be provided with a copy and have there been any material exceptions? If
no, what is the reason and does the custodian intend to have one produced?
▪ Who is on the team that oversees security of the private keys and what is their relevant
experience?
▪ Does the custodian provide documentation on the security procedures in place to investors?
▪ What are the security processes in place for both key generation and key storage? How does
the custodian protect against collusion and coercion?
▪ Has there ever been a breach in these security controls?
▪ What back-up and redundancy plans are in place at the custodian and how would a private
key be recovered if there was a disaster event?
▪ Has there previously been an event that required the recovers of a private key and was the
recovery successful?
▪ What is the process for accessing a private key and does it require multi-factor
authentication?
▪ Does accessing the key require personnel from both the custodian and the asset manager?
▪ What are the change management controls to change permissions or code and how are
these enforced?
▪ Does the custodian provide proof-of-existence audits on demand?
▪ How does the custodian prove exclusive control of private keys to auditors?
▪ Are wallets segregated or commingled at the custodian?

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 Self-Custody Additional Questions
▪ Does self-custody of the assets require additional regulatory requirements and if so, who is
responsible for the oversight of this?
▪ Are self-custodied assets belonging to any one fund commingled with assets belonging to
other funds and/or the GP and its affiliates at any stage?
▪ Which service providers are performing independent verification of the assets in the portfolio
and at what frequency is this completed?
▪ Can assets be moved with no independent authorisation or is another service provider
involved in transaction authorisation?
▪ What is the background of the team responsible for designing the self-custody solution, does
this background qualify them for the task?

Valuation and Asset Verification

▪ Are the crypto assets in the portfolio considered liquid or hard to value?
▪ For liquid assets:
o Does the valuation policy clearly state the time of the valuation point?
o Has the manager ever deviated from this time, and if yes why?
o Can the manager evidence adherence to this valuation point via automated
timestamps or an alternative method?
o Does the manager use multiple exchange prices to create an average price?
o If yes, what is the verification process for these prices including testing against high
and low prices for the day, monitoring of exceptions, and back-testing against traded
prices?
▪ For Hard to Value assets:
o Does the fund liquidity align with the frequency of reliable valuations?
o How is the manager valuing these assets?
▪ Is the fund administrator and auditor able to independently verify the assets in the portfolio?
(Investors should also raise this same question to these parties independently).
▪ What is the process used to verify the assets?
▪ Who manages the complete list of wallet addresses to ensure third parties have the
complete list?

Conflicts of Interest

▪ Does the asset manager, custodian, third party administrator, or any other service provider to
the fund own equity or debt in any affiliated businesses such as exchanges, custodians, or
trading desks?
▪ If yes, what are the processes in place for mitigating any conflicts of interest? For example,
does the manager prohibit the fund trading with an affiliated trading desk?
▪ Are the conflicts of interest clearly disclosed to investors?
▪ Will the manager provide access to the firm’s balance sheet to verify other interests?

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Regulatory Risk

▪ What is the manager’s understanding of the current and forward-looking regulatory

environment in the jurisdictions that it operates in?
▪ Does the manager trade any assets that have the potential to be classified as a security by
the US SEC?
▪ What does the manager see as the main regulatory risk to the portfolio?

AML and KYC

▪ Does the asset manager limit subscriptions in the fund to fiat currencies?
o If no, what processes are in place for AML and KYC checks on the non-fiat
currencies?
▪ Does the asset manager conduct due diligence on the exchanges used?
▪ Does this due diligence cover AML and KYC checks?
▪ Will the manager provide a complete list of exchanges used by the fund?

Crypto Assets and Responsible Investment

Questions for Investors to Ask:

▪ Do the crypto assets in the portfolio rely on Proof of Work for mining or Proof of Stake?
▪ Is the manager aligned with any initiatives to reduce energy consumption in the mining of
crypto assets?

Appendix B: Glossary of Common Crypto Asset Terms

The below table contains definitions for some of the common terms that may appear when discussing
crypto assets. Note that some of these terms did not appear in this memo but are listed below for
information purposes.

Term Definition
Airdrop The distribution of new digital assets to the public for either holding another
token or having an active wallet address on a particular blockchain.
Altcoin A generic term for crypto currencies that are not Bitcoin and are considered
an alternative.
Blockchain Decentralised14 ledger technology that offers a permanent, immutable
record of transactions divided between different nodes. Essentially, a
network of information, like an online ledger, stored in no single place and
used to detail anything from crypto currency transactions to recording who
owns specific properties.
Coin The term can be used to describe a crypto-currency asset that is not a
token. It describes a crypto currency that is independent of any other
blockchain or platform.
Cryptocurrency A digital currency that is secured by cryptography and used as a medium of
exchange within a peer-to-peer economic system.

14
To note there are also permissioned blockchain networks that are “less decentralised”

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 Decentralised An ecosystem comprised of non-centralised financial applications
Finance (“DeFi”) developed using blockchain technology. Uses computer codes known as
smart contracts to conduct and settle transactions in real time.
Encryption Conversion of information or data into a secure code to prevent
unauthorised access to the information or data.
Fork A change in a blockchain’s protocol that the software uses to decide
whether a transaction is valid or not. This causes a split in the blockchain
network that results in the creation of a new asset.
Hash Taking a transaction as input and generating an output of fixed length to
identify the transaction
Initial Coin Offering A fund-raising method in which new projects sell their cryptocurrencies to
(ICO) investors
Mining The verification of transactions within a blockchain network where
transactions are added as entries into the blockchain ledger. The method
of verification depends on whether proof of work or proof of stake is
used.
Node A participant on a blockchain network that communicates with other
participants to ensure the security and integrity of the system.
Non-fungible token A type of cryptographic token that represents a unique digital or real-world
asset that isn’t interchangeable.
Off-chain Transactions that occur off a given blockchain network, that may be later
reported or batched together before being submitted to the main chain.
Private Key A lengthy sequence that allows users to sign transactions and to generate
receiving addresses. Can be thought of as a password.
Proof of Stake This is a consensus mechanism where miners are required to have an
investment in the designated crypto currency and the ability to validate new
transactions (“mine”) is typically proportionate to their stake
Proof of Work A mechanism to validate transactions. For example, Bitcoin miners must
solve complex mathematical challenges to verify a transaction.
Sharding The breaking of the private key into several individual fragments
Simple Agreement A form of fund-raising directed to accredited investors which promises
for Future Tokens tokens when the project or company becomes operational.
(SAFT)
Smart Contract An automated contract that triggers certain actions when predetermined
conditions are met. It works following an “If… Then…” methodology so that
certain conditions must be met before other actions can be taken.
Stable Coin A crypto asset that uses a device to stabilise its value, for example, by
maintaining a reserve of underlying currencies or commodities.
Staking A process that involves buying and setting aside a certain amount of
tokens to become an active validating node for the network.
Token Digital assets issued on a blockchain which can hold value or be
redeemed for assets. These are not the same as coins.
Wallet A secure digital wallet that allows users to store digital assets electronically.

Appendix C: Contributors
The SBAI would like to thank the following for their contribution towards this Toolbox memo

(Alphabetically by Firm)

Steven D’Mello
Partner, Operational Due Diligence, Albourne Partners

Seerat Maini
Associate, Operational Due Diligence, CPP Investments

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Garima Grover
Associate, Galaxy Digital

Karl Ngok
Vice President, Client Services, Galaxy Digital

Steve Kurz
Head of Asset Management, Galaxy Digital

Andrew Chen
Absolute Return Strategies, Lockheed Martin Investment Management

Matt Lundy
ORAM Head of Operations, One River Asset Management

Wei Xie
Director, Co-Head of Multi-Strategy Investments, Capital Markets Group, OPTrust

Matt Perona
Chief Operating Officer and Chief Financial Officer, Polychain Capital LLC

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