How a Blockchain-Based Fund Works
Disclaimer: I am one of the founders of CoinAlpha, a company that creates blockchain-based financial protocols and products. This is a discussion about a new way to apply blockchain technology, not a solicitation for investment nor investment advice.
While describing CoinAlpha’s long-term vision in a recent blog post, I mentioned that our first product is a blockchain-based hedge fund.
As you can imagine, readers had many questions about how the fund works from a mechanics standpoint. This is a more technical deep dive that strives to answer those questions.
Why use the blockchain?
The blockchain streamlines payments and information flows without the need for intermediaries.
Like all financial securities, funds are legal contracts between market participants that govern the flows of capital. To ensure that the flows of capital are prompt and accurate throughout the lifecycle of a traditional fund, each participant either maintains redundant systems and siloed databases, or they rely on other intermediaries like fund administrators, accountants, and auditors to do so. By providing a single source of truth, blockchain-based smart contracts make funds more efficient, transparent and liquid.
What’s a smart contract?
To explain how this works, let’s first define a smart contract. Smart contracts are mini-computer programs that allows you to set the rules that govern a cryptocurrency transaction. For example, a simple smart contract is a multi-sig wallet, a wallet owned by multiple parties. For a wallet with two owners, both signatures are needed to authorize any transfers to external parties. Because the smart contract is deployed on the blockchain, it can set and enforce these rules without the need for a trusted third party.
It’s critical that these rules are encoded correctly. When they are not, bad things happen.
“Smart contract” is a great marketing term, but today’s smart contracts are neither smart nor are they contracts. In fact, a term that more accurately describes a smart contract’s current functionality is dumb program.
Dumb programs are still extremely useful: the ability to combine the logic and data of a computer program with the transparency and trust of distributed ledger technology is a true game-changer for many applications in financial services.
Rather than many participants translating legal language into code across multiple closed system, a smart contract lives in the blockchain and executes in a publicly verifiable, transparent manner. Rather than redundant data structures that need to reconcile with one another, the blockchain prevents fraudulent, incorrect transactions and provides an immutable, replayable audit trail.
How does a blockchain-based fund work?
To fulfill the role of the administrator, custodian, payment bank, accountant, and auditor in traditional fund, CoinAlpha created a set of open-source smart contracts that we call the Fund Protocol:
- Handle fund inflows and outflows: enforce investment restrictions and process subscriptions and redemptions;
- Calculate net asset value: retrieve the portfolio’s gross asset value on a daily basis, allocate gains/losses between investors and management fees, and maintain the high water mark;
- Maintain data for reporting: log data needed for performance monitoring, tax, and audit purposes to the Ethereum blockchain.
How does a blockchain-based fund compare to an ICO?
Unlike an ICO in which the proceeds are used to build a project of uncertain value, our fund’s investment proceeds can only be invested in a limited portfolio of liquid cryptocurrencies, marked-to-market on a daily basis. The “tokens” that investors receive from our fund directly represent each investor’s proportional holdings of assets held in the fund. Investors cannot transfer our fund’s tokens among one another; however, they can redeem their tokens for Ether or invest more Ether in exchange for tokens each day.
Is this a decentralized autonomous organization (DAO)?
No. An investment in our fund requires a high degree of trust placed in the fund manager.
This is by design. Fund investors want their capital to be managed by a centralized professional manager, not managed via decentralized consensus.
What happens to investor proceeds after investment?
Once shares have been allocated, the smart contract immediately deploys investor capital to a CoinAlpha-registered account at an approved cryptocurrency exchange such as GDAX or Gemini. The fund manager has trading authority over this account and employs proprietary strategies to actively manage the portfolio.
We eagerly anticipate the evolution of decentralized exchanges such as RadarRelay, EtherDelta, and Paradex in order to reduce our dependency on centralized exchanges. However, at today’s average daily volumes of less than $5,000, decentralized exchanges are simply not a practical option today.
How does the fund handle blockchain-related challenges like scalability and transaction costs?
Compared to other sectors like payments, the fund administration world is slow and expensive. Hedge funds typically allow new subscriptions and redemptions once per month, and monthly operational costs are typically $50–100k per month.
Relative to those options, a blockchain-based solution offers significant efficiency improvements. For example, it costs approximately $3.00 and takes 2 minutes for us to perform the daily net asset value (NAV) calculation process, process subscriptions and redemptions at the new NAV, and publish a permanent record of all transactions on the Ethereum blockchain.
How do you handle security and other operational issues?
A smart contract that operates a fund that may exist for 10 or more years requires a different design than a one-time ICO contract:
- Security: We only expose selected functions to external investors. Administrative functions such as NAV calculation are only callable from addresses stored in air-gapped hardware wallets that we securely store.
- Upgradability: We delegate logic related to processing fund flows and calculating net asset values to child contracts that may be upgraded to resolve security vulnerabilities and fix bugs.
- Modularity: Daily calculations rely on data supplied by off-chain data sources. Modules that encapsulate interactions with these data sources need to be flexible, hot-swappable, and resilient in case the data sources are unavailable or need to be adjusted.
- Compliance: Instead of making the fund open to all, our contract makes the manager manually approve every new investor, since the fund is limited to 99 qualified clients. Non-whitelisted investors are unable to send Ether into the fund.
I want to dive into the code!
In order to instill trust through transparency, we have open-sourced the smart contracts used for our fund (Github repo). In addition, we have created a wiki that provides an overview of the technical architecture.
