Lessons for Independent Directors from the FTX Collapse: Gain insights on navigating bear and bull markets to counter risks associated with market downturns.
In part 1 we discussed the basic duties of directors and how it relates to the state of the crypto market. In this article we will be delving deeper into lessons learned through bear and bull markets, that independent directors can consider, to counter the risk associated with a downturn in the digital asset market.
1. PROOF OF RESERVES
After the collapse of FTX, the industry is implementing proof of reserve audits as a measure of good will. A proof of reserve (PoR) audit is an independent audit conducted by a third party which seeks to ensure that a custodian holds the assets it claims to on behalf of its clients. PoR audits will give investors on a CeFi exchange the comfort of knowing that their assets are held as collateral by the exchange. This is not a foolproof system as a PoR audit does not take the liabilities of the CeFi exchange into account, it’s only an audit on the assets. It proves that the clients’ assets are held by the exchange, not that the exchange has the liquidity to pay all client assets back in case of a mass withdrawal.
The American banks Tier 1 capital ratio requirements are between 3 – 5%. As seen in the last financial recession banks have the safety blanket of a government bailout, such as the $20 billion bailout of Bank of America in 2009. In the crypto industry there are no bailouts as the industry is not regulated. Mixed with the volatile nature of the asset class, it is becoming clear the CeFi exchanges need to keep very high capital ratios, if not 100%, to avoid liquidity issues. Going forward, directors will be looking at an exchange’s reserves to establish the associated risk.
2. SERVICE PROVIDERS
Directors are permitted to delegate powers to service providers of a company but in so doing cannot be absolved from the duty to acquire information about the company’s financial affairs or exercise supervisory responsibility for the company. In the digital asset field it becomes increasingly important to screen service providers thoroughly and perform due diligence on their capabilities, policies and procedures, ensuring that it covers additional requirements. One thing to look at is your fund administrator’s AML policy and procedures. We would motivate AML delegates to apply OFAC guidance that calls for Geolocation Tools and Blockchain Intelligence to be applied. The guidance highlights several key areas, including the use of geolocation tools blocking IP addresses that originate in sanctioned jurisdictions. It also highlights the need to employ monitoring and investigations software that can identify transactions involving cryptocurrency addresses associated with sanctioned individuals and entities listed on the specially designated nationals (SDN) list.
3. PROJECT, INVESTMENT, AND EXCHANGE DUE DILIGENCE
As independent directors, we ensure that our clients perform exchange due diligence procedures before onboarding an exchange for trading and custody solutions. A fund is expected to determine what their risk appetite is and onboard exchanges that are within their risk parameters.
When investing in seed, venture investments or SAFT’s, due diligence and KYC procedures should be performed by the management team, smart contact audits and in-depth valuation and legal reviews performed.
4. CUSTODY AND DIVERSIFICATION
It was estimated by Crypto Fund Research that 25-40% of crypto hedge funds have some direct exposure to FTX exchanges or the FTT token and that the average direct exposure of crypto hedge funds is around 7-12% of AUM. The fallout will even extend to funds not directly exposed, due to the spillover effects of Solana and the cryptocurrency markets more generally. Independent directors and investment managers could have reduced exposure to losses if sufficient diversification of custody solutions were implemented. Understandably certain exchanges provide more liquidity and a better return than others, but the security of the assets should not be compromised to chase a higher return. Funds that used multiple reputable custodians had a smaller exposure to assets being locked up in FTX.
Hash believes that, as in traditional finance, well documented policies and procedures form the backbone of any company’s operations. As independent directors that specialize in digital assets, we review your custody policy and procedures in detail and ensure proper diversification is implemented, the custody solutions are reputable, and policies are in place for seed phase management and other custody related requirements. The custody policy could include areas such as self-custody, 3rd party service providers such as custodians and centralized exchanges, DeFi and NFT storage.
5. JURISDICTION
According to PWC’s 2021 Crypto Hedge Fund Report 34% (2020: 42%) of all crypto hedge funds are domiciled in Cayman Islands. FTX’s bankruptcy filing claims that 22% of the customers are domiciled in Cayman Islands, followed by the British Virgin Islands with 11% and China and the UK with 8% each.
Having an independent director on the board that is well versed in the jurisdiction is cardinal to the success of the fund.
Hedge funds are increasing their governance and maturing the fund structure, by appointing independent directors to the board of the funds. PWC’s research shows that in 2018 25% of crypto hedge funds had independent directors, which grew to 51% in 2021.
In Cayman Islands independent directors bring diversity of knowledge and experience, complying with economic substance requirements.