Hashdex’s intense focus on risk management is one reason we avoided exposure to FTX, Alameda, and FTT. In their discussion, Chris and Bruno covered best practices to help investors avoid blow-ups like this in the future. The two also spoke about the impact of Genesis Global Capital pausing redemptions this week, the three most important criteria when evaluating service providers, and how these events will affect the broader industry going forward.
Chris: There’s quite a lot to unpack from what has transpired the last few weeks. The fallout from FTX will be fluid for the foreseeable future, but let’s start with what we know. What exactly happened with FTX and how is Hashdex impacted?
Bruno: First, Hashdex had no exposure to FTX, FTT, or Alameda. I’ll speak more about the processes we have in place to mitigate the risk of being involved with these kinds of meltdowns, but in terms of what happened last week what we know is that Binance’s announcement that it would sell its FTT token holdings sparked a classic run at FTX on November 6.
We then learned that FTX potentially has a $8 billion hole1 in its balance sheet that could be associated with loans to Alameda Research (owned by the founder of FTX) pledged with FTT as collateral and using client deposits. This cascade of events really damaged investor sentiment, leading to liquidity problems and falling prices for other crypto assets.
Prior to these events, the reputation of Sam Bankman-Fried—the founder of FTX—had become that of a crypto wunderkind who was helping make crypto more mainstream. His media appearances and public policy advocacy helped push this narrative, and his fall is a major embarrassment and setback for the crypto industry.
But we strongly believe there are two key things to keep in mind regarding FTX. First, the promise of crypto didn’t fail, it was the unscrupulous actions of a centralized third party that led to this failure. Second, this event underscores that ETPs and other regulated investment funds remain the best way to access the crypto ecosystem in a secure way for investors.
Chris: This week a subsidiary of Digital Currency Group, Genesis Global Capital, announced it is temporarily suspending redemptions. What is the impact on Hashdex and other crypto fund managers?
Bruno: Hashdex has no relationship with Genesis Global Capital. We’ve used Genesis Trading for over-the-counter (OTC) trading, but currently have no counterparty risk exposure to Genesis. We cover this in detail in a letter to clients this week, but our funds don’t engage in unregulated borrowing, lending, leverage, or derivatives2 trading of crypto assets. And our risk management policy does not allow us to custody assets on exchanges or with trading counterparties (e.g., OTCs and market makers).
To mitigate risk, we use a large set of approved custodians that currently includes Fidelity Digital Assets, Coinbase Custody (segregated from its exchange), BitGo Trust, and Anchorage Digital Bank. We have very strict rules for selecting custodians, that include a requirement that the custodian is licensed by a reputable US regulator, has insurance, and requires that client assets be technologically and legally segregated. We believe our strict due diligence processes and focus on operational controls help prevent events like FTX and Genesis from materially impacting our shareholders.
Chris: In this environment, what questions should investors be asking their crypto fund managers right now?
Bruno: Well, they should be asking lots of questions! But there are a number of specific questions we think investors should prioritize in the current environment.
For example, how is the eligible universe defined? And would it have avoided FTT, LUNA, etc.?
There should be a strict methodology behind any process behind selecting crypto assets for a portfolio. This is why we co-developed the Nasdaq Crypto Index™ to ensure that investors have an institutional-quality benchmark that screens out assets that don’t meet liquidity, market capitalization, or other important criteria.
Another question that should be asked is, what is the fund manager allowed to do with fund assets? Investors should know that anything the fund is doing, whether lending or other activities, are being done in the best interest of shareholders.These activities can add counterparty risk for investors, so they should be disclosed to give investors a way to track how much risk is being taken on and—more importantly—confirm how the revenue from these activities is returning to shareholders. As part of this, investors should know if the fund manager has other business lines that could create conflicts of interest.
Of course, there are many other important questions to ask, such as: How are assets custodied? Is the fund fully collateralized or are there synthetic structures that could expose investors to balance sheet risk? How are service providers selected?
Chris: Regarding your last point about the selection of service providers, can you talk about the most important criteria to consider when evaluating these third parties?
Bruno: There are many things we take into consideration, but I think three of the most important components of a selection process are:
First, the service provider must use the highest available custody practices. This must include certification of segregation of the fund's assets as well as structures disconnected from the internet. Storage must require multiple signatures and geographic distribution of cryptographic keys to mitigate the existence of a single point of failure and key-man risk. There have been no known cases of compromised accounts with this type of security.
Second, the quality and effectiveness of a custodian’s operational processes must be attested by an independent accredited auditor. This audit is generally summarized by SOC 2 Type II (Service Organization Control) reports and includes BCP (Business Continuity Plan). In addition to this, we also look for insurance policies against private key theft and loss, as well as against fraud and internal theft.
Third, OTCs need to meet strict standards, including having a license in their jurisdiction and submitting their corporate structure and balance sheet for us to analyze. This allows us to adjust our internal counterparty risk policies in trade settlements.
Our CEO Marcelo shares more detail about our operational focus in the letter to investors we sent earlier this week. But as the effects of the FTX fallout unfold, we are closely monitoring any impact to our service providers.
Chris: What does the FTX bankruptcy and its knock-on effects mean for the crypto ecosystem going forward?
Bruno: In the short term, there will be a lot of skepticism about crypto which will require a lot of education on the part of the industry. But thinking longer term, I think this moment has made people realize the value of operational and risk management.
Regulated investment funds remain the most secure and simple way to access the crypto ecosystem. As many investors with assets on exchanges have learned the hard way this year, directly investing in crypto assets has many challenges and risks. Many exchanges are loosely regulated, with no transparency, and safeguards for their clients. Compare this to the regulated structure of ETPs and it becomes clearer that paying a fund manager a modest fee is a small price to pay for the security of knowing you won’t be wiped out by an unscrupulous exchange.
It’s also important to remember that there’s a lot that has worked as it should with crypto. Since early 2020, all major crypto assets have maintained their monetary policies and operational functionality. Bitcoin’s investment case is as strong as ever, Ethereum is becoming more scalable, and decentralized finance (DeFi) projects have proved their worth in a challenging investment environment.
At the end of the day, this industry is still demonstrating incredible promise. And our team is as excited about crypto’s potential as we were when we founded Hashdex five years ago.
 Binance Walks Away From Deal to Rescue FTX, Wall Street Journal, November 10, 2022
 The only exception is the US-listed Hashdex Bitcoin Futures ETF, which invests in Bitcoin Futures contracts listed on the CME.
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