Starting a crypto hedge fund is a daunting task. If you are not represented throughout the process by a skilled and experienced blockchain lawyer, though, it can also be incredibly risky. Depending on the nature of the fund, everything from the fund itself to the investment manager to any partners involved in it could be exposed to a huge variety of different federal laws regarding securities and digital monetary assets. Some of these laws can even lead to criminal charges for cryptocurrency fraud.
The blockchain lawyers at Oberheiden P.C. have helped numerous clients put together successful crypto hedge funds. With their experienced legal assistance and guidance, you can start up your own and rest assured that your venture complies with the law and is insulated from legal liability to the greatest extent possible.
If a crypto hedge fund is not structured properly, it can both create huge inefficiencies and leave the fund, its partners, and its investment manager exposed to substantial legal liabilities – both from law enforcement agencies and from private parties and even the fund’s own investors.
Typically, a crypto hedge fund is structured around three entities:
- The investment manager
- A limited partnership (LP)
- A general partner
A well-structured hedge fund will use these elements to minimize the exposure of these parties to liability and to business risks, while also maximizing their ability to invest the fund’s pool of assets. However, the size of the hedge fund’s operation can limit how this can best be done.
Generally, crypto hedge funds are structured as an LP. Investors receive partnership shares when they contribute capital to the fund. The size of the share in the LP that they receive is determined by the amount of capital they have contributed. Their share in the LP includes a capital account, through which the gains and losses of the fund are passed on to the investor.
The LP’s logistics and daily activities are conducted by the general partner. The general partner can be the investment manager, especially in smaller ventures, but does not have to be. It is generally wiser to use a limited liability company (LLC) or a second limited partnership as the hedge fund’s general partner. This increases the distance between the individual people behind the fund and the legal and financial risks that the fund will face as it operates. Using an LLC or a second LP as the general partner in the fund’s LP is also usually a good idea because it avoids the serious legal issues that can come up if an individual person is the general partner and either passes away or opts to leave the organization. Dissolution is much simpler if the person’s role and responsibilities can simply be shifted to the others in the LLC.
Finally, there is the investment manager. In smaller or startup funds, the manager is usually also the general partner. However, more legitimate firms with the assets to do so will hire an investment manager. The investment manager is the face of the hedge fund, as he or she will be responsible for managing the fund’s assets and investment portfolio.
While these are the general tendencies in structuring a crypto hedge fund, your particular needs, interests, assets, and risk aversion will all influence what is best for your given situation. An experienced blockchain lawyer will know about those other options and can guide you towards a hedge fund structure that best suits your needs.
Anti-Money Laundering Laws
Perhaps the chief concern that U.S. law enforcement agencies have with cryptocurrencies is the potential for them to be used to launder money. After all, the privacy and anonymity of cryptocurrency transactions is one of the main attractions to crypto.
While this concern is supposed to target terrorists, drug lords, and the criminal underbelly, in practice it has subjected upstanding crypto hedge funds to increased scrutiny, as well. Regulators want to make sure that your investors are not using your fund to move ill-gotten money around and potentially support other criminal elements.
As a fund manager or partner, you are legally obligated to take substantial steps towards ensuring that your fund is not used for one of these purposes. Those obligations are triggered from the moment you begin taking investors on. Having adequate compliance mechanisms in place from the very beginning is essential.
Know Your Customer (KYC)
In a similar vein, crypto hedge funds also have to take steps to know their customer base. Known as KYC compliance, federal regulators require crypto companies to take precautions and conduct identity verification checks to ensure that they are dealing with reputable customers, individuals, and businesses. These same regulators have shown that they are very willing to take legal action against crypto companies, including crypto hedge funds, that fail to take adequate KYC precautions or that do not take any, at all.
Unfortunately, the privacy and anonymity of cryptocurrency exchanges and hedge funds is one of the biggest perks that potential customers are looking for. Taking your KYC obligations seriously will almost certainly deter investors who would rather keep their identity hidden, even if only from the manager of the hedge fund. These shady or privacy-concerned investors will likely find another crypto hedge fund – usually one overseas – that is willing to do business with them without asking the basic and legally-required questions that they find overly intrusive.
While losing this business can be frustrating, taking it on can expose your entire fund to significant liability, government oversight, and extremely invasive investigations and auditing.
Just because your hedge fund deals in cryptocurrency does not mean that regular securities laws will no longer apply to it. The U.S. Securities and Exchange Commission (SEC) still regulates hedge funds that handle or that focus on cryptocurrencies – perhaps even more than traditional investment funds. The SEC sees these digital assets as even more speculative than other investment mediums, and scrutinizes the methods that hedge funds use to appeal to prospective investors even more closely than those used by other types of funds. The wariness of investment fraud among government regulators is still very real, in spite of the fact that it has been years since cryptocurrencies have lost their novelty, so hedge funds should take extra precautions to do things the right way.
SEC compliance is a huge part of the formation of crypto hedge funds, and the costs of shirking this fundamental component of opening a hedge fund can be disastrous. The financial penalties alone can cripple your fund in its very early days, and the potential for criminal sanctions are very real.