Blockchain innovation for private investment funds

Blockchain technology offers unprecedented innovation opportunities for the private investment fund industry. Several private investment funds have spearheaded the implementation of blockchain technology and smart contracting in their business model. While some funds simply focus on trading bitcoin and other cryptocurrencies to avoid market fluctuations, others invest in or acquire companies that use blockchain technology to provide synergies to their other portfolio companies. Yet others go much further by fully automating a hedge fund secured by blockchain technology, using blockchain technology to improve administrative procedures of private equity deal making, or using cryptocurrencies as incentives for data scientists’ competitive models that facilitate investment analysis efficiencies. Examples include private investment funds such as Polychain Capital, the Northern Trust in cooperation with IBM, Numerai, LendingRobot, and Intellisys Capital LLC, among many others.

Naturally, this article cannot encapsulate all recently emerging trends in the private fund industry pertaining to the application of blockchain technology but rather is limited to pointing to prominent examples that illustrate the emerging use of blockchain technology in the private investment fund industry.

Despite these limitations, it is possible to forecast that once blockchain-based hedge funds that trade by algorithm are able to expand beyond peer-to-peer lending investments into the stock market, it is possible that they will monopolize and substantively change the hedge fund industry.

Blockchain technology

A blockchain is a shared digital ledger or database that maintains a continuously growing list of transactions among participating parties regarding digital assets – together described as “blocks.” The linear and chronological order of transactions in a chain will be extended with another transaction link that is added to the block once such additional transactions is validated, verified and completed. The chain of transactions is distributed to a limitless number of participants, so called nodes, around the world in a public or private peer-to-peer network. The central elements of blockchain technology include: transaction ledger, electronic, decentralized, networked, immutable, cryptographic verification, among several others.

Vitalik Buterin, the founder of Ethereum, perhaps most prominently defined blockchain as follows: “A public blockchain is a blockchain that anyone in the world can read, anyone in the world can send transactions to and expect to see them included if they are valid, and anyone in the world can participate in the consensus process – the process for determining what blocks get added to the chain and what the current state is. As a substitute for centralized or quasi-centralized trust, public blockchains are secured by crypto economics – the combination of economic incentives and cryptographic verification using mechanisms such as proof of work or proof of stake, following a general principle that the degree to which someone can have an influence in the consensus process is proportional to the quantity of economic resources that they can bring to bear. These blockchains are generally considered to be ‘fully decentralized’”.

Smart contracts and smart property are blockchain enabled computer protocols that verify, facilitate, monitor, and enforce the negotiation and performance of a contract. The term “smart contract” was first introduced by Nick Szabo, a computer scientist and legal theorist, in 1994. An often-cited example for smart contracts is the purchase of music through Apple’s iTunes platform. A computer code ensures that the “purchaser” can only listen to the music file on a limited number of Apple devices.

More complex smart contract arrangements in which several parties are involved require a verifiable and unhackable system provided by blockchain technology. Through blockchain technology, smart contracting often makes contractual legal contracting unnecessary as smart contracts often emulate the logic of legal contract clauses. Ethereum, the leading platform for smart contracting, describes smart contracting in this context as follows: ”Ethereum is a decentralized platform that runs smart contracts: applications that run exactly as programmed without any possibility of downtime, censorship, fraud or third party interference. These apps run on a custom built blockchain, an enormously powerful shared global infrastructure that can move value around and represent the ownership of property. This enables developers to create markets, store registries of debts or promises, move funds in accordance with instructions given long in the past (like a will or a futures contract) and many other things that have not been invented yet, all without a middle man or counterparty risk.”

Private investment funds’ use of blockchain technology

Several private investment funds have spearheaded and continue to expand the implementation of blockchain technology and smart contracting in their business models. In February 2017, Northern Trust and IBM entered into a partnership for the commercial use of blockchain in the private fund industry. The partnership provides an enhanced and efficient approach to private equity administration. The implementation of the Northern Trust and IBM blockchain is intended to increase efficiency, transparency, and the speed of private equity transactions, improve security, and bring innovation to the private equity market by simplifying the complex and labor intensive transactions in the private equity market. While the current legal and administrative processes that support private equity are time consuming, expensive, lack transparency, involving lengthy, duplicative, and fragmented investment and administration processes; the partnership’s solution delivers an enhanced and efficient approach to private equity administration. More specifically, unlike the current deal practice in private equity, which requires parties to reconcile multiples copies of documents that form deals to understand the greater picture, the blockchain program announced by Northern Trust and IBM allows all involved parties in an equity deal to look at one single compiled version of the transaction and all other data relating to the deal.

Another example of the use of blockchain technology for private investment funds is Numerai. Numerai is a private investment fund with a global equity strategy that will go live on the blockchain later this year. Numerai operates on the Ethereum blockchain, utilizing a cryptocurrency called “Numeraire.” Numerai uses artificial intelligence to convert financial data into machine learning problems for data scientists. On February 21, 2017, Numerai, announced: “[Today] 12,000 data scientists were issued 1 million crypto-tokens to incentivize the construction of an artificial intelligence hedge fund.”

Using data scientists for investment analysis creates efficiency through a synthesis of data. Data scientist working in this model work to solve the same problems in their own unique way with different strategies. Numerai synthesizes these models to create a meta-model out of all the predictions from the data scientists. In the Numerai model, the use of artificial intelligence ultimately helps achieve the goal of efficiency and perfect capital allocation by reducing overhead costs because there is no cost of human capital. In addition, Numerai eliminates barriers to entry because users do not need capital or any special finance or data knowledge.

Lending

Robot’s Lending Robot Series is a fully automated hedge fund secured by blockchain technology. Unlike other blockchain-based hedge funds that invest specifically in crypto currency, such as Global Advisers and Polychain Capital, Lending Robot Series invests in lending marketplaces such as Lending Club, Prosper, Funding Circle, and Lending Home. Its trading is determined by an algorithm based on the investor’s risk preferences. Once the investor has created a trading profile, Lending Robot selects and executes trades that are recorded in the blockchain public ledger on a weekly basis. Unlike traditional hedge funds that are rather secretive, the Lending Robot ledger shows detained holdings and provides a “hash code” signature as evidence that the data is tamper-proof in the blockchain. Unlike investors in traditional hedge funds, Lending Robots’ investors can cash out on a weekly basis at no additional cost and Lending Robot only charges a 1 percent management fee and a maximum of 0.59 percent fund expense fee per year. Lending Robots’ business model creates superior efficiencies by removing the investment advisers, overhead costs, and legal fees associated with each investor agreement.

Mainstreet Investment, LP incorporates blockchain technology into its operations. Mainstreet Investment LP operates like a private equity firm by allocating investment capital in American companies, blockchain companies, and real estate. By using blockchain technology the fund intends to provide investors with higher returns in the U.S. compared to low-yielding bonds, high risk equity picks, and profit-erasing fees of mutual funds. Mainstreams’ managers incorporated blockchain technology into the funds structure by issuing an asset-backed token security on the public Ethereum blockchain using a smart contract that records all assets in the portfolio. Moreover, blockchain is also used by issuing cash flow distributions to token holders through the smart contract. Mainstreet is powered by Ethereum with an organizational framework focused on transparency of the investment portfolio. Blockchain technology will be used to facilitate and administer the decentralized fund, which includes token purchasing, tracking, dividend payouts and dissemination of investor information.

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Wulf A. Kaal

Wulf Kaal is a tenured associate professor of law at the University of St. Thomas School of Law in downtown Minneapolis. He is a leading expert on hedge fund regulation in the United States and the European Union.  Before entering the academy, Kaal worked for Cravath, Swaine & Moore LLP in New York and Goldman Sachs in London.  Kaal has published more than two dozen articles in the United States and Europe. His articles were published in leading peer reviewed law and finance journals and in American law reviews such as the Minnesota Law Review, the Washington & Lee Law Review, and the Wake Forest Law Review, among others.  Kaal’s study on the effects of hedge fund registration requirements under Title IV of the Dodd-Frank Act has gained national attention and was covered in a Business Week article and other journals. He is the author of a book chapter on Investment Advisers and Investment Companies in the Securities Law Handbook published by Edward Elgar.
He has also been a consultant to major corporations and hedge funds regarding various aspects of financial markets and regulation.

 Wulf A. Kaal
Associate Professor
University of St. Thomas School of Law
1000 LaSalle Avenue
MSL 400
Minneapolis, MN 55403
United States
 

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