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Alternative Market Briefing

Other Voices: Every crypto fund on which Castle Hall has conducted ODD has been "watch list" or "reject"

Monday, November 21, 2022

Chris Addy, FCA, CFA
By Chris Addy, FCA, CFA, Founder and CEO, Castle Hall Diligence:

Every crypto fund on which Castle Hall has conducted ODD has been "watch list" or "reject".

This is not to say that we detected evidenced fraud with respect to the (relatively small number) of crypto managers and funds we have reviewed. Some were certainly young and lacking in controls; others were working to build checks and balances to mitigate crypto risks. Rather, the inherent nature of the emerging crypto / digital asset industry did not enable us to tell our clients that the funds in question were subject to acceptable levels of operational risk.

Castle Hall Diligence's focus is to help our clients avoid the bottom 20% of the industry. We seek to help our clients allocate only to managers with at least a minimum, threshold level of controls and procedures, combined with investor protection from external gatekeepers such as plausible auditors and administrators. That does not mean that managers must have hundreds of staff and be fully "institutional". But, we do want to see baseline protections in place.

This is an extract from Castle Hall's ODD executive summary on a manager reviewed a couple of months before the FTX collapse (my thanks to Calvin, Colby and Mathieu at Castle Hall for your work on this review):

"As a general note, we reiterate that the portfolio holds cryptographic assets and is invested in tokens and other digital assets. As an emerging asset class, we highlight that investments in such assets are subject to various specialized risks, including technological, existence, counterparty, security, fraud, illiquidity, volatility, regulation, and transferability (among others). In addition, we note that several crypto exchanges and service providers are being sued, have frozen and / or restricted withdrawals of assets due to recent downturns in public markets. Further drawdowns across the sector could lead to more restrictions by exchanges, insolvency, or closures of exchanges unable to meet capital obligations.

"[Redact manager specific information]. Furthermore, investors could lose access to their holdings if the company went bankrupt, because custodially held crypto assets may be considered to be the property of a bankruptcy estate. We also highlight the lack of history around the failures of crypto custodians. As such, we highlight the counterparty risk associated with the Master Fund's custodians. Given the above points, we designate our "Watchlist" rating. Investors should only allocate if they are aware of the various risks identified herein associated with crypto counterparties and monitor developments surrounding ongoing initiatives and performance."

Due diligence can be summed up three basic questions:

  1. Existence - have I got what I say I've got?
  2. Valuation - is it worth what I say it's worth?
  3. Cash - can anyone steal the money?
These are the ODD must haves.

Which, of course, raises the question as to how FTX ever passed anyone's due diligence, ever.

This was exactly the theme I explained in depth at Opalesque's inaugural RISK BRIEFING on "Due Diligence Lessons from FTX".

You can access the user-friendly video replay of the session here: and navigate to the following sections as you wish:

  • 04:47 (min:sec): Conflicts of interest and affiliated entities
  • 11:34 (min:sec): The need for an adequate operational infrastructure
  • 15:34 (min:sec): Regulation and compliance
  • 20:30 (min:sec): Auditor and audited financial statements
  • 24:32 (min:sec): Transparency
    See here for FTX org chart
  • 27:35 (min:sec): Inability to rely on other investors' due diligence
  • 30:18 (min:sec): Fear of Missing Out
  • 32:48 (min:sec): CONCLUSION: A structured ODD process should have raised at least (the following) red flags ("reject") on FTX
  • 34:17 (min:sec): Cult of the founder, Sam Bankman-Fried
  • 41:51 (min:sec): Did your crypto fund tell you they are "doing due diligence" on their exchanges?
  • 44:38 (min:sec): Q&A: Why did investors fail to identify red flags as part of the due diligence process?
"The best summary of the compliance situation I have seen." (AC)
"Just wanted to say it was a great webinar. One of the most helpful/interesting ones I listened to in a long time. Thanks for putting this together." (ET)
"That was fantastic and very helpful to have all the key points summarized in one place." (BL)

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