As the cryptocurrency market experiences heightened interest from institutional investors, particularly with the anticipation of SEC-approved Bitcoin ETFs, the need for robust due diligence practices is more critical than ever. The collapse of FTX and recent trial findings underscored the lack of understanding about the unique risks associated with digital assets. This due diligence primer outlines key components essential for institutions navigating the complexities of the crypto landscape during the potential next bull run.
Governance & Operational Resilience:
Risk Management Frameworks: Address board effectiveness, roles, responsibilities, and leadership accountability.
Operational Resilience: Cover business continuity, disaster recovery, third-party oversight, and segregation of duties. Understand the governance and decentralization of Layer 1 and Layer 2 blockchains, where applicable.
Regulatory Compliance:
KYC/AML Controls: Implement robust processes for evolving regulations, encompassing KYC/AML controls and crypto intelligence tools.
Trust Structures: Establish trust structures, client asset segregation, data protection, conflict of interest, and ethics.
Digital Asset Operations:
Secure Custody: Prioritize secure custody of digital assets. Cover key lifecycle management, stablecoin management, staking activities, account management, transaction handling, and change management.
Technology Controls: Understand tokenomics and blockchain technology. In order to address the risks in certain corporate operations, a SOC report might not be adequate.
Financial Analysis & Reporting:
On-Chain Reviews: Go beyond traditional financial metrics. Conduct on-chain reviews for insights into management and transactions, initial distributions, key personnel holdings, and related party transactions.
Accounting Treatments: Evaluate accounting treatments and counterparty risks. Understand reserve asset management, customer liabilities, balance sheets, and digital asset encumbrances.
Financial Risk Management:
Liquidity Risk Management: Develop strategies for liquidity risk management, funding strategy assessment, digital asset liquidity and quality, and supporting systems.
Stress Testing: Conduct stress testing for liquidity events, capital management processes, and frameworks for credit, interest rate, and currency exchange risk.
Internal Audit: The presence of an internal audit department is a positive indicator.
This framework's categories all require in-depth investigation to maintain higher requirements for risk management effectiveness. These due diligence practices are not just compliance checkboxes; they are vital tools to safeguard the integrity of the financial market and protect investor interests.
As institutions continue to engage with the crypto market, moving beyond mere participation to becoming informed, responsible actors is imperative. This approach is crucial for realizing the full potential of the crypto market, ensuring its sustainable growth, and integrating it into the broader financial landscape responsibly.