As with any new investment, there are always risks that have to be carefully weighted before proceeding.

The recent failure of cryptocurrency exchange QuadrigaCX (QX) is certainly upsetting for those who may not recover their money. QX is an exchange where individuals can buy Bitcoin or other cryptocurrencies and store them in a wallet. Cryptocurrencies are interesting because they can be considered both a currency (store of value) and an investment category (people acquiring them hoping for capital appreciation).

When I look at the QX situation, I’m struck by three particular risks that don’t seem to have been managed by those who chose to use the platform. These are proper due diligence, key person risk and safe custody of assets.

Read: OMERS expanding presence in blockchain, cryptocurrency sector

We always advise our clients to review the manager and product according to specific criteria — business, people, process, fees and performance. It’s important to do research on the organization sponsoring the management team and product.

How long have they been around? Are they well-capitalized? How are they governed? Are they aligned with their investors? How is the investment team compensated and incentivized? Is there succession within the investment team? Is the process well-understood, sustainable and repeatable? Are the results consistent with the stated philosophy and approach?

Quadriga Fintech Solutions, the owner of QuadrigaCX, was founded in November 2013 to complete local Bitcoin trades, but expanded to include an online exchange of multiple cryptocurrencies by 2014. From 2016 onward, the sole director was also the founder of QX, and the firm operated with a few contractors but no employees. The QX business appears to have little corporate structure, governance or financial backing.

Read: What are the merits and risks of investing in Bitcoin?

The full story is still unfolding, but it would appear that individual wallets held by QX can’t be accessed, since the “key” was only known to one individual, the founder who’s now deceased. Key person risk is something institutional investors have to deal with regularly in the management of their assets.

Relying on a talented individual — or individuals — to manage their money isn’t for everyone, but for those who believe the opportunity is worth their while, there are ways to mitigate this risk. In the context of public markets, having direct title to the assets is one way to minimize the risk, if for some reason the individual isn’t available to manage the assets (termination, resignation, health impairment or even death).

Pooled funds offer a bit less protection in the case of a key investment professional.

However, unit holders can hire a new manager and/or sell their assets. From the context of private markets, there are usually key person provisions in the limited partnership agreements that spell out what will happen if a key person (or more than one key person) isn’t available to manage assets for the contracted period. Remedies can range from finding another general partner to full liquidation of the assets.

Read: The vast potential of blockchain technology

Most often, institutional investors’ assets are safe-custodied by a third party, a custodian responsible for maintaining proper records, including title to the assets. The custodian also provides price discovery of the assets, ensuring an independent review of their value.

I’m reminded of a time earlier in my career (the mid-1990s) when many global equity portfolios managed by U.K.-based managers were self-custodied. This ultimately changed for two reasons. First, investors wished to receive valuation of the assets independent of those managing them; there’s an inherent conflict when someone is setting the price of an asset for which they’re being compensated.

Second, institutional investors preferred to maintain their assets in one place, which enabled better oversight and surety of title, as well as ease of movement of assets. Maintaining these records requires technology, which can be expensive, and investors preferred to maintain their assets with organizations that were well-capitalized.

Read: What Bitcoin investors can learn from the rise and fall of gold, dot-com companies

In the case of cryptocurrencies, the valuation is ensured through the blockchain technology, which maintains a record of each transaction, and the price at which it was undertaken. However, the cryptocurrency exchanges, such as QX, are untested when it comes to safe custody.

Hopefully, there will be a positive outcome for the holders of the “lost” wallets. Regulators are now reviewing the situation to better understand what happened and to see if any securities laws have been broken. The real lesson is that investors need to apply proper due diligence and apply the same decision framework they would to more developed investments.

Janet Rabovsky is a partner at Ellement. She has more than 25 years of experience in the industry. These are the views of the author and not necessarily those of Benefits Canada.
Copyright © 2019 Transcontinental Media G.P. Originally published on benefitscanada.com

Join us on Twitter

Add a comment

Have your say on this topic! Comments that are thought to be disrespectful or offensive may be removed by our Benefits Canada admins. Thanks!

* These fields are required.
Field required
Field required
Field required