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Blockchain Innovation for Private Investment Funds
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# **BLOCKCHAIN INNOVATION FOR PRIVATE INVESTMENT FUNDS** Wulf A. Kaal<sup>*</sup> # **Abstract** Blockchain technology innovation is proliferating in the private investment fund industry. Using a hand-selected dataset of private investment fund advisers that utilize blockchain technology in various functions (N=120), this article shows that the private fund advisers who utilize blockchain technology are able to generate significant benefits for their clients. The data analysis suggests that blockchain technology plays a primary role in front office and investment functions, in the securing of crypto assets, but als o in private investment fund managers’ attempts to satisfy the growth expectations of clients. The findings are consistent with anecdotal evidence suggesting that the returns attainable through crypto investments have no short-term match in legacy systems. Although the use of blockchain technology in private investment fund strategies is still in its infancy, as it evolves and accelerates, the associated innovation benefits promise lasting change for the industry. **_Key Words:_** Blockchain, Distributed Ledger Technology, Artificial Intelligence, Machine Learning, Data Science, Data Scientists, Meta Models, Innovation, Entrepreneur, Startup, Big Data, Private Investment Funds, Hedge Funds, Private Equity, Diversification, Compliance, Optimization, Efficiency **_JEL Categories:_** K20, K23, K32, L43, L5, O31, O32 > *Associate Professor, University of St. Thomas School of Law (Minneapolis). The author is grateful for outstanding support from librarians Ann Bateson and Megan McNevin as well as research assistants Samuel Evans and Colin Phaneuf. # Table of Content |I.|INTRODUCTION.................................................................................. 3| |---|---| |II.|BLOCKCHAINTECHNOLOGY............................................................. 4| |_1._|_Definition ...................................................................................... 5_| |_2._|_Trust Through Immutability .......................................................... 7_| |_3._|_Disruptive Innovation ................................................................. 10_| |_4._|_Limitations .................................................................................. 11_| |_5._|_Regulatory Implications .............................................................. 14_| |III.|PRIVATEINVESTMENTFUNDS’ USE OFBLOCKCHAINTECHNOLOGY<br>19| |_1._|_Administrative Process & Compliance Optimization ................. 19_| |_2._|_Combining AI, Big Data, and Blockchain ................................... 21_| |IV.|IMPACT OFBLOCKCHAINUSE ONPRIVATEINVESTMENTFUND| |INDU|STRY................................................................................................. 22| |_1._|_Diversification ............................................................................ 22_| |_2._|_Competitive Pressure .................................................................. 23_| |_3._|_Pressure on Fee Structure ........................................................... 23_| ||a)<br>Funds Lowering Fees via Blockchain Technology........................................ 26| ||b)<br>Per-Transaction Fees...................................................................................... 27| |V.|DATA, METHODOLOGY& CODING.................................................. 28| |_1._|_Descriptive Statistics ................................................................... 29_| |_2._|_Predominant Uses of Blockchain Technology ............................ 32_| |VI.|DISCUSSION..................................................................................... 36| # **I. Introduction** Private investment fund managers have started to embrace the use of blockchain technology to facilitate investment and process optimization. Several private investment funds have spearheaded the implementation of blockchain technology and smart contracting in their business model and continue to expand it. While some funds simply focus on trading bitcoin and other cryptocurrencies to avoid market fluctuations, others invest in and/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. This is accomplished by improving the administrative procedures of private equity deal making, or using cryptocurrencies as incentives for data scientists’ competitive models that facilitate investment analysis efficiencies.<sup>1</sup> Examples include private investment funds such as Polychain Capital,<sup>2</sup> the Northern Trust<sup>3</sup> in cooperation with IBM, Numerai,<sup>4</sup> LendingRobot,<sup>5</sup> and Intellisys Capital LLC,<sup>6</sup> Vega Fund, and Melonport,<sup>7</sup> among many others. Using a dataset of private investment fund advisers that utilize blockchain technology in their investment strategy or internal operations (N=120), this article shows that the private fund advisers who use the technology in front office and investment functions, in the securing of crypto assets, but also with regards to the growth expectation of clients, can generate many benefits. The article explores the reasons for the increasing use of blockchain technology, among other technological trends in the industry. While the overall proportion of strategies of private investment funds that apply modern technologies, including blockchain technology, is still small, as the use of blockchain technology grows in the private investment fund industry, the innovation benefits for private investment funds and their clients promise to result in lasting change for the industry. The article has six parts. After this short introduction, Part II introduces the basic characteristics of blockchain technology, including its potential to disrupt the private investment fund industry and its limitations. Part III introduces the private investment fund industry’s use of blockchain technology, citing examples of prominent private investment fund managers who started utilizing the many benefits offered by the technology. Part IV evaluates the impact of the > 1 RICHARD CRAIB ET AL., Numeraire: A Cryptographic Token for Coordinating Machine Intelligence and Preventing Overfitting 1-2, NUMERAI (2017), https://numer.ai/whitepaper.pdf.. > 2 Polychain Capital, https://angel.co/polychain-capital (last visited Apr. 17, 2017). > 3 Northern Trust, https://www.northerntrust.com/ (last visited Apr. 17, 2017). > 4 Numerai, https://numer.ai/ (last visited Apr. 17, 2017). > 5 LendingRobot, https://www.lendingrobot.com/#/ (last visited Apr. 17, 2017). > 6 Intellisys Capital LLC, http://www.intellisys.ai/ (last visited Apr. 17, 2017). > 7 Melonport, https://melonport.com/, (last visited Apr. 17, 2017). technology on the private investment fund industry. Topics pertaining to the impact of the technology on the industry include the increasing competitive pressure, enhanced diversification, and increasing pressure on the traditional fee structure. Part V introduces the dataset for this study (N=120), the methodology, and the coding. Part V also highlights the development of the industry’s adoption of blockchain technology including the types of funds, the predominant use of the technology, assets under management, and fee structure. Part VI concludes with a summary of key findings and implications of the evidence. # **II. Blockchain Technology** Leading technologists around the world have hailed blockchain technology as one of the most important technological innovations since the Internet.<sup>8</sup> Blockchain technology is enabled by a distributed ledger that records transactions efficiently and in a verifiable and permanent way.<sup>9</sup> The technology provides near unlimited opportunities and applications in peer-to-peer interactions and transactions in a decentralized network where all participants are equal and verification and validation of each transaction is provided by all parties in the network through the blockchain technology. For instance, in the financial world, a global consensus record of information and transactions creates the much-needed transparency and, at the same time, opens global access to finance, including in areas of the world where the banking system — in contrast to a mobile telephone > 8 Cognizant, ET AL., THE FUTURE OF RETAIL FINANCIAL SERVICES 6, 28-30 (2016), https://www.pega.com/sites/pega.com/files/docs/2016/Jan/the-future-of-retailfinancial-services-study.pdf; John Naughton, _Is Blockchain the Most Important IT Invention of Our Age?,_ The Guardian (Jan. 24, 2016), https://www.theguardian.com/commentisfree/2016/jan/24/blockchain-bitcointechnology-most-important-tech-invention-of-our-age-sir-mark-walport; William Mougayar, _The Blockchain Is the New Google_ , TECHCRUNCH (May 11, 2016), https://techcrunch.com/2016/05/11/the-blockchain-is-the-new-google/; Michael Crosby, ET AL., Blockchain Technology Beyond Bitcoin, 3 (2015), http://scet.berkeley.edu/wp-content/uploads/BlockchainPaper.pdf; Kyle Torpey, _Why the Bitcoin Blockchain Is the Biggest Thing Since the Internet_ , NASDAQ (Apr. 19, 2016), http://www.nasdaq.com/article/why-the-bitcoin-blockchain-is-the-biggestthing-since-the-internet-cm608228; Carrie Kirby, _Andreessen at Coin Summit: Bitcoin Today Is the Internet in 1994_ , COINDESK (Mar. 25, 2014), http://www.coindesk.com/marc-andreessen-balaji-srinivasan-discuss-bitcoin/; Dinis Guarda, _Over 50 Bitcoin and Blockchain Thoughts and Quotes You Need to Read_ , TRADERSDNA (July 4, 2016), http://www.tradersdna.com/bitcoin-andblockchain/over-50-bitcoin-and-blockchain-thoughts-and-quotes-you-need-to-read/; Rich Daly, _Blockchain: Wall Street’s Most Game-Changing Technology Advance Since the Internet_ , Forbes (July 11, 2016), https://www.forbes.com/sites/richdaly/2016/07/11/blockchain-wall-streets-mostgame-changing-technology-advance-since-the-internet/#33987a154d87. 9 Marco Iansiti & Karim R. Lakhani, _The Truth About Blockchain_ , HARV. BUS. REV. (Jan.–Feb. 2017), https://hbr.org/2017/01/the-truth-about-blockchain. network — is not readily available.<sup>10</sup> The technology incentivizes direct peer-to-peer transactions, including compensation, between the creator and consumer, eliminating the need for intermediation.<sup>11</sup> Intermediaries, including lawyers, are replaced by code, connectivity, crowd, and collaboration.<sup>12</sup> Blockchain technology’s elimination of intermediaries removes transaction costs and creates a platform for trust through truth and transparency for parties through its immutability and use of cryptography.<sup>13</sup> # _1. Definition_ Blockchain technology has been defined in many different ways, and no truly uniform definition seems to exist. Some refer to it as a giant worldwide, distributed, immutable “google spreadsheet” for transactions.<sup>14</sup> Others define blockchain by focusing on its central elements, e.g., it is a transaction ledger, electronic, decentralized, immutable, and provides cryptographic verification, among several > 10 _See, e.g_ ., Michele Chandler, _Mobile Banking Takes Off in Nigeria_ , Stan. Grad. Sch. Bus. (Jan. 24, 2012), https://www.gsb.stanford.edu/insights/mobile-bankingtakes-nigeria; Cade Metz, _Why Bitcoin Will Thrive First in the Developing World_ , WIRED (Feb. 2, 2016), https://www.wired.com/2016/02/why-bitcoin-will-thrivefirst-in-the-developing-world/ (noting that in Nigeria, for example, banking transactions are readily executed over mobile phones because no infrastructure exists for consumer banking. Donations and aid to third world countries can finally be provided without the interference of suboptimal bureaucratic organizations that don’t allocate the aid as intended by the donor. > 11 _See, e.g.,_ Alex Tapscott & Don Tapscott _, How Blockchain Is Changing Finance,_ HARV. BUS. REV. (Mar. 1, 2017), _https://hbr.org/2017/03/how-blockchain-ischanging-finance;_ Rene Bader & Thorsten Deckers, _How Does Blockchain Work? Transactions Without an Intermediary_ , ISBUZZNEWS (May 6, 2017), http://www.informationsecuritybuzz.com/articles/blockchain-work-transactionswithout-intermediary/; Jill Richmond, _How Blockchain Is Transforming the Creative Industry_ , NASDAQ (Apr. 26, 2017), http://www.nasdaq.com/article/how-blockchainis-transforming-the-creative-industry-cm780005. > 12 Erik P.M. Vermeulen, _There Is No Escape from Blockchains and Artificial Intelligence…Lawyers Better Be Prepared!_ , MEDIUM (Jan. 23, 2017) https://medium.com/@erikpmvermeulen/there-is-no-escape-from-blockchains-andartificial-intelligence-lawyers-better-be-prepared-2d7a8221c627. 13 Because the blockchain (at the least the public blockchain) is in fact public and immutable, the technology increases transparency, while at the same time significantly reducing transaction costs. Sean Murray, _This So-Hot Robot Is Launching a Marketplace Lending Hedge Fund_ , DEBANKED (Jan. 26, 2017), http://debanked.com/2017/01/this-so-hot-robot-is-launching-a-marketplace-lendinghedge-fund/. > 14 Jonathan Shieber, _Colu Aims to Bring Blockchain Technology Everywhere_ , TECHCRUNCH (Jan. 27, 2015), https://techcrunch.com/2015/01/27/colu-aims-tobring-blockchain-technology-everywhere/; Craig Leppan, _Who Is Blockchain Going to Affect the Most_ , OVATIONS (July 29, 2015), http://www.ovationsgroup.com/blockchain/. other elements.<sup>15</sup> Vitalik Buterin, the founder of Ethereum, perhaps most prominently defined blockchain as follows: Public blockchains: 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 quasicentralized trust, public blockchains are secured by cryptoeconomics – 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”.<sup>16</sup> Rather than attempting to agree on a mutually acceptable phraseology for a definition, a description of the core elements of ledger technology can help define the blockchain. As such, a blockchain is a > 15 _See, e.g_ ., ALAN MORRISON, BLOCKCHAIN AND SMART CONTRACT AUTOMATION: BLOCKCHAINS DEFINED, PWC (2016), http://www.pwc.com/us/en/technologyforecast/2016/blockchain/pwc-smart-contract-automation-definition.pdf; Alistair Dabbs, _What Is Blockchain, and Why Is It Growing in Popularity?_ , ARSTECHNICA (Nov. 6, 2016), https://arstechnica.com/information-technology/2016/11/what-isblockchain/; Lee Grant, _Blockchain – Definition, Origin, and History_ , TECHBULLION (Sept. 6, 2016), http://www.techbullion.com/blockchain-definition-origin-history; DELOITTE, BLOCKCHAIN ENIGMA. PARADOX. OPPORTUNITY 4–7 (2016), https://www2.deloitte.com/content/dam/Deloitte/uk/Documents/Innovation/deloitteuk-blockchain-full-report.pdf. > 16 Vitalik Buterin, _On Public and Private Blockchains_ , ETHEREUM BLOG (Aug.7, 2015), https://blog.ethereum.org/2015/08/07/on-public-and-private-blockchains/, contrasting public blockchains (the original idea) with consortium blockchains and fully private blockchains: “Consortium blockchains: a consortium blockchain is a blockchain where the consensus process is controlled by a pre-selected set of nodes; for example, one might imagine a consortium of 15 financial institutions, each of which operates a node and of which 10 must sign every block in order for the block to be valid. The right to read the blockchain may be public, or restricted to the participants, and there are also hybrid routes such as the root hashes of the blocks being public together with an API that allows members of the public to make a limited number of queries and get back cryptographic proofs of some parts of the blockchain state. These blockchains may be considered ‘partially decentralized.’” _Id_ . “Fully private blockchains: a fully private blockchain is a blockchain where write permissions are kept centralized to one organization. Read permissions may be public or restricted to an arbitrary extent. Likely applications include database management, auditing, etc [sic] internal to a single company, and so public readability may not be necessary in many cases at all, though in other cases public auditability is desired.” _Id_ . shared digital ledger or database that maintains a continuously growing list of transactions among participating parties regarding digital assets – together described as “blocks.”<sup>17</sup> 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 transaction is validated, verified, and completed.<sup>18</sup> The chain of transactions is distributed to a limitless number of participants, so-called nodes,<sup>19</sup> around the world in a public or private peer-to-peer network. # _2. Trust Through Immutability_ Blockchain technology removes fraudulent transactions. Compared with existing methods of verifying and validating transactions by third-party intermediaries, blockchain’s security measures make validation technologies more transparent and less prone to error and corruption. While blockchain’s use of digital signatures helps establish the identity and authenticity of the parties involved in the transaction, it is the completely decentralized network connectivity via the internet that allows the most protection against fraud.<sup>20</sup> Network connectivity allows multiple copies of the blockchain to be available to all participants across the distributed network.<sup>21</sup> The decentralized, fully-distributed nature of the blockchain makes it practically impossible to reverse, alter, or erase information in the blockchain.<sup>22</sup> Blockchain’s distributed consensus model, e.g., the network “nodes” > 17 _See, e.g_ ., Michele D’Aliessi, _How Does the Blockchain Work?_ MEDIUM (June 1, 2016), https://medium.com/@micheledaliessi/how-does-the-blockchain-work- <u>98c8cd01d2ae#.w76hifcu2; Monica Pearson,</u> _Blockchain Is the New Buzzword_ , EXPERIAN, (Jan. 31, 2016), https://www.experian.com/blogs/insights/2016/01/blockchain-is-the-new-buzzword/. > 18 _See, e.g_ ., D’Aliessi, _supra_ note 17; Pearson, _supra_ note 17. > 19 _See, e.g_ ., D’Aliessi, _supra_ note 17. Participants can be individuals, organizations, and even things. _See, e._ g., Hemant Saxena, _Blockchain Technology and Microsoft’s Plan to Develop Blockchain As a Service_ , WINDOWS CLUB (Feb. 16, 2017), http://www.thewindowsclub.com/blockchain-microsoft-plans-developservice?utm_source=feedburner&utm_medium=feed&utm_campaign=Feed%3A+Th eWindowsClub+%28The+Windows+Club%29; Sloane Brakeville & Bhargav Perepa _, Blockchain Basics: Introduction to Distributed Ledgers_ , IBM: DEVELOPERWORKS (May 9, 2016; updated Dec. 15, 2016), https://www.ibm.com/developerworks/cloud/library/cl-blockchain-basics-introbluemix-trs/. The only condition for participants is the necessity of an Internet connection. _See, e._ g., D’Aliessi, _supra_ note 17. > 20 _See, e.g_ ., Brakeville & Perepa, _supra_ note 19. For an in-depth, nuanced discussion of this point, _see_ PETER VAN VALKENBURGH, OPEN MATTERS: WHY PERMISSIONLESS BLOCKCHAINS ARE ESSENTIAL TO THE FUTURE OF THE INTERNET 3– 4, 23–26 (2016), https://coincenter.org/files/2016-12/openmattersv1-1.pdf. . > 21 _See, e.g_ ., D’Aliessi, _supra_ note 17. > 22 _See, e.g.,_ Brakeville & Perepa, _supra_ note 19; Antony Lewis, _A Gentle Introduction to Immutability of Blockchains_ , BITS ON BLOCKS (Feb. 29, 2016), https://bitsonblocks.net/2016/02/29/a-gentle-introduction-to-immutability-ofblockchains/. verify and validate chain transactions before execution of the transactions, makes it extremely rare for a fraudulent transaction to be recorded in the blockchain.<sup>23</sup> That model also allows node verification of transactions without compromising the privacy of the parties and is therefore arguably safer than a traditional model that requires thirdparty intermediary validation of transactions.<sup>24</sup> Cryptographic hashes further increase blockchain security. Cryptographic hashes are complex algorithms that use the details of all previous transactions in the existing blockchain before adding the next block to generate a unique hash value.<sup>25</sup> That hash value ensures the authenticity of each transaction before it is added to the block. The smallest change to the blockchain, even a single digit/value, results in a different hash value. A different hash value makes any form of manipulation immediately detectable.<sup>26</sup> Smart contracts and smart property are blockchain-enabled computer protocols that verify, facilitate, monitor, and enforce the negotiation and performance of a contract.<sup>27</sup> The term “smart contract” was first introduced by Nick Szabo, a computer scientist and legal theorist, in 1994.<sup>28</sup> An often-cited example for smart contracts is the purchase of music through Apple’s iTunes platform.<sup>29</sup> A computer code > 23 _See, e.g._ , Francois Janinotto, _The Blockchain Explained to Web Developers, Part 1: The Theory_ , MARMELAB BLOG (Apr. 28, 2016), https://marmelab.com/blog/2016/04/28/blockchain-for-web-developers-thetheory.html; Razvan Peteanu, _Fraud Detection in the World of Bitco_ in, BITCOIN MAG. (Mar. 26, 2014), https://bitcoinmagazine.com/articles/fraud-detection-worldbitcoin-1395827419/ (noting, “ Fundamentally, detecting fraud is hard precisely because it is rare, dynamic and not necessarily obviously fraudulent.”). > 24 For a discussion of privacy on the blockchain, _see_ Valkenburgh, _supra_ note [__], at 33–40. For an overview of various consensus mechanisms _see_ SIGRID SEIBOLD & GEORGE SAMMAN, CONSENSUS: IMMUTABLE AGREEMENT FOR THE INTERNET OF VALUE (2016), https://assets.kpmg.com/content/dam/kpmg/pdf/2016/07/kpmgblockchain-consensus-mechanism-channel-islands.pdf; Valkenburgh, _supra_ note 20, at 15-40. > 25 _See, e.g_ ., Lewis, _supra_ note 22. > 26 _Id_ . > 27 _See e.g._ , ALAN MORRISON _,_ BLOCKCHAIN AND SMART CONTRACT AUTOMATION: INTRODUCTION AND FORECAST, PWC (2016), http://www.pwc.com/us/en/technologyforecast/2016/blockchain/pwc-smart-contract-automation-introduction.pdf; Nicolette Kost De Sevres & Bradley Cohen, _The Blockchain Revolution, Smart Contracts and Financial Transactions_ , DLA PIPER (Apr. 26, 2016), https://www.dlapiper.com/en/czech/insights/publications/2016/04/the-blockchainrevolution/. > 28 _Smart Contracts: The Blockchain Technology That Will Replace Lawyers_ , BLOCKGEEKS, http://blockgeeks.com/guides/smart-contracts/ (last visited Mar. 18, 2017); _Not-So-Clever Contracts_ , ECONOMIST, July 30, 2016, at 53, http://www.economist.com/news/business/21702758-time-being-least-humanjudgment-still-better-bet-cold-hearted. > 29 _See, e.g_ ., HORSTEN KOEPPL & JEREMY KRONIK, BLOCKCHAIN TECHNOLOGY— WHAT’S IN STORE FOR CANADA’S ECONOMY AND FINANCIAL MARKETS? 17 (2017), https://www.cdhowe.org/sites/default/files/attachments/research_papers/mixed/Com ensures that the “purchaser” can only listen to the music file on a limited number of Apple devices.<sup>30</sup> More complex smart contract arrangements in which several parties are involved require a verifiable and unhackable system provided by blockchain technology.<sup>31</sup> Through blockchain technology, smart contracting often makes legal contracting unnecessary as smart contracts often emulate the logic of legal contract clauses.<sup>32</sup> 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.<sup>33</sup> mentary_468_0.pdf; R. Douglas Vaughn & Anna Outzer, _Understanding How the Block Chain Could Impact the Legal Industry_ , LAW 360 (Jan. 11, 2017), https://www.law360.com/articles/879810/understanding-how-blockchain-couldimpact-legal-industry. 30 Vaughn & Outzer, _supra_ note 29; Jeffrey Glazer, _Smart Contracts Are a Future_ , U. WIS. – MADISON: LAW & ENTREPRENEURSHIP CLINIC (Sept. 14, 2015), https://www.uwle.org/blog/smart-contracts-are-a-future. 31 _See, e.g_ ., ETHEREUM, https://www.ethereum.org/ (last visited Apr. 17, 2017); GAVIN WOOD, ETHEREUM: A SECURE DECENTRALISED GENERALISED TRANSACTION LEDGER EIP-150 REVISION, http://gavwood.com/paper.pdf (last visited June 28, 2017); Luke Parker, _Industry Research Papers Highlight Blockchain Technology’s Disruptive Potential_ , BRAVE NEWCOIN (July 3, 2016), https://bravenewcoin.com/news/industry-research-papers-highlight-blockchaintechnologys-disruptive-potential/. > 32 Mark Anderson, _Smart Contracts and Blockchain Technology_ , IP DRAUGHTS (June 18, 2016), https://ipdraughts.wordpress.com/2016/06/18/smart-contracts-andblockchain-technology/. _See generally_ Josh Stark, _Making Sense of Blockchain Smart Contracts_ , COINDESK (June 4, 2016), http://www.coindesk.com/makingsense-smart-contracts/; Josh Stark, _How Close Are Smart Contracts to Impacting the Real World of Law?_ , COINDESK, (Apr. 11, 2016), http://www.coindesk.com/blockchain-smarts-crntracts-real-world-law/; Ted Mylnar & Ira Schafer, _Why Smart Contracts Will Need ‘Smart Term Sheets’ to Match_ , COINDESK (Dec. 9, 2016), http://www.coindesk.com/smart-contracts-will-needsmart-term-sheets-match/. For an example of what startups hope to accomplish with smart contracting, _see_ LEGALESE, https://legalese.com/ (last visited Apr. 17, 2017). 33 ETHEREUM, _supra_ note 31. # _3. Disruptive Innovation_ Blockchain technology has vast disruptive innovative properties. Despite the very early stage developments in blockchain technology, the possible applications are near limitless. For example, until recently, most commentators viewed Bitcoin as a hype, susceptible to fraud, price manipulation and corruption.<sup>34</sup> Yet, the pace of innovation in cryptocurrencies and their application in different industries and commercial settings is faster than ever.<sup>35</sup> The high levels of investor activity in the blockchain area appears to provide a reliable indicator of the commercial maturity of blockchain technology. The VC investment in startup companies that utilize blockchain technology has increased exponentially since 2012.<sup>36</sup> Investor interest in the technology is further increasing. In particular, the applicability of blockchain-based smart contracts to digital marketplaces, the sharing economy, the Internet of Things ( _IoT_ ) and artificial intelligence will further accelerate its development. The disruptive properties of blockchain technology are largely developed and utilized by startup companies. Such startups have the potential to create lasting societal changes. Blockchain technology startups attempt to replace intermediaries in many types of transactions, including and most notably contracts analyses, real estate, and intellectual property.<sup>37</sup> Some commentators predict a future in which blockchain startups can remove lawyers altogether from commerce as smart contracts in the blockchain, such as the ones in the Ethereum platform,<sup>38</sup> regulate commerce entirely, enabled by the trust created between parties through immutable blockchain technology.<sup>39</sup> 34 Mark Fenwick, Wulf Kaal &Erik Vermeulen, The “Unmediated” and “TechDriven” Corporate Governance of Today’s Winning Companies, (Forthcoming 2017) > 35 _Id_ . > 36 _Id_ . > 37 _See_ CLAUSE, http://clause.io (last visited June 30, 2017). Clause is a platform for self-managing legal contracts. The contract integrates “real-time data from the 'internet of things', web services, and business and accounting systems.” _See also_ , BINDED, https://binded.com (last visited June 30, 2017) (uses blockchain to track and enforce copyright); ASCRIBE, https://www.ascribe.io (last visited June 30, 2017) (uses the bitcoin blockchain to establish digital ownership of art and other creative works); UBITQUITY, https://www.ubitquity.io/web/index.html (last visited June 30, 2017) (uses Software-as-a-Service (SaaS) blockchain platform to track property). 38 ETHEREUM, http://www.ethereum.org (last visited June 30, 2017). 39 _See, e.g_ ., Philipp Kristian, _How Do P2P Platforms Build Trust Between Strangers?_ , E27 (Apr. 13, 2016), https://e27.co/how-do-peer-to-peer-platforms-build- <u>trust-between-strangers-20160413/; Anand Iyer,</u> _How Modern Marketplaces Like Uber and Airbnb Build Trust to Achieve Liquidity_ , TC (Mar. 4, 2014), https://techcrunch.com/2014/03/04/how-modern-marketplaces-like-uber-and-airbnbbuild-trust-to-achieve-liquidity/; FREDERIC MAZZELLA & ARUN SUNDARARAJAN, ENTERING THE TRUST AGE (2016), https://www.blablacar.com/wpcontent/uploads/2016/05/entering-the-trust-age.pdf; Eric Piscini et al., _<u>Blockchain:</u>_ Business, administrative, and legal processes that rely on legal intermediaries may become redundant because of advances in and acceptance and implementation of blockchain technology. Forms of keeping business and legal ledgers such as notary and registry services, legal motions practice in court, legal title companies, among several others, may be among the first services to disappear in the not too distant future. Similarly, corporate processes that have ledger functionality but rely on legal intermediaries could be streamlined very quickly by implementing blockchain technology. When blockchain technology becomes more widely accepted and applications are spreading into consumer territory, existing corporate processes and structures will likely be among the first processes to become redundant. The combination of blockchain technology startups with platforms, artificial intelligence and machine learning offer opportunities for developing new technologies. Leveraging the big data that is collected by using FinTech and LegalTech solutions and blockchain applications in combination with machine learning creates more creative and faster tools. This, in turn, creates a surge of new and innovative platforms with disruptive effects for various industries. # _4. Limitations_ Blockchain technology and smart contracts executed on blockchain technology platforms, such as Ethereum, are faced with multiple possible technological and business as well as legal limitations. The world of blockchain and smart contracting has not reached maturity yet.<sup>40</sup> Legal limitations pertaining to smart contracts and blockchain technology originate mostly from concerns over the legal origin of smart contracting.<sup>41</sup> While smart contracts may reflect the underlying contract between parties, lawyers may argue that “smart contracts” are void and unenforceable under the law. Contractual legal rules regarding formation, interpretation, conditions and remedies require substantive adjustments for smart contracts in contract law.<sup>42</sup> Such limitations are _<u>Trust Economy</u>_ <u>, DELOITT UNIVERSITY PRESS</u> (Feb. 7, 2017), https://dupress.deloitte.com/dup-us-en/focus/tech-trends/2017/blockchain-trusteconomy.html. > 40 Mark Fenwich, Wulf Kaal, and Erik P.M. Vermeulen, _Legal Education in the Blockchain Revolution_ (U. St. Thomas Legal Studies Research Paper no. 17-05, Mar. 22, 2017), https://ssrn.com/abstract=2939127. 41 While blockchain enabled smart contracting does not require legal involvement across the spectrum of transactions, legal professionals often still believe that “code” in smart contracts can only deal with very simple transactions, such as buying music or perhaps a car, arguing that more complicated legal arrangements will necessitate the draftsmanship and negotiations of traditional lawyers. Even if more complex transactions could be coded and included in smart contracts, a widespread believe in the legal community suggests that lawyers will remain responsible for drafting the terms and arrangements that would later have to be coded by specialists. > 42 _Id._ slowly disappearing. For instance, Arizona passed a law in early 2017 that makes smart contracts fully enforceable under Arizona law.<sup>43</sup> Delaware is looking into similar rules proposed in the Blockchain Initiative.<sup>44</sup> The Blockchain evolution in combination with smart contracting also raises legal concerns regarding: privacy, data protection, security and integrity. While blockchain technology itself offers unprecedented genuine data and privacy protection, the storage of blockchain data across a global network of nodes often will not comply with specific consumer protection rules, directives, and guidelines around the world.<sup>45</sup> The existing legal issues arising in the context of sharing platforms,<sup>46</sup> demonstrate that future blockchain-enabled sharing services may not be accepted quickly and without resistance on the part of incumbents challenged by new ways of delivering a service or product. A prominent example, the Decentralized Autonomous Organization (DAO), provides ample evidence pertaining to the outstanding technological and legal issues that surround blockchain technology. The DAO was launched in May 2016,<sup>47</sup> in the founders’ attempt to set up a corporate-type organization without using a conventional corporate structure. The founders’ central idea was that the wisdom of the crowd would lead to smarter and more game-changing investment decisions.<sup>48</sup> The DAO had to operate as a kind of venture capital fund managed directly by the token holders.<sup>49</sup> The DAO governance structure was built on software, code and smart contracts that ran on the public decentralized blockchain platform _Ethereum_ .<sup>50</sup> The DAO did not have a physical address as it was merely computer code. And it was not an organization with a traditional hierarchy as we know it from traditional corporate structures where 43 H.R. 2417, 53rd Leg., Reg. Sess. (Ariz. 2017). > 44 Garrett Keirns, _Delaware is Drafting Law That Would Recognize Blockchain Records_ , COINDESK (Mar. 15, 2017), http://www.coindesk.com/delaware-draftinglaw-recognize-blockchain-records/. > 45 _Id_ . > 46 Such as _Uber, Lyft, Sidecar, RelayRides, SpinLister and JustPark_ (transportation), _Airbnb and DogVacay_ (lodging), _Postmates_ , _Prime Now_ , and _Instacart_ (on-demand delivery services), and _Rent the Runway_ (clothing). > 47 Christoph Jentzsch, the co-founder of IoT company _Slock.it_ , was one of the “key founders” of _The DAO_ , a new style venture capital fund. Carla Reyes, et al, _Distributed Governance_ , WM. & MARY L. REV. ONLINE (forthcoming 2017), <u>https://ssrn.com/abstract=2884978.</u> > 48 _Id._ 49 Id. > 50 Quinn DuPont, _Experiments in Algorithmic Governance: A History of Ethnography of “The DAO,” a Failed Decentralized Autonomous Organization_ in BITCOIN AND BEYOND (Malcolm Campbell-Verduyn ed., forthcoming 2017), <u>http://iqdupont.com/assets/documents/DUPONT-2017-Preprint-AlgorithmicGovernance.pdf.</u> authority and empowerment flows downwards from investors/shareholders through a board of directors to management and eventually staff.<sup>51</sup> Indeed, it had no directors, managers or employees. Because a series of smart contracts granted DAO token holders voting rights, the blockchain-based smart contracts imitated the role of articles of association or bylaws. Because the DAO code was open source, the token holders would not only vote on “investment proposals”, but also on any change made to the code.<sup>52</sup> Accepted proposals would also be backed by a software code, defining the relationship (in terms of rights, obligations and performance metrics) between the DAO and the funded proposals. During a crowdfunding campaign in May 2016, all investors could become a DAO participants by purchasing DAO Tokens.<sup>53</sup> The DAO raised more than $168 million from approximately 10,000 “investors”.<sup>54</sup> DAO Token _s_ were designed to be fully transferable and tradeable on “peer-to-peer” exchanges, similar to shares in a traditional listed corporation. The automated structure was intended to give “participants” in the DAO direct real-time control over contributed funds. Alas, things went terribly wrong with the DAO. Fundamental flaws in the DAO code enabled hackers to transfer one third of the total funds to a subsidiary account.<sup>55</sup> This hack in combination with additional technological limitations brought down the DAO initiative.<sup>56</sup> Open legal issues pertaining to the DAO would need to be addressed before future DAO setups can operate seamlessly.<sup>57</sup> Such > 51 Jonathan Chester, _Can A Company Be Run Without Leadership, Management Or Employees? $150m Invested In The DAO Says Yes_ , FORBES (May 20, 2016), https://www.forbes.com/sites/jonathanchester/2016/05/20/can-a-company-be-runwithout-leadership-management-or-employees-150m-in-investment-saysyes/#2f794a5254a5. > 52 _Id._ > 53 _See_ Reyes _supra_ note 47. 54 Hailed as the largest crowdfunding effort in the shortest time frame. Cade Metz, _The Biggest Crowdfunding Project Ever—The DOA—is Kind of A Mess_ , WIRED (Jun. 6, 2016), https://www.wired.com/2016/06/biggest-crowdfundingproject-ever-dao-mess/. > 55 Vitalik Buterin, _Critical Update Re: DAO Vulnerability_ , Ethereum Blog (June 17, 2016), https://blog.ethereum.org/2016/06/17/critical-update-re-dao-vulnerability. > 56 _Id._ > 57 Drew Hinkes, _A Legal Analysis of the DAO Exploit and Possible Investor Rights_ , NASDAQ (Jun. 21, 2016), http://www.nasdaq.com/article/a-legal-analysis-of-thedao-exploit-and-possible-investor-rights-cm638561.; Lucy Liu, _The Legality of the DAO_ , Mich. Bus. & Entrepreneurial L. Rev. (Jan. 22, 2017), http://mbelr.org/thelegality-of-the-dao/.; Justin O’Connell, _The Securities Law Implications of the DAO Hack and Proposed Ethereum Hard Fork_ , BITCOIN MAGAZINE (Jun. 29, 2016, 11:50 AM), https://bitcoinmagazine.com/articles/the-securities-law-implications-ofthe-dao-hack-and-proposed-ethereum-hard-fork-1467215402/.; Tanya Macheal, _The DAO Might Be Groundbreaking, But is it Legal?_ , American Banker (May 19, 2016, 3:12 PM), https://www.americanbanker.com/news/the-dao-might-begroundbreaking-but-is-it-legal . legal issues include: what legal regime governs the issuance of DAO tokens - corporate law, if and how are minority DAO token holders protected, DAO subject to taxation, are legally binding obligations generated by DAO smart contracts legally binding, ownership of the intellectual property rights generated by the crowd funded proposals, and conflict resolution between DAO token holders, the DAO itself and the proposals. # _5. Regulatory Implications_ The lack of regulatory recognition of Blockchain technology creates significant uncertainty for the blockchain community. The lacking recognition hinders the implementation of the technology across industries and undermines the infrastructure conversion via blockchain technology. The regulatory uncertainty derives from insufficient or nonexistent regulatory guidance, lacking court decisions, and uncertainty over applicable jurisdiction. Courts have not yet recognized blockchain technology or addressed its applications. The technology industry agrees for the most part that Blockchain technology is immutable and secure.<sup>58</sup> However, a review of published court opinions suggests that no court at the time of publication of this article had to review, assess, or scrutinize the uses and applications of blockchain technology.<sup>59</sup> It is entirely uncertain how courts may perceive and treat blockchain technology.<sup>60</sup> While some judges, untrained in technology and technology novices on the bench, could misunderstand and misinterpret the new technology, the technology is no different from other software that courts have evaluated.<sup>61</sup> Accordingly, courts assisted by well-trained attorneys > 58 Ben Dickson, _Blockchain’s Brilliant Approach to Cybersecurity_ , Venture Beat (Jan. 22, 2017), https://venturebeat.com/2017/01/22/blockchains-brilliant-approachto-cybersecurity/. 59 A search of “blockchain” or “block chain” in federal and state cases on Westlaw reveals that only two cases have mentioned blockchain technology. The courts in both cases refused to discuss blockchain in depth, and did not take a position on the legitimacy of the technology. _See In re Dole Food Co., Inc. Stockholder Litigation_ , C.A. No. 8703–VCL, 2017 WL 624843 at n. 1 (Del. Ch. Feb. 15, 2017); _United States v. Petix_ , 15-CR-227A, 2016 WL 7017919 (W.D. N.Y. Dec. 1, 2016). 60 “While countless undisputed transactions utilizing smart contracts are likely to move forward on the basis of such automatic, electronic enforcement, there will likely always be the need for human intervention to settle legal disputes.” Reggie O'Shields, _Smart Contracts: Legal Agreements for the Blockchain_ , North Carolina Banking Institute (March 2017). > 61 Ronald L. Chichester, _Wide Open Spaces_ , TEX. B. J. (April 2017), https://www.texasbar.com/AM/Template.cfm?Section=articles&Template=/CM/HT MLDisplay.cfm&ContentID=36379. (“There is no reason to think that links within a blockchain could not be admissible in court. While an expert may be needed to opine on the authenticity of the particular blockchain and the specific transaction, there is nothing inherently different about blockchains than other software programs.”). should be able to appreciate the economic and societal significance of blockchain technology. For private investment funds that use blockchain technology and are set up on the blockchain via the Ethereum network, the issues of domicile over their fund is particularly important. Some private investment funds may exist through the combination of smart contracts on the Ethereum blockchain.<sup>62</sup> Such funds may not have a domicile either foreign or domestic. If managers use digital currencies to invest in digital assets and are set up through Ethereum smart contracting via Melonport,<sup>63</sup> ostensibly the fund would exist entirely in cyberspace. However, managers cannot assume that they are judgment-proof. Instead, fund managers may be required to comply with more regulations not fewer.<sup>64</sup> The Securities and Exchange Commission (SEC) has started to evaluate the application of blockchain technology in the financial services industry. In November of 2015, Commissioner Stein commented on blockchain’s potential for tracing securities lending, repo, and margin financing and monitoring systemic risk.<sup>65</sup> Commissioner Stein cautioned, however, that as blockchain becomes more fluent in the market “regulators need to be in a position to lead, harnessing its benefits and responding quickly to potential weaknesses.”<sup>66</sup> Despite this early cautioning and call for action, the SEC has not yet addressed core issues pertaining to the recognition of blockchain technology applications in finance. Guidance is especially needed regarding the recognition and application of crypto-currencies, tokens as securities, and decentralized autonomous organizations (DAOs) as investment advisers, among many other issues pertaining to blockchain applications or derivatives that are applied in finance. SEC recognition of the most basic crypto-currency features is uncertain. In early 2016, in a significant setback for crypto-currencies and the crypto-currency industry, the SEC rejected the Winklevoss > 62 _See_ Reto Trinkler & Mona El Isa, _Melon Protocol: A Blockchain Protocol for Digital Asset Management_ , > https://github.com/melonproject/greenpaper/blob/master/melonprotocol.pdf (“The Green Paper”) at 4. > 63 _Id_ . > 64 “[E]very transaction potentially comes under the legislative umbrella of wherever a node exists whether in respect of financial services or data protection.” Gregory Brandman & Samuel Thampapillai, _Blockchain – Considering the Regulatory Horizon_ , OXFORD BUS. L. BLOG (Jul. 7, 2016), https://www.law.ox.ac.uk/businesslaw-blog/blog/2016/07/blockchain-%E2%80%93-considering-regulatory-horizon. > 65 FSOC, ANNUAL REPORT 2016, https://www.treasury.gov/initiatives/fsoc/studiesreports/Documents/FSOC%202016%C20Annual%20Report.pdf. > 66 Kara Stein, SEC Commissioner, Surfing the Wave: Technology, Innovation, and Competition, Harvard Law School’s Fidelity Guest Lecture Series (Nov. 9, 2015), https://www.sec.gov/news/speech/stein-2015-remarks-harvard-law-school.html. twins’ application to establish an exchange traded fund (ETF) that was intended to invest in Bitcoin exclusively.<sup>67</sup> To allow individuals to invest in Bitcoin without creating a Bitcoin wallet, the proposed ETF had been intended to serve as a dollar-denominated proxy pegged to the price of Bitcoin.<sup>68</sup> In rejecting the application, the SEC reasoned that, because of the unregulated nature of Bitcoin, the proposed fund was susceptible to fraud.<sup>69</sup> The SEC’s decision regarding the Bitcoin ETF reflects its distrust towards the crypto asset class as a whole, especially funds attempting to trade digital currencies. The SEC’s assessment pertaining to ETFs can be distinguished from private investment funds created via the Ethereum smart contracting on Melonport. Most importantly, private investment funds on Melonport would be actively trading a more diverse array of crytocurrencies, not just Bitcoin. Moreover, the audience of a Melonport-type fund is much more limited and curtails the risk to investors. By contracts, the Bitcoin ETF application that was denied by the SEC would have been offered to a much broader investor group, reinforcing the fears described by the SEC.<sup>70</sup> The Coinflip case seems to suggest that the CFTC intends to regulate Bitcoin as a commodity.<sup>71</sup> In 2015, the CFTC brought an action against Coinflip, Inc. for operating a facility for trading commodities futures without being registered under the Commodities Exchange Act (CEA).<sup>72</sup> In this case, Coinflip, Inc. operated a website that connected buyers and sellers of standardized Bitcoin options and futures contracts.<sup>73</sup> The CFTC opined that “Bitcoin and other virtual currencies are encompassed in the definition and properly defined as commodities,”<sup>74</sup> and are thus subject to the CEA. The CEA defines the term “commodity” rather broadly to include “all services, rights, and interests in which contracts for future delivery are presently or in the future dealt in.”<sup>75</sup> Nevertheless, Coinflip agreed to settle the > 67Russell Brandom, THE VERGE (Mar. 10, 2017), > http://www.theverge.com/2017/3/10/14883350/sec-bitcoin-etf-order-winklevossdenied. > 68 _See id._ > 69 _Id._ Self-Regulatory Organizations; Bats BZX Exchange, Inc.; Order Disapproving a Proposed Rule Change, as Modified by Amendments No. 1 and 2, to BZX Rule 14.11(e)(4), Commodity-Based Trust Shares, to List and Trade Shares Issued by the Winklevoss Bitcoin Trust, Exchange Act Release No. 34-80206 (Mar. 10, 2017), https://www.sec.gov/rules/sro/batsbzx/2017/34-80206.pdf. > 70 _See id._ 71 In the Matter of: Coinflip, Inc., d/b/a Derivabit, and Francisco Riordan, Respondents, CFTC No. 15-29, 2015 WL 5535736, *2 (Sept. 17, 2015). > 72 _Id._ at *1. > 73 _Id._ > 74 _Id._ at *2. 75 7 U.S.C. § 1a(9) (2012). administrative action with the CFTC without admitting or denying this finding. Private investment funds that utilize blockchain technology may only be limitedly exposed to CFTC rules. Because the CFTC has not labelled digital assets a currency under CFTC guidelines, private investment funds operating solely on the Melon protocol will be less likely to be required to register as a CPO or CTA. Moreover, Congress and the CFTC have not addressed the commodity status of cryptolimited partnership interests, such as Mainstreet’s tokens. It may be debatable if the definition of commodity could be broad enough to include crypto-limited partnership interests.<sup>76</sup> The IRS treats virtual currency, such as Bitcoin, as property. The IRS has opined generally that: “the sale or exchange of convertible virtual currency, or the use of convertible currency to pay for goods or services in a real-world economy transaction, has tax consequences that may result in a tax liability.”<sup>77</sup> In 2014, the IRS issued a notice in response to numerous questions on the tax status of digital currencies.<sup>78</sup> While the IRS acknowledged digital currencies have many of the characteristics of other currencies, the IRS stipulated that “it does not have legal tender status in any jurisdiction.”<sup>79</sup> Accordingly, the IRS declared that crypto currencies should be taxed as property for U.S. federal tax purposes, because “General tax principles applicable to property transactions apply to transactions using virtual currency.”<sup>80</sup> However, the IRS was very specific about limiting its current position to transactions involving “convertible virtual currency,” leaving the tax treatment of crypto-limited partnership interests unaddressed. 76 While, Bitcoin and Mainstreet tokens are both blockchain products, they do not share some of the key features underlying the CFTC’s position that Bitcoin is a commodity. The most important, and dispositive, characteristic is uniformity across producers. Bitcoin is the asset underlying its futures contracts. It is a virtual currency functioning as a medium of exchange or unit of account. Bitcoin retains its characteristics across all producers, so the argument can be made (as it was by the CFTC) that it is in fact a commodity. On the other hand, crypto-limited partnership interests cannot, by definition, be uniform across producers. Mainstreet’s investment strategy, fee structure, governance rights, and dividend structure are unique to the fund. Other funds offering crypto-limited partnership interests will almost certainly differ in investment strategy and other aspects of their smart contracts. Thus, because of a lack of uniformity, it may be possible that digital ownership interests in private investment funds cannot be classified as commodities. 77 I.R.S. Notice 2014-21, 2014-16 I.R.B. 938-39 (Apr. 14, 2014), https://www.irs.gov/pub/irs-irbs/irb14-16.pdf . > 78 _IRS Virtual Currency Guidance: Virtual Currency Is Treated as Property for U.S. Federal Tax Purposes; General Rules for Property Transactions Apply_ , INTERNAL REVENUE SERVICE (Mar. 25, 2014), https://www.irs.gov/uac/newsroom/irs-virtualcurrency-guidance. > 79 _Id._ > 80 _Id._ While the value of Bitcoin in 2013 under $20 and its value appreciated to over $1200 in 2017, in the past four years, the IRS has only received around 900 Form 8949 that would indicate some gain or loss from cryptocurrencies.<sup>81</sup> The IRS treats cryptocurrencies the same as any other security. However, the tech industry has not been claiming income from cryptocurrency in the same way other securities are being accounted for – requiring an 8949 to be filed when considering capital gains or losses.<sup>82</sup> As a result, the IRS has started investigating the under reporting of cryptocurrencies. To address the underreporting of cryptocurrency gains and losses, the IRS has started targeting individual companies that have a large presence in the market, most notably, Coinbase. Coinbase claims to host over one-million accounts.<sup>83</sup> Late in 2016, the IRS issued a subpoena asking for Coinbase to turn over data to determine the possible tax consequences for their users. Coinbase did not comply with the subpoena and the IRS filed suit in Federal Court in March of 2017.<sup>84</sup> In March 2013, the Department of the Treasury Financial Crimes Enforcement Network (“FinCEN”) released guidance on the use of virtual currencies.<sup>85</sup> FinCEN extended the Bank Secrecy Act (“BSA”) to cover persons creating, obtaining, distributing, exchanging, accepting or transmitting virtual currencies.<sup>86</sup> However, whether such person is a Money Service Business (“MSB”)<sup>87</sup> , and subject to the reporting requirements of FinCEN is unresolved.<sup>88</sup> While a user of a virtual currency is not a MSB and not subject to any registration requirements, a user of virtual currencies who is deemed to be an administrator or exchanger will be required to comply with its reporting and recordkeeping regulations. Thus, only users who exchange or transmit bitcoins from one currency to another are subject to the recordkeeping and reporting requirements.<sup>89</sup> > 81 _Id_ . > 82 Ed Zwirn, _No, You Can’t Avoid Taxes by Investing In Bitcoin_ , N.Y. POST (Apr. 8, 2017) http://nypost.com/2017/04/08/no-you-cant-avoid-taxes-by-investing-inbitcoin/. > 83 Matthew Heller, _Bitcoin Users May Be Cheating on Taxes_ , CFO (Mar. 28, 2017) http://ww2.cfo.com/tax/2017/03/bitcoin-users-may-cheating-taxes/. > 84 _Id_ . > 85 Brad Jacobsen & Fred Peña, _What Every Lawyer Should Know About Bitcoins_ , UTAH B.J. July-Aug. 2014, at 40, https://www.utahbar.org/wpcontent/uploads/2014/07/2014_edition_04_jul_aug.pdf. > 86 _Id_ . > 87 MSBs include: (1) any person doing business, whether or not on a regular basis, as currency dealers or exchangers; (2) check cashers; (3) issuers of traveler’s checks, money orders or stored value; (4) sellers or redeemers of traveler’s checks, money orders or stored value; (5) money transmitters; and (6) the U.S. Postal Service. _Id_ . > 88 _Id_ . > 89 _Id_ . # **III. Private Investment Funds’ Use of Blockchain Technology** A recent trend in the private investment fund industry pertains to the increasing use of blockchain technology to facilitate investment and process optimization. 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 and/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,<sup>90</sup> the Northern Trust<sup>91</sup> in cooperation with IBM, Numerai,<sup>92</sup> LendingRobot,<sup>93</sup> and Intellisys Capital LLC,<sup>94</sup> Melonport,<sup>95</sup> among many others. # _1. Administrative Process & Compliance Optimization_ A significant application of blockchain technology for private investment funds involves the improvement of administrative processes and compliance procedures. For instance, LendingRobot’s LendingRobot Series is a fully automated hedge fund secured by blockchain technology.<sup>96</sup> Unlike other blockchain-based hedge funds that invest specifically in cryptocurrency, such as Global Advisers and Polychain Capital, the LendingRobot Series invests in lending marketplaces— Lending Club, Prosper, Funding Circle, and Lending Home.<sup>97</sup> Its trading is determined by an algorithm based on the investor’s risk preferences. Once the investor has created a trading profile, LendingRobot selects and executes trades that are recorded in the blockchain public ledger on a weekly basis. This facilitates significant efficiencies and facilitates administrative and compliance optimization. Moreover, by recording all transactions in the public blockchain, LendingRobot is able to comply with its best execution obligations as well as locate and audit past trades. The technology helps > 90 _SEE_ Polychain Capital, _supra_ note 2. > 91 NORTHERN TRUST, https://www.northerntrust.com/ (last visited Apr. 17, 2017). > 92 NUMERAI, https://numer.ai/ (last visited Apr. 17, 2017). > 93 LENDINGROBOT, https://www.lendingrobot.com/#/ (last visited Apr. 17, 2017). > 94 INTELLISYS CAPITAL LLC, http://www.intellisys.ai/ (last visited Apr. 17, 2017). > 95 MELONPORT, https://melonport.com/, (last visited Apr. 17, 2017). > 96 Press Release, deBanked, Introducing LendingRobot Series: One-Stop Investing in Alternative Lending (Jan. 26, 2017), http://debanked.com/2017/01/introducing- > lendingrobot-series-one-stop-investing-in-alternative-lending/; Dan Cummings, _LendingRobot Introduces Robo-Fund LendingRobot Se_ ries, ETHNEWS _https://www.ethnews.com/lendingrobot-introduces-robo-fund-lendingrobot-series_ . > 97 Press Release, deBanked, _supra_ note 96; Cummings, _supra_ note 96 _._ the firm conduct investigations, but it also facilitates reporting to the SEC. Most prominently, 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.<sup>98</sup> While the current legal and administrative processes that support private equity are timeconsuming, expensive, lack transparency, and involve lengthy, duplicative, and fragmented investment and administrative processes, the partnership’s solution delivers an enhanced and efficient approach to private equity administration by simplifying the complex and laborintensive transactions in the private equity market.<sup>99</sup> More specifically, unlike the current deal practice in private equity, which requires parties to reconcile multiples copies of the documents that form the 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 a single compiled version of the transaction and all other data relating to the deal.<sup>100</sup> Several key benefits are associated with the introduction of blockchain technology in private investment funds’ back-office administrative processes and compliance. By automatically recording all transactions in a given private investment fund along with any documentation or information that is associated with a given transaction, blockchain technology reduces the otherwise significant costs associated with human oversight in recording, organizing, and maintain investment fund data and records. Blockchain technology also creates a verified marketplace and provides market participants with reliable and fully transparent data on market transactions. The technology reduces the need for information exchange among parties because all transactions are fully recorded and transparent. Blockchain increases security because transactions are recorded in an immutable database that ensures the validity of data and removes expensive security procedures and labor-intensive data maintenance while reducing the need for a paper trail. Overall, the technology allows for a significant simplification of transactions and enormous increases in efficiency and speed of private investment fund transactions while providing significant security improvements. > 98 _See_ Press Release, IBM, Northern Trust and IBM Pioneer Use of Blockchain Technology to Help Transform Private Equity Administration (Feb. 22, 2017), http://www-03.ibm.com/press/us/en/pressrelease/51655.wss. > 99 _See id._ > 100 _See id._ # _2. Combining AI, Big Data, and Blockchain_ Private investment funds that utilize blockchain technology often combine the benefits offered by the technology with other evolving technologies and cutting-edge applications to create synergies. Perhaps the most prominent example of a private investment fund that very successfully incorporates the combination of technologies is Numerai. Numerai is a private investment fund with a global equity strategy.<sup>101</sup> 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.<sup>102</sup> Using data scientists for investment analysis creates efficiency through a synthesis of data. Data scientists working in this model work to solve the same problems in their own unique ways with different strategies. Numerai synthesizes these models to create a metamodel out of all the predictions from the data scientists.<sup>103</sup> In the Numerai model, the use of artificial intelligence increases efficiency and optimum capital allocation by reducing overhead costs.<sup>104</sup> Adaptive data analysis is one of the important problems that are being addressed in the Numerai model. When data scientists use the same data set repetitively a risk exists that the training model will overfit the test set of data which can limit the performance of the applied model on a different dataset.<sup>105</sup> To overcome this problem, data scientists working for Numerai are tasked with staking Numeraire on their predictions which in effect represents data scientists’ confidence in their model’s live performance. The staking process, in turn, enables Numerai to choose the optimal model and in the process improve the performance of its hedge fund.<sup>106</sup> > 101 _See_ Laura Shin, _This Is the World’s First Cryptocurrency Issued by a Hedge Fund_ , FORBES (Feb. 21, 2017), https://www.forbes.com/sites/laurashin/2017/02/21/this-is-the-worlds-firstcryptocurrency-issued-by-a-hedge-fund/#61dcf68560b6. 102 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.” _A New Cryptocurrency for Coordinating Artificial Intelligence on Numerai_ , MEDIUM (Feb. 21, 2017), https://medium.com/numerai/anew-cryptocurrency-for-coordinating-artificial-intelligence-on-numerai9251a131419a. 103 _See_ Shin, _supra_ note 101. 104 _See_ Daniel Fagglla _, Crowdsourcing a Machine Learning Hedge Fund,_ TECHEMERGENCE (Nov. 10, 2016), https://www.techemergence.com/crowdsourcinga-machine-learning-hedge-fund/ (providing excerpts from and the audio of an interview with Richard Craib, the founder of Numerai.) 105 CRAIB , _supra_ note 1. 106 _Id._ at 2. # **IV. Impact of Blockchain Use on Private Investment Fund Industry** Blockchain technology has the potential to restructure large parts of the private investment fund and banking industry.<sup>107</sup> Most legacy systems at private investment funds and banks are much more expensive than blockchain technologies, are subject to human error, and take much more time. Banks charged $1.7 trillion in processing fees in 2014.<sup>108</sup> Because blockchain technology is transparent, verifiable, selfauthenticating, and self-enforcing, financial transactions can be executed instantaneously at near zero transaction costs, increasing the efficiency for business and individuals exponentially. These factors in addition to blockchain technology’s disintermediation through technology driven democratized trust, precipitated the financial industry’s substantial investments into blockchain technologies<sup>109</sup> in fear of becoming obsolete.<sup>110</sup> # _1. Diversification_ Diversification is a key element of blockchain-based change in the private investment fund industry. A benefit of investing in digital currencies rather than traditional investments is that digital currencies can be immune to the vicissitudes of traditional stock investments and the equity markets. Although crypto investments can to be just as and more volatile than traditional investments, digital currencies might be used to hedge against traditional investments.<sup>111</sup> Traditionally, investors that were interested in cryptocurrencies and crypto assets had to purchase a single digital asset, like bitcoin, hold it in an application like Coinbase, among others, and often tried to diversify themselves by investing in multiple cryptocurrencies. Several private investment funds, such as TheToken Fund,<sup>112</sup> Polychain,<sup>113</sup> and Logos Fund,<sup>114</sup> provide investors with exposure to a wide range of digital currencies without the risk of investing in either the underlying organization behind a protocol or the digital currency itself. Rather than make one large investment in one cryptocurrency, these funds employ an asymmetric investment strategy by making large-scale investments in numerous > 107 Lawrence J. Trautman, _Is Disruptive Blockchain Technology the Future of Financial Services?_ , 69 CONSUMER FIN. L.Q. REP. 232 (2015). > 108 _Id_ . 109 Financial institutions are expected to spend over $1 billion on blockchain projects in 2017. This is on top of the $1.4 billion invested in the last three years. _Id_ . 110 Reggie O'Shields, _Smart Contracts: Legal Agreements for the Blockchain_ , 21 N.C. BANKING INST. 177 (2017). > 111 In fact, bitcoin has been arguably more volatile _See e.g_ ., Neil Haran, _What’s keeping cryptocurrencies from mass adoption?_ TECHCRUNCH (Apr. 20, 2017), https://techcrunch.com/2017/04/20/whats-keeping-cryptocurrencies-from-massadoption. 112 THETOKEN, https://thetoken.io/ (last visited June 30, 2017). > 113 _See_ Polychain Capital note supra 2. 114 THE LOGOS FUND, http://logos-fund.com (last visited Apr. 24, 2017). cryptocurrencies. The Logos Fund combines such crypto investment diversification with the mining of bitcoins to increase the value of the fund during downswings in the volatile cryptocurrency markets. # _2. Competitive Pressure_ The use of blockchain technology increases the competitive pressure in the private investment fund industry. Private investment funds implementing blockchain technology are facilitating and spearheading radical changes in financial markets. First and foremost, the structural characteristic of blockchain as a decentralized model for financial transactions disintermediates and disrupts the existing financial infrastructure. Private investment funds that are first movers in the implementation of the blockchain infrastructure systems in finance directly contribute to that disintermediation and facilitate the accelerating evolution of the blockchain infrastructure in finance. The competitive pressure in the private investment fund industry increases through operational and business efficiencies gained by those funds that implement the technology. Most large fund advisers in the private equity and hedge fund industry have not yet considered implementing blockchain technology in combination with big data applications and artificial intelligence. This, however, may change in the foreseeable future if and when larger managers realize that their smaller competitors who utilize these technologies gain substantial operational efficiencies and cost savings and are able to substantially diversify their portfolio holdings via such technologies. The threshold for change for bigger managers may be dictated by the implementation cost of such new technologies. If and when the long-term benefits of using the technologies exceed the implementation cost, which are much larger for larger managers than for the smaller managers who are currently experimenting with such technologies, larger managers are incentivized to start the innovation process as well. # _3. Pressure on Fee Structure_ The fee structure of private investment funds has changed substantially in the last ten years. Traditionally, the hedge fund industry has charged fees to investors based on the so-called “2/20” formula.<sup>115</sup> This means that most fund advisers were paid monthly or quarterly an annualized 2% management fee based on assets under management and a 20% annual performance or incentive reallocation based on net fund profits.<sup>116</sup> Similarly managers of private equity funds generally used to > 115 _Two and Twenty_ , INVESTOPEDIA, > http://www.investopedia.com/terms/t/two_and_twenty.asp (last visited Mar. 30, 2017). > 116 _Id_ . Such fees are typically used by managers to pay for salaries, rent, and equipment. The remainder goes to the partners. _See, e.g._ , Houman B. Shadab, _The Law and Economics of Hedge Funds: Financial Innovation and Investor Protection_ , charge an annualized 2% management fee based on committed capital and most commonly received a 20% commission on returns over a designated amount (referred to as the carry) as incentive compensation. However, the historical fee of 2% of commitments through the reinvestment period, then 2% on the cost basis for the investments/value of fund has shifted in recent years closer to 1.0% for new managers and 1.5-1.8% for established managers with an adequate track record.<sup>117</sup> It has become increasingly common in recent years for investors to negotiate fees with fund managers, particularly with newer fund managers<sup>118</sup> who may be more willing to engage in such negotiations to induce seed investors at the time of fund formation.<sup>119</sup> Alternative fee arrangements include but are not limited to modified highwater marks, incentive hurdles, and triggers, as well as clawbacks.<sup>120</sup> Several market factors help explain the pressure on the fee structure of the private investment fund industry. Private fund investors 6 BERKELEY BUS. L. J. 250 (2009), http://scholarship.law.berkeley.edu/cgi/viewcontent.cgi?article=1066&context=bblj _; Hedge Fund Performance and Management Fees_ , HEDGECO.NET (Aug. 5, 2009), https://www.hedgeco.net/hedgeducation/hedge-fund-articles/hedge-fundperformance-management-fees/. > 117 _See_ Irwin Latner, _Trends for Early-Stage Investing in Emerging Managers_ , HEDGE CONNECTION: THE EDGE (July 24, 2015), http://hedgeconnection.com/blog/?p=5071; _Funds Forced to Reduce Fees and Increase Transparency_ , CITCO, https://www.citco.com/ourthinking/thoughts/funds-forced-to-reduce-fees-and-increase-transparency/; Amanda Cantrell, _The Beginning of the End for High Hedge Fund Fees?_ INSTITUTIONAL INVESTOR (Sept. 15, 2016), http://www.institutionalinvestor.com/article/3585979/banking-and-capitalmarketsdaily-agenda/the-beginning-of-the-end-for-high-hedge-fundfees.html#/.WORK7fkrKUl. According to Hedge Fund Research, Inc., the average management fee for funds launched in 2016 was 1.33. https://www.hedgefundresearch.com/sites/default/files/articles/4Q16_HFR_MMIR_ FINAL.pdf. According to Prequin, the average hedge fund earned 1.57 in management fees in 2016. Press Release, Prequin, Investors Increase Pressure on Hedge Funds to Lower Fees (Sept. 22, 2016), https://www.preqin.com/docs/press/HF-Fees-Sep-16.pdf 118 First-time or new managers are particularly affected by the new fee structure. Unlike in the recent past, first-time managers are now often forced to share the business budget (rent, employee salaries, etc.) to justify the 1.5% management fee. Moreover, the industry is increasingly seeing contested track records for new managers, i.e., the new firm cannot get a consensus from the new manager’s old employer about the manager’s track record with that employer. Another phenomenon that affects first-time managers pertains to early limited partnership investors who increasingly throw their weight around to negotiate tough terms on fees. > 119 _See, e.g.,_ Latner, _supra_ note 117. > 120 _See, e.g_ ., TOWERS WATSON, HEDGE FUND INVESTING OPPORTUNITIES AND CHALLENGES 16–18 (Apr. 2012), https://www.towerswatson.com/en/Insights/ICTypes/Survey-Research-Results/2012/04/Hedge-Fund-investing-opportunities-andchallenges; _7 Differences Between Private Equity and Hedge Funds_ , ARTIVIST (Dec. 1, 2014), https://artivest.co/blog/7-differences-between-private-equity-andhedge-funds/. withdrew $70.1 billion from the private investment fund industry in 2016.<sup>121</sup> In 2016 a total of 1,057 private investment funds closed down, exceeding the 1,023 liquidations of private investment funds in 2009, and falling just shy of the record 1,471 closures in 2008.<sup>122</sup> According to some observers the market is oversaturated which increases pressure on private investment fund managers’ performance<sup>123</sup> and results in compromise fee arrangements, such as paying fees on invested capital only.<sup>124</sup> Blockchain-enabled platforms for setting up a private investment fund cause significant pressure on the existing fee structure of the private investment fund industry. Platforms such as Melonport or Drago enable competitive gains for their clients through fewer costs and time barriers to setting up and running a private investment fund.<sup>125</sup> While such competitive gains will benefit the majority of private investment fund managers and investors, the lower operating costs enabled by the platform models will especially enable new and future managers to enter the market because the start-up costs and compliance costs can be significantly reduced. By enabling low set-up requirements and low costs of running a portfolio, platform models may be able to create an unprecedented competitive environment for asset management strategies. The cost of running a private fund adviser portfolio on the blockchain equals the core usage fees, modular commissions, and the infrastructure costs to be paid on the Ethereum platform.<sup>126</sup> The usage fees are determined by the protocol, and the modular fees are set by the > 121 _HFR: Hedge Fund Industry AUM Crests to 3T to End 2016_ , FINALTERNATIVES (Jan. 20, 2017), http://www.finalternatives.com/node/34475. > 122 William Watts, _1,057 Hedge Funds Shut Down Last Year—the Most Since the Financial Crisis_ , MARKETWATCH (Mar. 20, 2017), http://www.marketwatch.com/story/hedge-funds-closed-down-last-year-at-a-paceunseen-since-2008-2017-03-17. “Some industry watchers have put the withdrawals closer to $100 billion. The shutdown total was 10.4 percent worse than 2015, bringing the total number of remaining hedge funds to 9,893, according to HFRI's estimates.” Jeff Cox, _Hedge Fund Fees Are Falling As Shutdown Hits a Post-Crisis High_ , CNBC (Mar. 17, 2017), http://www.cnbc.com/2017/03/17/hedge-fund-feesfalling-as-shutdowns-hit-a-post-crisis-high.html. 123 "The market is oversaturated," said Don Steinbrugge, managing partner at Agecroft Partners, a hedge fund marketing firm. "It's highly competitive, and for a hedge fund manager to raise money they can't have any flaws." Cox, _supra_ note 122. 124 Madison Marriage, _Guy Hands: Private Equity Fees Are ‘Driving Investors Away_ ,’ FIN. TIMES (Oct. 3, 2015), https://www.ft.com/content/1cd7cff2-67aa-11e5a57f-21b88f7d973f. 125 “The costs and complexity of setting up a portfolio using the Melonprotocol are lower than they are with traditional asset management [funds], seconds and cents versus months and millions." RETO TRINKLER & MONA EL ISA, MELON PROTOCOL: A BLOCKCHAIN PROTOCOL FOR DIGITAL ASSET MANAGEMENT: DRAFT 4 https://bravenewcoin.com/assets/Whitepapers/melonprotocol.pdf. 126 _Id._ module developers and are a fraction of a cent or a fraction of the trade volume for each usage.<sup>127</sup> # a) Funds Lowering Fees via Blockchain Technology The increasing use of blockchain technology in combination with artificial intelligence and big data contributes to the market pressure on the fee structure of private investment funds. Anecdotal evidence suggests that the majority of private fund advisers that use blockchain technology, artificial intelligence, and big data in different aspects of their operations or strategy have a substantially lower fee structure than those who do not use them. Prominent examples of lower fee structures driven by the use of blockchain technology include those of Lending Robot’s Lending Robot Series, and platforms for blockchain-enabled fund management, such as those offered by Melonport or Drago, among others.<sup>128</sup> While the overall proportion of strategies of private investment funds that apply modern technologies, including blockchain technology, is still small, as the use of blockchain technology grows in the private investment fund industry, the pressure on the fee structure is likely to continue to grow. Investors in LendingRobot’s Lending Robot Series, the fully automated hedge fund secured by blockchain technology,<sup>129</sup> unlike investors in traditional hedge funds, can withdraw funding on a weekly basis at no additional cost to the investor. Because LendingRobots’ business model removes the investment adviser, overhead costs, and legal fees associated with each investor agreement, LendingRobot is able to charge a mere 1% management fee and a maximum 0.59% fund expense fee per year.<sup>130</sup> Other factors that help keep the fee low include the increased transparency that allows LendingRobot to expense fewer > 127 _Id_ . > 128 _See, e.g._ , Berenice Magistretti, _LendingRobot Launches Automated Hedge Fund Secured by Blockchain Technology_ , VENTUREBEAT (Jan. 26, 2017), https://venturebeat.com/2017/01/26/lendingrobot-launches-automated-hedge-fundsecured-by-blockchain-tech/; MELONPORT, https://melonport.com/ (last visited Mar. 30, 2017); Jim Manning, _Melonport Brings Digital Asset Management to Polkadot’s Multi-Chain Framework_ , ETHNEWS (Nov. 14, 2016), https://www.ethnews.com/melonport-digital-asset-management-polkadot-multichain. _See generally_ Attracta Mooney, _Blockchain Could Be Totally Transformative for Fund Industry_ , FIN. TIMES (May 22, 2016), https://www.ft.com/content/bca31b78-1d02-11e6-b286-cddde55ca122; OLIVER WYMAN & J.P. MORGAN, UNLOCKING ECONOMIC ADVANTAGE WITH BLOCKCHAIN 10–12 (2016), http://www.the-blockchain.com/docs/joint-report-by-jp-morgan-andoliver-wyman-unlocking-economic-advantage-with-blockchain-A-Guide-for-AssetManagers.pdf. > 129 Berenice Magistretti, _LendingRobot Launches Automated Hedge Fund Secured by Blockchain_ , VENTUREBEAT (Jan. 26, 2017), http://venturebeat.com/2017/01/26/lendingrobot-launches-automated-hedge-fundsecured-by-blockchain-tech/. > 130 _Id._ resources on auditing the fund. LendingRobot claims an average performance of from 6.86% to 9.66% depending on the investment strategy selected by the clients.<sup>131</sup> As of March 2017 an analysis of a broad range of traditional hedge funds shows an average of 8.89% annualized return.<sup>132</sup> The increased transparency, reduced costs, and competitive performance enabled by LendingRobot’s use of blockchain technology may give it a competitive advantage in the private fund industry that could continue to exert pressure on fees charged by competitor funds. The Logos Fund is an alternative investment fund that invests in blockchain and cryptocurrency-related investments.<sup>133</sup> It aims to make blockchain-based currencies accessible to professionals and a broad range of investors by investing in the mining of blockchain-based cryptocurrencies as well as into such currencies directly.<sup>134</sup> To cover base costs and administration, the Logos Fund charges an administrative fee of between 1.2% and 1.92% depending on the size of the investment.<sup>135</sup> The fund management also charges a performancerelated fee of from 9% to 21% plus investment surcharges and redemption surcharges in accordance with market practices.<sup>136</sup> # b) Per-Transaction Fees Blockchain technology enables managers to charge pertransaction fees which undermines the existing 2/20 fee model. Blockchain technology facilitates a seamless and efficient calculation of management fees per transaction. In contrast to the traditional settlement and calculation of fees in a per-transaction model that created a prohibitive amount of work making such operations very difficult to execute, blockchain technology overcomes all of these restrictions. It enables the fully automated allocation of the appropriate fee to the correct executed trade and associated client account without any manual reconciliation or settlement.<sup>137</sup> While normally the use of this type of fee is prone to human errors that occur during manual calculation or settlement, these errors are removed through the use of blockchain technology which performs the required calculations and settlement > 131 LENDINGROBOT SERIES, https://www.lendingrobot.com/#/series/ (last visited Apr. 17, 2017). > 132 Eurekahedge Hedge Fund Index, EUREKAHEDGE, > http://www.eurekahedge.com/Indices/IndexView/Eurekahedge/473/Eurekahedge_He dge_Fund_Index (last visited Apr. 17, 2017). > 133 LOGOSFUND, http://logos-fund.com/wordpress/the-logos-fund/(last visited Apr. <u>17, 2017).</u> > 134 _Id._ > 135 _Frequently Asked Questions_ , LOGOSFUND, http://logosfund.com/wordpress/faqs/. > 136 _Id._ > 137 _See id_ . at 1–2. procedures automatically and seamlessly. The blockchain enabled pertransaction fee can be pre-determined or modified by the manager in cooperation with clients. It also can be publicly available which allows the private fund adviser to determine the applicable fee in a competitive market.<sup>138</sup> Accordingly, clients who invest in a more transaction-prone strategy will be able to agree upfront to higher fees whereas clients who invest in a less transaction-rich strategy will pay overall lower fees. While not all blockchain-enabled private investment funds charge per-transaction fees, the majority of private fund advisers that use blockchain technology, artificial intelligence, and big data in different aspects of their operations or strategy charge their investors lower fees. Prominent examples of lower fee structures driven by the use of blockchain technology include those of LendingRobot’s LendingRobot Series, the Logos Fund, and platforms for blockchainenabled fund management, such as those offered by Melonport or Drago, among many others. # **V. Data, Methodology & Coding** The dataset comprises a representative sample of private investment funds that utilize blockchain technology in either their strategy or operations (N=120). The author and a team of two research assistants hand-coded individual use of blockchain technology for each fund in the dataset. The researchers compiled the dataset through various sources, including individual web searches to identify funds operating on the Ethereum network,<sup>139</sup> as well as searches on multiple databases including Westlaw, Bloomberg, and Google to identify funds that were not operating on the Ethereum blockchain. Once a core dataset of private fund advisers that use blockchain technology was established, the author and three research assistants obtained the individual contact information through additional searches. Most of the companies/fund advisers provided email contact details on their website. The author contacted each individual person / organization to obtain relevant and codeable information for the dataset. The main interview questions for each of these advisers involved topics pertaining to: (1.) type of fund, (2.) assets under management, (3.) inception dates, and (4.) fee structure. Some companies responded directly to the questions and others directed the researchers to their > 138 See generally _Northern Trust Using Blockchain for Private Equity Administration_ , ISF (Feb. 22, 2017), > https://globalinvestorgroup.com/Articles/3663824/Northern-Trust-using-blockchainfor-private-equity-administration; Nick Ayton, _Blockchain Means the End of Asset Management As We Know It_ , INNOVATION ENTERPRISE (July 29, 2016), https://channels.theinnovationenterprise.com/articles/blockchain-will-revolutionizeasset-management. > 139STATE OF THE DAPS, http://dapps.ethercasts.com/ (Last visited Jun. 29, 2017). white papers.<sup>140</sup> Many corporations did not provide an answer to these questions. The most important means of communication with representatives of the investment funds in the dataset included telephone interviews, email communication, Facebook, among other social media means.<sup>141</sup> If the company did not respond by email or did not have an email, the researchers called the company. Some funds preferred a telephone interviewed instead of emails. For certain funds in the dataset, such as the American Fund, that filed Form ADV with the securities and exchange commission, the researchers obtained personal contact information for the fund manager. # _1. Descriptive Statistics_ <!-- Start of picture text --> Inception Date<br>n=60<br>35<br>30<br>25<br>20<br>15<br>10<br>5<br>0<br>2000 2002 2004 2006 2008 2010 2012 2014 2016<br>Year<br>Fund Inception Date Blockchain Inception Date<br>Number of Funds<br><!-- End of picture text --> Figure 1: Time Series Fund Inception Date versus Blockchain Use Inception Date (in fund structure). Figure 1 shows that between the years 2000 and 2012, despite an initial pickup in 2005, the use of blockchain in private investment > 140 Richard Craib, _Supra_ note 1; GABRIELE RIGO, DRAGO: DECENTRALISED HEDGE FUND AND SOCIAL TRADING PLATFORM A NEW PARADIGM FOR ASSET MANAGEMENT, DRAGO, (Mar. 2017), etherworld.co/uploads/files/1495830632377-rigoblockpaper.pdf; George K. Van Hoomissen & William Russell, _Vega: A Decentralized Funding Platform_ , VEGA, https://docs.google.com/document/d/1rgMqqoE7NNTPCLEGyCSBfYW39hqAPEi0 U6tS105-U3g/edit (last visited June 30, 2017). > 141 The author used the crunchbase database. This website allows the user to type in a company’s name and see various facts about the company. The website provides, among other information: individual investors, how much has been invested, phone numbers, emails, company valuation etc. The author used the information on crunchbase to contact the companies and used this website to find inception date of funds and types of funds that were being managed. funds was minimal. In 2012, coinciding with the more public debate of blockchain based solutions, private investment fund managers started to get involved in the technology by setting up separate and new fund entities that utilized the technology in various forms. In 2015, however, existing funds also started to create substructures that utilized blockchain technology. <!-- Start of picture text --> Contact Method<br>n=98<br>60<br>50<br>40<br>30<br>20<br>10<br>0<br>Email Phone Website Contact Other<br>Method<br>Figure 2: Contact Methods: Email, Phone, Website, and Other.<br>Update June 20, 2017.<br>Figure 2 shows that the author predominantly contact fund<br>participant in this study via email, followed by phone contacts and<br>website contacts. The author and his team of researchers contacted a<br>total of 98 firms, with some contacted more than once. Firms were<br>contacted using a different method if they did not respond to the first<br>mode of contact.<br>Type of Fund<br>n=105<br>60<br>50<br>40<br>30<br>20<br>10<br>0<br>Hedge Fund Venture Capital Private Equity Tech. Other<br>Type of Fund<br>Number of Funds Contacted<br>Number of Funds<br><!-- End of picture text --> Figure 2 shows that the author predominantly contact fund participant in this study via email, followed by phone contacts and website contacts. The author and his team of researchers contacted a total of 98 firms, with some contacted more than once. Firms were contacted using a different method if they did not respond to the first mode of contact. Figure 3: Type of Funds in Dataset, including hedge funds, venture capital, private equity, technology fund and others. Figure 3 shows that the clear majority of private investment funds in the dataset is engaged in venture capital. <!-- Start of picture text --> Platform Utilized<br>n =113<br>80<br>70<br>60<br>50<br>40<br>30<br>20<br>10<br>0<br>Ethereum Other<br>Platform<br>Number of Funds<br><!-- End of picture text --> Figure 4: Blockchain Platform for Private Investment Funds’ Utilization of Blockchain Technology. Figure 4 shows that the predominant blockchain platform used by private investments funds in the dataset is the Ethereum platform. Reviewing the raw data suggests that the larger the fund by AUM the less likely the fund will be to utilize the Ethereum platform. <!-- Start of picture text --> Status<br>n=120<br>80<br>70<br>60<br>50<br>40<br>30<br>20<br>10<br>0<br>Live Working Work in Other Unknown<br>Prototype Progress<br>Status<br>Number of Funds<br><!-- End of picture text --> Figure 5: Status of Private Investment Fund Utilization of Blockchain Technology including Status: Live, Working Prototype, Work in Progress, Other, and Unknown. Electronic copy a vaila ble at: htt ps:/ /ssrn.com/abstract=2998033 Electronic copy av aila ble at: ht tps: //ssrn.co m/a bstract= 2998 033 Figure 5 highlights that at the publication of this article most of the blockchain projects in the private investment fund industry are live but many are still in the development and test phase. <!-- Start of picture text --> AUM<br>n= 59<br>20<br>15<br>10<br>5<br>0<br>1-50 51-100 101-150 151-200 201+<br>AUM IN $US<br>Figure 6: Assets Under Management.<br>Figure 6 shows that in the dataset for this study, the majority of<br>fund advisers controlled more than $200 million in assets under<br>management, followed by the smaller fund advisers that manage<br>between $1 million and $50 million in assets under management.<br>2. Predominant Uses of Blockchain Technology<br>Cluster Graph<br>n=74<br>45<br>40<br>35<br>30<br>25<br>20<br>15<br>10<br>5<br>0<br>Crypto Smart K Assets Security Growth Innovation Fintech Decentralized<br>Currency<br>Terms<br>Number of Funds<br>Number of funds<br><!-- End of picture text --> Figure 6 shows that in the dataset for this study, the majority of fund advisers controlled more than $200 million in assets under management, followed by the smaller fund advisers that manage between $1 million and $50 million in assets under management. Figure 7: Cluster Graph for Eight Key Categories of Blockchain Use Cases in Private Investment Funds. <!-- Start of picture text --> Term Radar<br>n=74<br>Crypto Currency<br>40<br>35<br>Decentralized 30 Smart K<br>25<br>20<br>15<br>10<br>5<br>Fintech 0 Assets<br>Innovation Security<br>Growth<br><!-- End of picture text --> Figure 8: Word Cluster Term Radar for Eight Key Categories of Blockchain Use Cases in Private Investment Funds. Private investment funds describe their funds’ use of blockchain technology with several key terms in their marketing materials. Clustering these words allowed the researchers to identify the funds’ strategy and approach in their use of blockchain technology. The author identified nine key terms to see how these companies are discussing their services. The purpose of the word clusters in Figures 7 and 9 is to show how often private investment funds are using certain words on their websites and marketing materials when discussing the approach and strategy of their respective fund. The categories in Figures 7 and 8 are the popular terms that the author found are consistently associated with the Blockchain platform. The terms used for coding the data for Figures 7 and 8 are defined as follows: (1.) C rypto Currency: Digital currency in which encryption techniques are used to regulate the generation of units of currency and verify the transfer of funds, operating independently of a central bank;<sup>142</sup> (2.) S mart Contracts : Smart contracts are computer > 142 Ex. “DC converts cash deposits into DC Assets, a form of digital currency that is secured by the Ethereum network and collateralized by these customer deposits.” _How Does Decentralized Capital Work?,_ DECENTRALIZED CAPITAL, https://www.decentralizedcapital.com/#!/faq (last visited May 28, 2017). Ex. “Our unique model enables us to deploy our resources to build the crypto currencies and blockchain ecosystem over the long term.” The nexus of blockchain technology and finance., DIGITAL CURRENCY GROUP, http://dcg.co/ (last visited May 28, 2017). protocols that facilitate, verify, or enforce the negotiation or performance of a contract, or that make a contractual clause unnecessary;<sup>143</sup> (3.) Digital Assets: A financial instrument – such as a dollar, bond, or derivative that is cryptographically issued, held, and transferred on a blockchain. This novel medium for assets, which is similar to bearer instruments like cash, but digital, is better suited to the security and innovation requirements of modern financial applications than centralized ledgers that immobilize assets and depend on messaging and reconciliation;<sup>144</sup> (4.) Security: Process to create rules and to take actions such as implementing systems and measures to protect a fund and their clients against attacks over the Internet;<sup>145</sup> (5.) Growth: Attainable growth;<sup>146</sup> (6.) I nnovation: A new method, idea, or product that a fund is using in the financial industry;<sup>147</sup> (7.) FinTech: 143 “Workflow Automation; Smart contracts ensure all relevant parties remain synchronized, even on the most complex financial instruments” Workflow Automation, AXONI, https://axoni.com/home (last visited May 28, 2017); “Smart contracts represent a next step in the progression of blockchains from a financial transaction protocol to an all-purpose utility. They are pieces of software, not contracts in the legal sense, that extend blockchains’ utility from simply keeping a record of financial transaction entries to automatically implementing terms of multiparty agreements.” Blockchain- the benefits of smart contracts, Deloitte United States, https://www2.deloitte.com/us/en.html (last visited May 28, 2017). 144 “The value of DC Assets is directly tied to that of the government currency backing it, e.g. 1 DUSD = 1 USD. As the value of the government currency fluctuates against other assets, so will the value of the DC Asset representing said currency.” Decentralized Capital – How do DC assets maintain a stable value?, https://www.decentralizedcapital.com/#!/faq (last visited May 28, 2017).; “ Chain Core is enterprise software that enables institutions to issue and transfer financial assets on permissioned blockchain networks. The assets on Chain blockchain networks are not new cryptocurrencies but are rather issued assets like currencies, securities, derivatives, gift cards, and loyalty points.” What is Chain Core?, Chain, https://chain.com/faq/ (last visited May 28, 2017) ; “ the assets on a blockchain are controlled directly by the owners of those assets through the use of secure, cryptographic keys.” Explore the Blockchain Potential, Blockchain Solutions, http://www.blockchain-solutions.com/ (last visited May 28, 2017). 145 “This is an added security feature available to members who have Static IPs if they choose to use it. Members who's IPs regularly change, that will be most of the world, should not use this function as it will lock you out of your account once your IP changes.”, cryptofund, https://www.cryptofund.org/ (last visited May 28, 2017).; “Chain’s technology is specifically designed for moving financial assets in permissioned, high-scale environments that require enterprise-grade security and privacy” What is a blockchain?, Chain, https://chain.com/faq/ (last visited May 28, 2017). 146 “Focus is on driving innovation in fintech and blockchain technologies, enabling businesses to take advantage of growth opportunities.” , Coinsilium, https://www.coinsilium.com/ (last visited May 28, 2017).; “We build applications on top of the Factom™ network that can be used as a public utility. These applications leverage the immutability of the blockchain and the growth of the network.” , Factom, https://www.factom.com/about/faqs (last visited May 28, 2017) 147 “ we continually strive to innovate, to make banking easier, more practical and better adapted to the needs of all our customers.”, Our Response to a Changing Algorithmic solutions and other technology used to support or enable banking and financial services;<sup>148</sup> (8.) Decentralized: A market structure that consists of a network of various technical devices that enable investors to create a marketplace without a centralized location.<sup>149</sup> Once the author defined the cluster category terms in the previous paragraph, the author and a team of researchers examined the funds in the sample for services, goals, strategies, policies and other accessible information to find the nine key cluster category terms. If a fund mentioned one of these words the researchers would record it as “yes=1”, if they did not then it would be recorded as “no=0”. With a completed list of all funds, the author combined all 1’s within the data sheet and entered them into a bar graph to show how many funds were using these nine terms. The bar graph is a representation of these funds as a whole to demonstrate how these funds are describing their services. Figures 7 and 8 suggest that the private investment funds industry’s predominant uses of blockchain technology originate in holding crypto assets of different kinds. This would suggest that blockchain technology plays a primary role in front office and investment functions. Another important use of the technology involves the securing of such crypto assets. While crypto assets are generally World, Bank BNP Paribas, https://group.bnpparibas/en/ (last visited May 28, 2017); “invests in the best entrepreneurs who are fostering innovation in the Blockchain economy.” Homepage, Blockchain Capital, http://blockchain.capital/ (last visited May 28, 2017); “ Our mission is to act as the catalyst for widespread blockchain adoption and innovation.” About | Pantera Capital - Blockchain Investment Firm, Pantera Capital, https://panteracapital.com/about/ (last visited May 28, 2017). 148 “ Financial Technology has evolved to the stage where it could help overhaul and reshape traditional industry structures and operating models.” Blockchain: What you need to know, Northern Trust | Wealth Management, Asset Management & Asset Servicing, https://www.northerntrust.com/ (last visited May 28, 2017); “Financial Technology start-up companies continue to alter the industry norm.” The blockchain revolution in trade finance, Barclays, https://www.barclayscorporate.com/insightand-research/trading-and-exporting/blockchain-revolution-in-trade-finance.html (last visited May 28, 2017). > 149 “connects all members of the supply chain to a decentralized network and allows them a direct exchange of documents.” Blockchain for the people, Waves Platform | Blockchain for the people, https://wavesplatform.com/ (last visited May 28, 2017); “By having decentralized storage and execution one can mitigate some of today's real world inefficiencies such as custody, counter-party and settlement. Melon creates a true alternative to traditional asset management.” About Melonport, Melonport, https://melonport.com/ (last visited May 28, 2017); "Blockchains are clunky databases, so why would you want to use one? Traditional systems have inherent flaws that make them easy targets for corruption of data. A Factom™ system gives a single version of the truth through a Decentralized Network of Authority. Once everyone can agree on a single version of the truth, then the truly game-changing applications can be built.", Factom, https://www.factom.com/about (last visited May 28, 2017). better suited for the security and innovation requirements of modern financial applications than centralized ledgers, the increased s ecurity offered by blockchain technology and utilized by private investment funds pertains to implementing systems and measures to protect a fund and their clients against attacks over the Internet. The third most important category of private investment fund use of blockchain technology pertains to its support for the growth of the fund. This is consistent with anecdotal evidence suggesting that the crypto returns attainable through crypto investments have no match in traditional finance. # **VI. Discussion** The rise of blockchain technology and the prominent applications of blockchain technology serve as prominent examples of the impending seismic shifts in the private investment fund industry. The paper has illustrated that the rise of blockchain applications in private investment funds already has an impact on the industry’s front office and investment functions, in the securing of crypto assets, but also in private investment fund managers’ attempts to satisfy the growth expectation of clients. As the industry continues to evolve in the blockchain realm, more change is inevitable. Legacy infrastructure upgrades via blockchain technology may only be a first step towards crypto integration and evolution via the private investment fund industry. R egulatory guidance will be essential to ensuring the continuing evolution and blockchain integration for the private investment fund industry.