Case study: Traditional Fund vs. On-chain Fund

Introduction

This case study delves into the key processes of an investment fund, namely subscriptions, Net Asset Value (NAV) calculation, fee extraction, and redemptions. Let’s explore how Fume's administration approach streamlines these operations for an on-chain fund compared to a traditional fund. 
The following processes for a traditional fund are described from a direct personal experience of a Luxembourg-based alternative investment fund (under AIFMD). Needless to say, the exact procedure could vary depending on the chosen structure and fund administrator. The fund is investing in liquid assets and has an open-ended policy with a monthly NAV calculation.

Subscription

The onboarding of an investor (LP) always starts with the KYC and the anti-money laundering checks. Once all the documentation has been collected and the investor has been approved, it’s time to receive the subscription payment. Let’s imagine that the investor and the fund manager agreed on a subscription of $100’000.

Traditional Fund

If the subscription is received via a bank transfer, the wire coordinates are shared with the investor. Possible issues arise:

• the investor sends the capital from a different bank than what was initially announced to the fund manager, invalidating the documentation for the source of funds.
• the capital sent differs from what was initially agreed (e.g. $100k) because of conversion rate, intrabank fees, or transaction fees.
• the transaction doesn’t go through because either the sending or the receiving bank’s compliance is blocking the process. (e.g. an investor with a perfectly clean record and supporting documentation but with an off-shore bank).
• the transfer takes up to several days to settle.
• as is often the case in the digital asset sector, the receiving bank takes a large commission (e.g. $2000 with 20bps/tx ).

Another option would be to subscribe via a clearing system (Euroclear or Clearstream) using the ISIN code. In that case, although there is no initial KYC required (already performed by the investor’s bank), the fund shares are held under the intermediary name. There is a tradeoff between the ease of execution and additional intermediaries’ commissions. 
Alternatively, the subscription can be received directly from the wallet of the investor to the wallet of the fund. Other potential issues could arise:

• a manual mistake in the copy-paste of the address might result in the loss of the subscription capital.
• the investor sends the capital from a different wallet than what was initially announced to the fund manager, invalidating the documentation for the source of funds (wallet screening).
• the capital sent differs from what was initially agreed, e.g. different currency (USDC instead of USDT), unaccounted withdrawal fees, and transaction fees.
• the capital is sent on a different network (e.g. Polygon instead of Ethereum).

The capital is received in a bank account or a wallet segregated from the rest of the portfolio.
Once the capital is received, the manager has to communicate the transaction’s information to the administrator. After the next NAV calculation, the fund manager will then manually move the assets into the rest of the fund’s portfolio.

On-chain Fund

The fund manager whitelists the investor specifying the subscription amount and other properties.
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The investor receives an email with the invitation to join the platform. Once the specified address is connected, the transaction of the subscription payment is already pre-filled. 

It forces the investor to send the capital from the correct (pre-screened) wallet, with the correct amount, to the correct address (i.e. the fund’s smart contract) without any risk of manual error. The transaction is then settled on-chain within a few seconds.
After the next NAV calculation, the subscription liquidity is automatically moved from the fund’s smart contract into the rest of the fund’s portfolio. At the same time, the new tokenized fund shares are issued to the subscribing investor.

NAV Calculation

Traditional Fund

To calculate the latest NAV, the fund manager provides the administrator with information concerning the fund portfolio’s transactions (e.g. extract from exchanges in .csv/.pdf format).
The administrator then proceeds to calculate the new NAV value, performing the shares equalization, computing the management, and performance fee (if any). This procedure can take between a few days and a few weeks. The price usually depends on the amount of portfolio transactions, assets, and the total amount of investors. 

On-chain Fund

For assets held on-chain or via supported exchanges, the portfolio positions are fetched automatically. To calculate the NAV, the fund manager simply validates the total assets and liabilities tracked from Fume’s protocol and clicks “Calculate NAV”. The protocol will then instantly calculate the new NAV value, and perform the equalization and computation of fees. 

Fee Extraction

The fund manager generally earns from the following fees:

• Management fee on the total assets under management
• Performance fee (a.k.a. carried interest for private equity funds)
• Entry fee (a.k.a. subscription fee) 
• Exit fee (a.k.a. redemption fee)

Traditional Fund

For every subscription, the fund manager needs to calculate the subscription fee and manually extract it to its account (e.g. via bank or wallet). 
Similarly, for every redemption, the fees need to be calculated and manually extracted.
After every NAV calculation, the administrator computes the management and performance fees to be manually extracted from the fund’s portfolio by the manager. 
Every time a fee is extracted, the manager has to report to the administrator to ensure the correctness of the following NAV calculation.

On-chain Fund

Every time a subscription payment is received, the fee is automatically extracted and sent to the manager. 
The management, performance, and exit fees are computed with the NAV calculation event and recorded on-chain as fund liabilities.
The manager can settle all liabilities in a single transaction via the protocol, without the need to report anything. Alternatively, should there be any incoming subscription, the pending fees will be automatically settled and the remaining capital (after fees) will be then forwarded into the rest of the fund’s portfolio.

Redemption

Traditional Fund

When an investor intends to redeem some shares, an email is sent to the fund manager requesting the redemption. 
The manager will then notify the administrator that, at the next NAV, the shareholder register needs to be updated. 
The administrator will communicate to the manager the redemption amount after exit fees.
Finally, the manager has to send the capital to the redeeming investor. For every redemption, the manager has to execute a separate transaction. Once executed, it needs to be reported to the administrator to remove the pending liability. Similarly to the subscription process, the following issues apply:

• up to a few days to settle the wire transaction
• the bank transaction fee (e.g. 20bps/tx)
• the investor’s bank could reject the transaction coming from a (digital asset) fund.
• For in-kind redemption (e.g. USDT), the manager faces the risk of manual error in copy-pasting the address of the redeeming investor.

On-chain Fund

The investors notify the redeeming intention on the Fume’s platform (sending the tokenized shares back to the fund’s smart contract).
At the next NAV calculation, the redeeming amount is automatically computed and added to the fund’s pending liabilities. This redemption can be directly offset from an incoming subscription, or settled by the manager at a later stage with the remaining liabilities (e.g. pending fees).
Multiple redeeming investors at the same time won’t result in any additional manual work from the manager, as they would all be paid automatically from the smart contract. Once again without requiring any report from the manager.

Single Execution

A traditional fund manager has to execute these tasks sequentially, resulting in tedious, time-consuming, and error-prone management.
Although when taken individually, these processes already show a vast improvement with an on-chain administration, the real breakthrough happens when executed simultaneously. 
Let’s finally look at a scenario where in a given month we have:

• 3 incoming subscriptions for a total of $10M (entry fee of 1%)
• 2 redemption requests for a total of $2M (exit fee of 1%)
• A portfolio resulting in management and performance of $1M (combined)

The protocol will perform all the following tasks in a single execution:

• Compute the new NAV calculation
• Issue new fund shares to the subscribing investors
• Burn the fund shares of the redeeming investors
• Send the fees to the manager’s wallet ($1M+$10*1%+$2M*1%=$1.12M)
• Payout the redeeming investors
• Send the remaining liquidity to the fund’s portfolio ($10M-$1.12M-$2M*99%=$6.9M).

Conclusion

The comparison between on-chain and traditional funds clearly demonstrates a substantial shift towards more efficient, transparent, and responsive fund management models. By harnessing the power of blockchain technology, platforms like Fume simplify traditionally complex processes and offer significant improvements in speed and accuracy. 
If you are intrigued by the potential of on-chain fund management and wish to explore how it can benefit your financial strategies, we invite you to get in touch to learn more. Our team at Fume is ready to assist you in setting up your own on-chain fund, guiding you through each step of the process to ensure a seamless and successful transition to this cutting-edge technology.