Risks, Indemnification, and Subsequent Events
Risk Factors
Management of the LLP seeks investment opportunities that offer the possibility of attaining substantial capital appreciation. Certain events particular to the industry in which the LLP invests, as well as general economic and political conditions, may have a significant negative impact on the LLP’s operations and profitability. In addition, the LLP is subject to changing regulatory and tax environments. These events are beyond the LLP’s control, and the likelihood that they may occur cannot be predicted. Furthermore, most of the LLP’s investments are made in private digital assets. Realization of the amounts invested are contingent in part upon liquidation, redemption or disposition of such investments. The amount to be realized, and the timing of such realization cannot be accurately estimated by the LLP at this time. Many risks affect more than one investment, and can compound. The risks are not in order of significance or probability of occurrence The fair value of the LLP’s investments could decline, and investors could lose part or all of your investment.
The LLP is subject to a number of risks and uncertainties, including those risks discussed at length below. These risks include, among others, the following, which we consider our most material risks:
- Our operating results have and will significantly fluctuate, including due to the highly volatile nature of crypto;
- Our income is substantially dependent on the prices of crypto assets. If the price of crypto assets declines, our business, operating results, and financial condition would be adversely affected;
- The future development and growth of crypto is subject to a variety of factors that are difficult to predict and evaluate. If crypto does not grow as we expect, our business, operating results, and financial condition could be adversely affected;
- Cyberattacks and security breaches of our systems, could adversely impact our investors, brand and reputation and our business, operating results, and financial condition;
- We are subject to an extensive, rapidly-evolving and uncertain regulatory landscape and any adverse changes to, or our failure to comply with, any laws and regulations could adversely affect our investors, brand, reputation, and financial results.
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Market Risk
Generally
Market risk refers to the possibility that the value of cryptocurrencies and other investments that the LLP may hold fluctuates due to changes in market prices, which could be influenced by various factors related to individual cryptocurrencies, their issuers, or broader market trends. It's important to note that all investments carry some level of risk, including the potential for loss of capital. For the LLP, the maximum risk associated with cryptocurrencies is equal to their fair value. In addition to this, there may be other market risks that affect the Fund's investments, stemming from uncertainties about future prices of the instruments.
Market & Liquidity Risk
The digital assets market in general tends to be more volatile when compared to traditional asset classes. Some digital assets inventory are less liquid than others. In addition, there is no single source of liquidity for digital assets, leading to a situation of fragmentation. These features of the digital asset markets may impact both the LLP’s own holdings or/and the digital asset market as a whole.
During times of heightened market stress and reduced liquidity, the inventory of digital assets listed and traded on centralized and decentralized digital asset exchanges may be vulnerable to sudden and significant price drops, known as "flash crashes". Digital asset markets are open 24 hours a day, which can result in significant fluctuations in liquidity levels. Furthermore, trading on such exchanges typically does not have trading curbs or circuit breakers.
Unfavorable media coverage Risk
The LLP and multiple unrelated entities share the same "Delphi Digital" brand. Unfavorable publicity related to certain investments, personnel, or business decisions could negatively impact our reputation and, in turn, indirectly affect the financial performance of our investments and our operating team.
Custody and Security Risk
Private key risk
Digital assets are stored in a digital wallet, and can only be accessed by the person who possesses the private key associated with that wallet. Each private key is unique to its respective blockchain. If a private key is lost, destroyed, or otherwise compromised, the LLP may not be able to access the digital assets associated with that key, which could result in a significant or even total loss of investment. Additionally, any damage or loss of the digital wallet used to store the Fund's digital assets could have a negative impact on the Fund's investment.
Security breaches, software errors or bugs damaging an exchange or blockchain
Security breaches, software errors, bugs, or unauthorized code could potentially harm a blockchain or exchange, which in turn could have negative consequences for the LLP's holdings and/or the broader digital asset market.
Transfer of funds risk
The LLP transfers value to many counterparties in the course of business as usual operations. These transfers include, but are not limited to: distributions to members, expense payments, and liquidation operations. There is a risk that these transfers may fail due to error (e.g., wrong address) and a direct loss would be realized by the fund.
Consensus risk
The consensus algorithm used by a blockchain network may have vulnerabilities that could be exploited by malicious actors, leading to a disruption of network operations or compromise of data integrity. A flaw in the consensus algorithm could also lead to the forking of the blockchain, resulting in a split in the network and potentially invalidating past transactions. Additionally, changes to the consensus algorithm may require a hard fork, which can be contentious and disruptive to the community. These risks could result in a loss of trust in the network, damage to the reputation of the blockchain, and financial losses for investors.
For example, there are certain risks associated with blockchains that use 'proof-of-stake' (PoS). One such risk is the potential for malicious actors who hold a significant share of the total available digital assets in the blockchain to engage in unilateral actions that could harm the network. These actions may include double-spending, forking, stopping and rejecting transactions, and preventing new transactions from being confirmed. If such actions were to occur, they could have a negative impact on both the LLP's holdings and the digital asset market as a whole.
Staking risk
The LLP engages in staking or delegating tokens to validate blocks of transactions on a network, or to receive rewards from decentralized applications. Validators who engage in staking earn rewards and can participate in project governance through voting. However, staking may involve a lockup period during which the delegated tokens cannot be moved or traded, thereby limiting the LLP's liquidity and ability to trade at market prices. Furthermore, some networks may have "slashing" mechanisms that penalize bad behavior by validator nodes, resulting in a loss of staked tokens that are redistributed to other stakeholders.
Custody Risk
The LLP holds its investments in digital assets in custody with financial institutions, digital asset custodians and/or trading counterparties such as digital asset exchanges. The LLP may have group concentrations of credit risk with the third - parties that hold its assets in custody. In the event of a custodial party’s insolvency, the LLP may be unable to recover some or all of its assets on deposit with that party, resulting in a partial or even total loss of capital.
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As of December 31, 2022, the LLP custodied assets at the following:
- Multisignature self-custody solutions
Cybersecurity Risk
As part of the ongoing business and operations of the LLP, the Partnership may utilize, process, store and transmit information on its internal and external systems and technology platforms. This will include software both developed in-house by the Investment Manager (and its affiliates) along with software licensed or utilized from a third-party service provider or a software development company. As such, there are operational risks that stem from the use of such technologies, and information security risks (collectively cybersecurity risk). Where there are bugs, breaches, failures leading to cybersecurity risk, this may have an impact on the ongoing business and operations, and as such, potentially negatively impacting the performance of the LLP, and cause it to be unable to continue operating during the duration of the impact by the cybersecurity risk.
Additionally, any security breaches or cyber attacks targeting other financial institutions or cryptocurrency companies, even if not directly affecting us, could lead to a decline in customer trust in the crypto economy and the use of technology for financial transactions. This could have adverse effects on us, including the perception of the effectiveness of our security measures and technology infrastructure.
DeFi Risk
The LLP holds investments in various DeFi protocols. The LLP's investments in DeFi protocols are facilitated by self-executing smart contracts, which, for example, allow users to invest in a pool and enable borrowing without intermediaries. These investments offer interest to investors based on borrower repayment rates and can typically be withdrawn without constraints. However, DeFi protocols are not immune to various risks, such as insecurity in the underlying smart contract, the possibility of borrower defaults resulting in loss of investment, fluctuations in the underlying collateral, and the potential for unauthorized modifications to the smart contract by certain core developers with administration rights. If any of these risks come to fruition, the LLP's investments may suffer negative consequences.
Risks Related to Portfolio Companies
Development team risk
Digital asset and blockchain networks typically involve various key actors and stakeholders, including the founding development teams (core), unaffiliated external development teams, and independent foundations responsible for network governance. These actors may face external challenges, such as litigation or regulatory action, which could impede or adversely affect the development of the blockchain network or digital assets involved.
Counterparty Risk between the LLP and Portfolio Companies
We are subject to various counterparty risks, including nonperformance risks, where our portfolio companies may not be able or willing to fulfill their respective obligations under the relevant contracts. In the case of non-performance, our fund's investments in or with foreign portfolio companies and/or development teams may be subject to significant risks associated with limited enforcement abilities under the applicable contracts. In particular, when investing in companies located in different jurisdictions, the fund may face challenges in enforcing its contractual rights due to differences in legal systems, regulatory frameworks, and enforcement mechanisms. This can result in the fund being unable to protect its interests effectively or to recover losses in a timely manner, which could negatively impact the overall performance of the fund.
Furthermore, the varying levels of legal protection and transparency across jurisdictions can create additional uncertainties and complexities when dealing with foreign investments. This may include difficulty in obtaining accurate information about the company's financial health, governance practices, or business operations, which could hinder the fund's ability to make informed investment decisions and monitor the performance of its investments.
In addition to the aforementioned risks associated with foreign investments, we face uncertainties related to litigation and potential significant costs when seeking to enforce our contractual rights with any investment. The cost of litigation can significantly impact the fund's financial performance, as it may be required to allocate substantial resources, including legal fees and management time, to resolve disputes or protect its interests in its investments. Additionally, the outcome of litigation can be uncertain, and even if the fund prevails, it may not be able to recover its full investment or the associated legal costs.
Moreover, the potential reputational risks stemming from litigation could have an adverse impact on the fund's ability to attract new investments or maintain positive relationships with stakeholders. Prolonged litigation or disputes may also distract the fund's management from focusing on its core investment activities, further exacerbating the negative impact on its performance.
Regulatory Risk
Generally
Regulatory developments, adverse regulatory action, legislative developments and political action may impact prices of digital assets inventory and undermine the viability and usage scenarios of a blockchain(s). This may affect both the LLP’s own holdings or/and the digital asset market as a whole.
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The regulatory classification of digital assets (both for specific digital assets and blockchain networks and for digital assets inventory generally) is relatively unclear on a global level, with various financial regulators, intergovernmental institutions, national treasuries and tax authorities issuing various declarations as to the status and nature of digital assets inventory. Digital assets have, in the past, been classified as the following: Currency, commodity and security. An adverse classification of digital assets may have regulatory and legal implications, which may undermine the viability of digital assets inventory and blockchain networks and impact the prices of digital assets in specific instances or in general.
Regulatory Risk related to Fund Operations
Due to its focus on crypto investments, the fund faces various risks related to its investment, sales of tokens, and advisory activities, including potential litigation risks and regulatory scrutiny. The fund's involvement with any given crypto investment, particularly if the fund is a lead investor, could expose it to legal challenges, regulatory enforcement actions, or reputational damage that may adversely impact its performance and ability to achieve its investment objectives.
The fund's investments in tokens related to its core activities may attract increased scrutiny from regulatory authorities. This could result in investigations or enforcement actions against the fund or its investments for perceived violations of securities laws, or other applicable rules. Regulatory actions may lead to fines, penalties, restrictions on the fund's operations, or requirements for additional compliance measures, which could increase the fund's operating costs and hinder its ability to achieve its investment objectives. Further, the fund may be exposed to claims or lawsuits arising from disputes over its investment activities, the execution of its advisory roles or sales of tokens. The cost of defending against such litigation, as well as the potential damages or settlements, could have a material impact on the fund's financial condition and overall performance.
The aforementioned risks may be heightened if the fund operates as a lead investor and/or advisor with respect to a particular investment.
Risks Associated with DAOs
The fund faces various regulatory risks and uncertainties associated with its participation in Decentralized Autonomous Organizations (DAOs), including voting on governance proposals in light of the CFTC’s Ooki DAO enforcement actions. As the regulatory landscape for DAOs and digital assets continues to evolve, there is a possibility that a fund's engagement with DAOs, including its voting activities, may attract increased scrutiny from regulatory authorities, leading to potential liabilities, fines, penalties, or restrictions on the fund's operations. The Ooki DAO enforcement actions serve as an example of how regulatory authorities may pursue actions against DAOs and their participants for perceived violations of applicable regulations. As a participant in DAO voting, the fund may be exposed to a variety of risks, including:
- Regulatory uncertainty: The legal and regulatory status of DAOs and their activities is still developing, and the fund's participation in DAO voting could be subject to new or changing regulations, interpretations, or enforcement actions that could negatively impact its operations or investment strategies.
- Liability for non-compliance: If the DAO in which the fund participates is found to be in violation of applicable laws or regulations, the fund may be held liable for its involvement or deemed to be complicit in the non-compliant activities. This could result in fines, penalties, or other adverse consequences for the fund and its investors.
- Reputational risk: Association with a DAO that faces regulatory enforcement actions or is deemed to be non-compliant with applicable laws may harm the fund's reputation, which could adversely affect its ability to attract new investments, maintain relationships with existing investors, or engage with other stakeholders in the market.
- Operational risk: Increased regulatory scrutiny or enforcement actions may require the fund to allocate additional resources to compliance efforts, diverting management attention and resources away from the fund's core investment activities and potentially impacting its performance.
Given these risks, the fund's participation in DAOs and exposure to the rapidly evolving regulatory landscape for DAOs could have a material impact on the fund's performance, financial condition, and ability to achieve its investment objectives.
Accounting and Tax Risks
Generally
The absence of comprehensive legal and tax guidance for crypto assets, coupled with their new and evolving nature, renders the tax treatment of crypto asset products and transactions uncertain. It remains unclear whether, when and what guidance may be issued in the future on the treatment of these transactions for U.S. and foreign income tax purposes. The IRS has released some guidance on virtual currency, but other significant aspects of the U.S. federal income tax treatment of crypto assets and related transactions are still unaddressed. There is also uncertainty with respect to the timing, character, and amount of income inclusions for various crypto asset transactions, including staking rewards and other products we offer. While we believe our treatment of crypto asset transactions for federal income tax purposes aligns with existing guidance, we acknowledge that disagreements with the IRS and various U.S. states may arise due to the constantly changing nature of crypto asset innovations and transactions. Such disagreements could have adverse effects on our customers and the vitality of our business. These uncertainties exist in foreign markets as well and may impact our non-US. customer base. Any changes in existing IRS, US state and foreign tax authority positions or new guidance regarding crypto asset products and transactions could result in adverse tax consequences for holders of crypto assets and could have an adverse effect on the value of crypto assets and the broader crypto assets markets. Additionally, future technological and operational developments with respect to crypto assets may increase the uncertainty surrounding their tax treatment, which could impact our business, both domestically and abroad.
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Accounting Risks due to the limited guidance from accounting standard setting bodies
The accounting rules and regulations that we must comply with are complex and subject to interpretation by the Financial Accounting Standards Board (the “FASB”), the SEC, and various bodies formed to promulgate and interpret appropriate accounting principles. A change in these principles or interpretations could have a significant effect on our reported financial results, and may even affect the reporting of transactions completed before the announcement or effectiveness of a change. Any changes or uncertainties in regulatory or financial accounting standards could require us to adjust our accounting methods, restate our financial statements, and potentially affect our ability to provide timely and accurate financial information. This could harm our financial statements, lead to a loss of investor confidence, and have a broader impact on our business operations and financial health.
Risks related to Effectively Connected Income
We may face risks related to Effectively Connected Income (ECI), which could result in adverse tax consequences for our international investors. If ECI is not effectively blocked, we could be subject to significant tax liabilities in foreign jurisdictions and our international investors could be subject to adverse tax consequences, which could negatively impact their investment returns and our ability to attract and retain international investors. Any changes to tax laws or regulations related to ECI, including the interpretation or enforcement of such laws or regulations, could also increase our exposure to tax liabilities and negatively impact our financial condition and results of operations.
Personnel and Service Provider Risk
Employee or Service Provider Risk
Employees or service providers, which could harm our reputation and negatively affect our operations. Employee misconduct may involve unauthorized transactions or activities, misappropriation of customer funds, insider trading, or misuse of confidential information. Additionally, employee or service provider errors such as mistakes in executing, recording, or processing transactions for customers may result in material losses, even if the errors are detected. While we have implemented processes and procedures to reduce the likelihood of misconduct and error, the risk of such incidents may be higher for novel products and services. It may not be possible to prevent all misconduct, and our precautions to prevent and detect this activity may not always be effective. If we fail to meet our regulatory oversight and compliance obligations, we could face regulatory sanctions, financial penalties, and restrictions on our activities. Our reputation may also suffer if our employees, contractors, or agents commit errors that result in financial liability, or if we are accused of improper trading activities by regulatory or criminal authorities.
Key Man Risk
Our success heavily relies on our Management team, as well as other essential employees across various departments legal and operations. As a new and highly technical industry, our business is reliant on the expertise and contributions of these individuals. Losing any key personnel could significantly disrupt our operations and negatively impact our business.
Indemnification
In the normal course of business, the LLP enters into contracts and agreements that contain a variety of representations and warranties and which provide general indemnifications. The LLP’s maximum exposure under these arrangements is unknown, as this would involve future claims that may be made against the LLP that have not yet occurred. The LLP expects the risk of any future obligation under these indemnifications to be remote.