Risk assurance for hedge funds using zero knowledge proofs

Abstract

This work introduces a new tool for a fund manager to verifiably communicate portfolio risk characteristics to an investor. We address the classic dilemma: How can an investor and fund manager build trust when the two party's interests are not aligned? In addition to high returns, a savvy investor would like a fund's composition to reflect his own risk preferences. Hedge funds, on the other hand, seek high returns (and commissions) by exploiting arbitrage opportunities and keeping them secret. The nature and amount of risk present in these highly secretive portfolios and hedging strategies are certainly not transparent to the investor. This work describes how to apply standard tools of cryptographic commitments and zero-knowledge proofs, to financial engineering. The idea is to have the fund manager describe the portfolio contents indirectly by specifying the asset quantities with cryptographic commitments. Without de-committing the portfolio composition, the manager can use zero knowledge proofs to reveal chosen features to investors - such as the portfolio's approximate sector allocation, risk factor sensitivities, or its future value under a hypothetical scenario. The investor can verify that the revealed portfolio features are consistent with the committed portfolio, thus obtaining strong assurance of their correctness - any dishonest portfolio commitment would later serve as clear-cut evidence of fraud. The result is a closer alignment of the manager's and investor's interests: the investor can monitor the fund's risk characteristics, and the fund manager can proceed without leaking the exact security composition to competitors. © Springer-Verlag Berlin Heidelberg 2005.