On January 18, 2018, the staff of the SEC’s Division of Investment Management issued a letter to representatives of the Investment Company Institute (ICI) and the Securities Industry and Financial Markets Association (SIFMA), raising questions concerning how funds holding substantial amounts of cryptocurrencies and related products would satisfy the requirements of the Investment Company Act of 1940. The letter follows the staff’s recent requests to several fund sponsors to withdraw registration statements filed to register such products.
Noting the recent growth in cryptocurrencies and cryptocurrency-related products and the interest among fund sponsors in offering registered funds that would hold these products, the SEC staff emphasized its commitment to fostering innovation in investment products and stated its intention to engage in dialogue with sponsors regarding the potential development of these funds. However, as outlined in the letter, the staff maintained that there are many investor protection issues that must be adequately addressed before sponsors can offer these funds to retail investors. The staff raised several compliance concerns regarding valuation, liquidity and custody, as well as potential issues regarding ETF arbitrage and the potential for manipulation and fraud. The staff invited interested sponsors to engage with the staff to address these concerns.
The SEC staff’s chief concerns are summarized below. The staff stated that until these concerns are adequately addressed by fund sponsors, it would not be appropriate for sponsors to initiate the registration of funds that invest substantially in cryptocurrencies and related products.
- Valuation. Given the requirement that mutual funds and ETFs value their assets every business day and the current volatility, fragmentation and lack of regulation of cryptocurrency markets, as well as the nascent state and low current trading volume in cryptocurrency futures markets, the SEC staff raised several concerns regarding valuation, including:
– Availability of adequate information to value cryptocurrencies and related products;
– How to develop fund policies and procedures to value such products;
– How accounting and valuation policies would address significant events relevant to cryptocurrencies;
– How to determine the eligibility and acceptability for investment of newly created cryptocurrencies; and –
– How to consider manipulation in the underlying cryptocurrency markets when determining settlement prices of cryptocurrency futures contracts.
- Liquidity. Given the need for mutual funds and ETFs to maintain sufficiently liquid assets to satisfy redemptions, as well as considerations regarding Rule 22e-4, the SEC’s new liquidity rule, the SEC staff noted various potential cryptocurrency-related issues relating to liquidity, including:
– How to ensure that cryptocurrency funds have sufficient liquid assets to satisfy redemptions;
– How to classify the liquidity of cryptocurrencies and related products for purposes of Rule 22e-4, including how funds would consider trading history, price volatility, trading volume, market depth and the fragmentation of cryptocurrency markets in determining cryptocurrency liquidity; and
– How to prepare for the possibility that funds investing in cryptocurrency futures could grow to represent a substantial portion of the cryptocurrency futures markets, and how this development may impact portfolio management and liquidity.
- Custody. The 1940 Act imposes safeguards to ensure that funds maintain custody of their holdings, including standards regarding who may act as a custodian and the circumstances in which funds must verify their holdings. The SEC staff noted that it is not aware of a custodian that currently provides fund custodial services for cryptocurrencies. In light of this, the staff raised the following concerns:
– How would a fund that plans to hold cryptocurrencies directly satisfy the custody requirements of the 1940 Act;
– How to validate the existence, exclusive ownership and software functionality of private cryptocurrency keys and other ownership records; and
– To what extent would cybersecurity threats or the potential for hacks on digital wallets impact the safekeeping of fund assets under the 1940 Act.
The SEC staff also raised concerns relating to the settlement of cryptocurrency futures contracts in the context of funds that may invest in cryptocurrency futures. Although bitcoin futures contracts are currently cash settled, the staff noted that in the future cryptocurrency futures contracts may provide for physical settlement, requiring funds that invest in cryptocurrency futures to hold cryptocurrencies directly under certain circumstances. This development would in turn raise custody-related concerns similar to those discussed above.
- ETF Arbitrage. Given the price volatility, fragmentation and low trading volumes in cryptocurrency markets, the SEC staff raised certain concerns regarding the functioning of the arbitrage mechanism for ETFs that may invest in cryptocurrencies, including how such ETFs would comply with the requirement of exemptive orders that the ETF’s market price not deviate materially from net asset value. The staff also asked whether funds have engaged with market makers and authorized participants to understand the feasibility of an effective arbitrage mechanism for cryptocurrency ETFs and how volatility-based trading halts in cryptocurrency futures markets or the shutdown of a cryptocurrency exchange may affect the arbitrage mechanism.
- Potential Manipulation and Other Risks. The SEC staff referenced concerns voiced by SEC Chairman Jay Clayton, among others, and highlighted by recent media reports that cryptocurrency markets provide substantially lower levels of investor protections than traditional securities markets, with correspondingly greater opportunities for fraud and manipulation. In this regard, the staff raised concerns regarding: how the potential for fraud and manipulation may affect considerations of valuation- and liquidity-related issues discussed above; and whether these risks would impact the appropriateness of a cryptocurrency fund for retail investors, suitability determinations and the ability of an adviser to satisfy its fiduciary obligations when investing in cryptocurrency funds on behalf of retail clients.
The SEC staff’s letter is available at: https://www.sec.gov/divisions/investment/noaction/2018cryptocurrency-011818.htm