The Director of the U.S. Securities and Exchange Commission (SEC) Division of Investment Management has outlined concerns of the SEC Staff (Staff) with respect to the registration of funds that hold cryptocurrencies and cryptocurrency-related financial instruments. In a January 18, 2018 letter (Letter) to the President and CEO of the Investment Company Institute and the Head of the Asset Management Group of the Securities Industry and Financial Markets Association, Director Dalia Blass requested engagement by those industry groups and their respective members, as well as fund sponsors, regarding the Staff’s concerns over funds registered under the Investment Company Act of 1940 (1940 Act) holding such investments.
The Letter follows the Staff’s requests to a number of fund sponsors to withdraw initial registration statements filed to register exchange-traded funds (ETFs) structured to obtain exposure to bitcoin through futures contracts. In these requests, the Staff identified valuation and liquidity of the underlying instruments as key concerns that would need to be addressed before a bitcoin ETF could be brought to market. These were included among the five categories of concern identified by Director Blass in the Letter: (i) valuation; (ii) liquidity; (iii) custody; (iv) arbitrage (for ETFs); and (v) potential manipulation and other risks.
With respect to each category of concern, Director Blass posed questions aimed at how funds holding cryptocurrencies and cryptocurrency-related financial instruments could fit within the current regulatory framework of the 1940 Act. While the Staff’s invitation did not foreclose the possibility that registered cryptocurrency-related funds could be offered at some point in the future, the Letter makes clear that “[u]ntil the questions identified [in the Letter] can be addressed satisfactorily, [the Staff] do[es] not believe that it is appropriate for fund sponsors to initiate registration of funds that intend to invest substantially in cryptocurrency and related products.”
The following is a discussion of the areas of focus in the Letter.
Cryptocurrencies, including bitcoin, are subject to volatile price fluctuations. The Letter notes the important role valuation plays in determining fund performance and investor fees, as mutual funds and ETFs must value their underlying portfolio holdings on a daily basis (including any holdings of cryptocurrencies or related instruments). The Letter asks how these products would be valued (or fair-valued), and whether differences among various types of cryptocurrencies would require revision of a fund’s valuation and accounting policies and procedures.
Given the unique characteristics of cryptocurrencies and the rapidly-evolving blockchain technology upon which they are built, the Staff also expressed concerns regarding how funds would address a situation “when the blockchain for a cryptocurrency diverges into different paths (i.e., a ‘fork’), which could result in different cryptocurrencies with potentially different prices.” When a fork occurs, holders of a particular cryptocurrency are given an additional, second, newly-formed cryptocurrency, whose initial trading price often diverges significantly from the price of the original cryptocurrency. In light of questions such as these, when preparing valuation policies and procedures, funds should consider whether to use a uniform valuation approach for all cryptocurrencies or a tailored approach based on the characteristics of a particular cryptocurrency.
The Staff also discussed valuation concerns with respect to investments in the nascent cryptocurrency futures market. As background, in early December 2017, both CME Group Inc. and Cboe Global Markets Inc. listed derivatives contracts for bitcoin, offering bitcoin futures contracts that are settled in U.S. dollars.1 For funds considering investments in cryptocurrency futures, the Letter asks fund sponsors to consider and to explain “the impact of market information and any potential manipulation in the underlying cryptocurrency markets on the determination of the settlement price of cryptocurrency futures.”
The Letter raises questions regarding how cryptocurrency-related holdings would be treated under new Rule 22e-4 of the 1940 Act (Liquidity Rule). Under the new liquidity classification requirement, non-money market mutual funds (except “in-kind ETFs”) will be required to classify the liquidity of their portfolio investments into one of four liquidity categories, and impose a 15% limit on illiquid investments.2 The Letter requests fund sponsors to clarify how a fund investing in cryptocurrencies or related products would ensure that the fund would have sufficient liquidity to satisfy the requirements of the Liquidity Rule and meet daily redemption requests. For example, the Letter asks whether funds would classify the liquidity of cryptocurrency and related products as other than illiquid under the Liquidity Rule. Fund sponsors would need to consider whether funds holding cryptocurrency would necessarily have to limit their holdings of such currency to the 15% illiquid bucket. Given that cryptocurrency liquidity is driven by trading volume and frequency, with some cryptocurrencies (e.g., bitcoin) having a higher trading volume than others, a response to the Staff’s liquidity concerns may depend both on the type of cryptocurrency and the exchanges on which the fund invests.
The Staff also expressed liquidity concerns with respect cryptocurrency futures, questioning how to address “the possibility that funds investing in cryptocurrency-related futures could grow to represent a substantial portion of the cryptocurrency-related futures markets … [and how] such a development [might] impact the fund’s portfolio management and liquidity analysis.”
Section 17(f) of the 1940 Act subjects funds to certain requirements with respect to the safe custody of their assets. The concept of custody is not a natural fit for cryptocurrencies, which are held in digital wallets and accessed using private cryptographic keys. Given the complexities of storing digital assets, it may be difficult to engage a qualified custodian to provide custody of cryptocurrencies. In fact, the Letter notes that the Staff is unaware of a custodian currently providing such services. The Letter asks how a fund might satisfy the 1940 Act’s custody requirements if the fund holds the cryptocurrency directly, or if it holds cryptocurrency-related derivatives that are physically settled (which are not currently offered, but may be in the future).
Additionally, the Letter highlights several security-related concerns relating to holdings of cryptocurrencies. For example, the Letter asks “how would a fund intend to validate existence, exclusive ownership and software functionality of private cryptocurrency keys and other ownership records? To what extent would cybersecurity threats or the potential for hacks on digital wallets impact the safekeeping of fund assets under the 1940 Act?”
Fund sponsors may wish to consider the method of cryptocurrency storage, as a first step, in an offline “cold wallet” format as a method of addressing some of the Staff’s concerns. Cold wallets are used as offline storage with no connection between the wallet and the internet, unlike a “hot wallet” in which cryptocurrencies are stored in an electronic format that is almost always connected to the internet.
The large number of 1940 Act products proposing to provide exposure to cryptocurrencies have been ETFs. The Letter addresses concerns with respect to the application of the ETF arbitrage process in cryptocurrency ETFs. Historically, a primary concern of the SEC in granting ETF sponsors the necessary relief to launch ETFs has been the ETF arbitrage mechanism, which ensures that ETF shares trade in the marketplace at or close to net asset value. The Letter asks for a consideration of the impact of cryptocurrency on the arbitrage process with questions including: “Have funds engaged with market makers and authorized participants to understand the feasibility of the arbitrage for ETFs investing substantially in cryptocurrency and cryptocurrency-related products? How would volatility-based trading halts on a cryptocurrency futures market impact this arbitrage mechanism?”
Potential Manipulation and Other Risks
Referring to SEC Chairman Jay Clayton’s previously expressed concerns regarding the cryptocurrency markets, the Letter indicates that “cryptocurrency markets, as they are currently operating, feature substantially less investor protection than traditional securities markets, with correspondingly greater opportunities for fraud and manipulation.”3 The Letter questions whether “investors, including retail investors, have sufficient information to consider any cryptocurrency-related funds and to understand the risks” associated with such funds. The Letter also asks how broker-dealers designated to distribute cryptocurrency-related funds “would analyze the suitability of offering the funds to retail investors in light of the risks.”
Ramifications for Other Fund Structures
While the Letter was issued by Director Blass on behalf of the Division of Investment Management, and thus primarily references issues arising under the 1940 Act for potential registered cryptocurrency funds, the Letter also stated that:
[t]he resolution of many of the questions we have raised in the context of a product seeking to register under the 1940 Act will also be important to the ongoing analysis of filings for exchange-traded products and related changes to exchange listing standards by the Division of Corporation Finance, the Division of Trading and Markets and the Office of the Chief Accountant….We have been and will continue working closely with the other Divisions and Offices as we analyze these significant issues.
Accordingly, certain of the concerns raised in the Letter may also be relevant for proposed cryptocurrency funds that would be publicly offered under the Securities Act of 1933, as amended, but would not be 1940 Act funds.
Currently, retail investors represent the majority of the market for bitcoin and other cryptocurrencies. As a result, the SEC is confronted with the difficult decision of whether (and on what basis) to give those retail investors access to the protections of the 1940 Act. The Letter demonstrates that the Staff is open to discussion and notes that “[f]lexibility to innovate is also a key feature of the [1940 Act].” However, in light of the Staff’s previous requests that sponsors withdraw registration statements filed for cryptocurrency-related ETFs, as well as the extent of the questions and concerns outlined in the Letter, it may take some time before the Staff will allow a cryptocurrency-related 1940 Act fund to be offered.
While the Letter may initially seem discouraging for those hoping for registered cryptocurrency funds to be offered in the near future, the Letter’s transparency regarding Staff concerns provides clarity over what must be addressed in order to offer such funds. As the cryptocurrency markets (and related futures markets) evolve and mature, and fund sponsors engage with regulators regarding the concerns raised in the Letter, the possibility remains for cryptocurrency-related funds (whether or not registered under the 1940 Act) to eventually be offered to retail investors.