With 2017 ("The Year of Crypto") in the rearview, business owners, financial advisors, estate planners, legislators, and any individual in regular contact with a millennial is likely asking this progression of questions: "What is Bitcoin? Is it a fraud? How can I invest in cryptocurrencies? How can I invest other people's money in cryptocurrencies?" This article will largely focus on the final question, paying particular attention to unique risk factors that should be included in a cryptofund's Private Placement Memorandum.
However, briefly addressing the first three questions: (1) Bitcoin is a digital "cryptocurrency" that relies on encryption techniques--namely "cryptographic hashing functions"-- to regulate and generate units of value, to verify the transfer of funds, and to run a "trustless" and decentralized ledger that tracks account balances without any support from banking institutions; (2) Bitcoin has been called a "fraud" by JPMorgan Chase's CEO, Jamie Dimon, and a legitimate "store of value" by the Winklevoss twins (the controversial co-creators of Facebook), the debate is still ripe; (3) Buying Bitcoin and alternative cryptocurrencies is as easy as downloading an application on your phone (Coinbase, Robinhood, Poloniex, etc.), linking your bank account, and executing a buy order.
Now, imagine that you have been investing in cryptocurrencies for a year or more, have realized impressive gains, and are ready to start a hedge fund trading exclusively in cryptocurrencies. You are going to need to draft four critical documents: (1) A Company Agreement for the Manager (i.e. "Kirkham Capital, LLC"), (2) a Company Agreement for the Fund (i.e. "Kirkham Fund, LLC"), (3) a Subscription Agreement (including an "Accredited Investor Questionnaire"), and (4) a Private Placement Memorandum ("PPM") describing the investment and disclaiming all contingencies. Drafting a bulletproof PPM that discloses all possible litigious contingencies is critical.
I have identified three categories of risks unique to cryptofunds that ought to be addressed in any fledgling cryptofund's PPM.
(1) Unforeseen Regulatory Risks
Unforeseen regulatory risks are perhaps the most important category of disclaimers because regulation of cryptocurrencies is imminent, but the scope, the promulgating agency, and the impact on your cryptofund remain uncertain. These disclaimers should not only contemplate changes in securities law--perhaps the most direct impact on your ability to manage a cryptofund--but should contemplate changes in tax law and commodities law.
A few examples:
- Adverse regulatory, tax, and legal changes could occur during the fund's operation that could negatively affect the fund's investment or business models.
- Adverse regulation could compromise the legality of the fund and could result in legal or tax liability to the fund's manager and/or the fund's investors.
- It may become illegal to buy, sell, or hold virtual currencies.
- The fund may be negatively affected by unforeseen regulation requiring the fund's manager to register the fund or otherwise satisfy burdensome reporting requirements.
- The fund may be required to disgorge digital assets currently under management in order to comply with unforeseen regulation.
- No assurances can be made about future regulatory schemes and their impact on the fund or the fund's assets.
(2) Cryptocurrencies are Speculative in Value
While there is debate about the inherent value of cryptocurrencies, your mission is to minimize risk by accepting and disclosing that the cryptocurrency market is--at least in part--driven by speculation.
Here is an idea of how:
- The fund invests in speculative tokenized assets that pose a substantial risk of total loss of value.
- There is no assurance that tokenized assets will maintain their short-term or long-term value.
- Tokenized assets held by the fund may have no inherent value and may increase or decrease in value purely based on speculation in the market.
- Investment in Virtual Currencies is Speculative. (intentionally capitalized)
(3) Lack of Liquidity
Lack of liquidity is an essential disclosure. Cryptofunds are especially vulnerable to liquidity squeezes for two reasons: (1) some of the fund's assets will likely be stored "cold"--on hardware wallets--separated from the immediate liquidity of exchanges and (2) exchanges only facilitate the purchase and sale of select tokens.
Cold storage is undoubtedly the safest way to store tokenized assets. On a hardware wallet (a souped-up thumb drive), assets are generally safe from hackers, exchange crashes, exchange glitches, or a meltdown of the protocol. In fact the only major draw back is the reduced transaction speed. Simply put, if the market for a particular token begins to crash, the fund manager will have to transfer assets from "cold storage" to an online exchange and will have to wait for that initial transaction to clear, before finally being able to sell the assets. This additional step can limit an asset's immediate liquidity and subject the fund to a loss.
Similarly, exchanges only support the purchase and sale of select cryptocurrencies. For this reason, the liquidity of certain tokens might be limited depending on the proper functioning of supportive exchanges. For instance, if the only exchange facilitating the purchase and sale of "Token X" goes offline, the fund may be adversely impacted by the sudden inability to sell "Token X." This counterparty risk necessitates disclosures about the fund's reliance on exchanges to buy and sell cryptocurrencies.
- The fund stores tokenized assets on hardware wallets, limiting the fund's ability to immediately sell tokenized assets.
- The fund may be negatively affected by a lack of immediate liquidity due to the fund's current or future custodianship of tokenized assets.
- The fund is reliant on third party exchanges to buy and sell tokenized assets and is therefore subject to liquidity squeezes in the event that a particular exchange is temporarily inaccessible.
The market for cryptocurrencies is rapidly changing, presenting huge opportunities for investors, and in turn, investment managers. But, individuals looking to capitalize on the inefficiencies of the market by offering interests in actively managed hedge funds need to be wary of and disclose the associated risk. The above is just a start, a way to get cryptofund managers thinking long and hard about the immediate risks, unforeseen risks, and those risks currently treated as immaterial.