On January 18, 2018, the staff of the Securities and Exchange Commission (“SEC”) Division of Investment Management (the “IM staff”) issued a letter to the Investment Company Institute (“ICI”) and the Securities Industry and Financial Markets Association (“SIFMA”). In this letter, the IM staff highlights significant investor protection issues presented by certain features of cryptocurrencies and cryptocurrency-related products that the IM staff believes must be addressed before funds investing in cryptoassets are offered to retail investors.1 In particular, the IM staff raised questions related to (1) valuation, (2) liquidity, (3) custody, (4) arbitrage and (5) market manipulation. The specific questions can be found here. The IM staff also formally announced its position that until the questions raised by the IM staff can be addressed satisfactorily, it does not believe that it is appropriate for fund sponsors to initiate registration of funds that intend to invest substantially in cryptocurrency and related products. In addition, the IM staff announced that it does not believe existing funds should file post-effective amendments under Rule 485(a) to register a fund that invests substantially in cryptocurrency or related products.
Valuation
The IM staff expressed its concern that mutual funds, which are required to determine net asset value (“NAV”) on a daily basis, face challenges in determining the value of their cryptocurrency-related holdings given the volatility of the assets, the fragmentation and general lack of regulation of the markets in general and the nascent nature of secondary markets. The IM staff noted that funds must develop appropriate accounting and valuation policies that (1) differentiate among various types of cryptocurrencies, (2) identify and determine acceptability for newly created cryptocurrencies and (3) properly address the distributed ledger technology on which most cryptocurrencies operate (e.g., how would policies account for a “fork,” or divergence, in the blockchain associated with a particular cryptocurrency).
Liquidity
Under the new fund liquidity requirements of Rule 22e-4, mutual funds will be required to implement a liquidity risk management program that classifies the funds’ holdings into one of four liquidity categories ranging from “highly liquid investments” to “illiquid investments.” A fund must limit its investments in illiquid securities to 15% of its assets. The IM staff questioned how funds investing in cryptocurrencies and related products can assure themselves that they have sufficient liquid assets to meet redemptions daily. The IM staff further questioned how cryptocurrency and related products would be classified, noting its concerns with the trading history, price volatility and trading volume of cryptocurrency futures contracts, which would make it difficult for funds to conduct a meaningful market depth analysis and may require them to assume an unusually sizable potential daily redemption amount in light of the potential for steep market declines in the underlying assets.
Custody
The IM staff noted its concerns that mutual funds may not be able to meet their obligations to custody assets with appropriate custodians and verify their holdings, and highlighted that it is currently unaware of any custodian that provides cryptocurrency custodial services meeting the safeguard and asset verification requirements of the Investment Company Act of 1940 (the “1940 Act”). The IM staff questioned how a fund could self-custody cryptocurrency and comply with requirements applicable to such arrangements. The IM staff also questioned how a fund could validate existence, exclusive ownership and functionality of the private keys associated with the cryptocurrencies on the custodian’s books and records. The IM staff also noted that while bitcoin futures contracts are currently cash settled, cryptocurrency derivative products might arise that are physically settled. A fund holding physically settled derivatives must determine how it would custody the cryptocurrency delivered upon settlement.
Arbitrage
Due to the fragmentation, volatility and trading volume of the cryptocurrency markets, the IM staff expressed concerns that ETFs holding such cryptocurrency and related assets would not be able to comply with the requirement that ETFs maintain a market price that does not deviate materially from the ETFs’ NAV, and questioned whether funds have engaged market makers and authorized participants in connection with this issue. Opportunity for arbitrage appears to be ripe in the cryptocurrency futures markets, which underscores the feasibility of arbitrage for ETFs investing in cryptocurrencies and cryptocurrency-related products.
Market Manipulation and Other Risks
The IM staff expressed substantial concern with the opportunity for fraud and manipulation in cryptocurrency markets and highlighted recent media reports pointing to a range of vectors for possible manipulation of cryptocurrency markets. The IM staff pointed out that such concerns should affect even funds that intend to invest in cryptocurreny related products (rather than cryptocurrencies themselves) since the pricing, volatility and resilience of markets for such products generally would be expected to be strongly influenced by the underlying markets. Both broker-dealers and investment advisers would have to consider their respective suitability and fiduciary obligations when offering funds that hold cryptocurrency products to retail investors.
Conclusion
Most of the IM staff’s concerns stem from the high volatility and thinly regulated nature of cryptocurrency markets to date and are rooted in its desire to protect “Main Street,” i.e. retail investors. It seems likely that no registration of funds that invest primarily in cryptocurrency or related assets will be approved until the IM staff has concluded that all of the concerns raised in this letter have been addressed.
The IM staff also notes that there may be registered offerings under the Securities Act of 1933 (the “Securities Act”) by entities holding similar products to cryptocurrencies and related products and pursuing investment strategies similar to funds registered under the 1940 Act, and that those entities would have to comply with the registration and prospectus disclosure requirements under the Securities Act. Given the fact that the registration statement for the Winklevoss Bitcoin Trust has been reviewed by the staff of Corporation Finance since its initial filing in 2013, with no end of the review process in sight, it seems likely that the staff of other divisions of the SEC views cryptocurrency vehicles with similar concern.
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1 Staff Letter: Engaging on Fund Innovation and Cryptocurrency-related Holdings (Jan. 18, 2018)