At the end of January, Dalia Blass, the Director of Investment Management at the SEC issues a staff letter discussing concerns, asking questions, and seeking input regarding the cryptocurrency asset class and how best it should satisfy the requirements of the 1940 Investment Company Act.
A summary of the questions are below:
- How would funds develop and implement policies and procedures to value/fair value cryptocurrency products?
- How would funds’ accounting and valuation policies address the information related to significant events relevant to cryptocurrencies? (i.e. when blockchain “forks” into different paths and potentially different prices.)
- What policies would a fund implement to identify, and determine eligibility and acceptability for newly created cryptocurrencies offered by promoters? How would a fund account for those holdings?
- How would the differences among various types of cryptocurrencies impact funds’ valuation and accounting policies?
- How would funds consider the impact of market information and any potential manipulation in the underlying cryptocurrency markets on the determination of the settlement price of cryptocurrency futures?
Under a new fund rule 22e-4, funds will be required to implement a liquidity risk management program. Under this rule, funds must classify their investments into one of four liquidity categories and limit their investments in illiquid securities to 15% of the fund’s assets.
- What steps would funds investing in cryptocurrencies or related products take to assure that they would have sufficiently liquid assets to meet daily redemptions?
- How would funds classify the liquidity of cryptocurrency and related products for purposes of the new fund liquidity rule, 22e-4?
- How would a fund prepare for the possibility that funds investing in cryptocurrency related futures could grow to represent a substantial portion of the cryptocurrency related futures markets?
The act of 1940 imposes safeguards to ensure that registered funds maintain custody of their holding. Those include standards regarding who may act as a custodian and when funds must verify their holdings.
- How would a fund holding cryptocurrency directly satisfy the custody requirements of the 1940 Act and relevant rules?
- 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?
- To the extent, a fund plans to hold cryptocurrency related derivatives that are physically settled, under what circumstances could the fund have to hold cryptocurrency directly? If the fund may take delivery of cryptocurrencies in settlement, what plans would it have in place to provide for the custody of the cryptocurrency?
Arbitrage (for ETFs)
In order to promote fair treatment of investors, an ETF is required to have a market price that would not deviate materially from the ETF’s NAV.
- In light of fragmentation, volatility and trading volume of the cryptocurrency marketplace, how would ETFs comply with this term of their orders?
- How would the volatility based trading halts on a cryptocurrency futures market impact this arbitrage mechanism?
- How would the shutdown of a cryptocurrency exchange affect the market price of the arbitrage mechanism?
Potential Manipulation and Other Risks
Concerns have been raised by chairman Jay Clayton noting that the current cryptocurrency market features substantially less investor protection than traditional securities markets, with correspondingly greater opportunities for fraud and manipulation.
- How have these concerns informed your responses to the foregoing questions concerning valuation and liquidity?
- How would you weigh these concerns in considering whether offering a proposed fund is appropriate for the wide range of investors, including retail investors, who might invest in the fund?
- Would investors have sufficient information to consider any cryptocurrency related funds and to understand the risks?
- Have you discussed with any broker-dealers who may distribute the funds how they would analyze the suitability of offering the funds to retail investors in light of the risks discussed?
- Are there particular challenges investment advisers would face in meeting their fiduciary obligations when investing in cryptocurrency related funds on behalf of retail investors?
Per the SEC, until these questions can be addressed, they do 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 SEC has asked sponsors that have registration statements filed for such products to withdraw them.
We will keep you updated on any response and updated rules and regulations. To read the SEC Staff Letter in its entirety, click here.