In this Ropes & Gray podcast, asset management partners Brian McCabe and Paulita Pike, and counsel Ed Baer, discuss digital assets and the ways these assets may be included in registered funds.
Paulita Pike: Hello, and thank you for joining us today on this Ropes & Gray podcast. I'm Paulita Pike, a partner in the Chicago office of Ropes & Gray. Joining me today are two of my colleagues from the asset management practice group—Brian McCabe, a partner in our Boston office, and Ed Baer, a counsel in our San Francisco office. In this podcast, which is part of a series of podcasts on asset management issues, we will discuss cryptocurrencies and digital assets, and the ways registered funds might be able to incorporate these assets into their investment portfolios. There is a lot of ground to cover on this topic, so we’ve focused on what we think are the key issues. Before we jump into investment options for registered funds, we should talk a bit about the regulation of these assets. Ed, can you summarize some of the key regulatory issues relating to cryptocurrencies and digital assets?
Ed Baer: Sure. Bitcoin was first conceived in 2009, and for several years, it seemed to fly below the regulatory radar. But eventually, regulators took notice of emerging digital assets, and in 2015, the Commodity Futures Trading Commission asserted that virtual currencies such as bitcoin are commodities.
Not to be outdone, the SEC began to consider how or whether to regulate digital assets. In 2017, the SEC issued the so-called DAO Report, which looked at digital assets through the lens of the “Howey Test,” which seeks to determine whether an asset is an “investment contract” and therefore a security under the Securities Act of 1933. An investment contract represents an investment of money in a common enterprise with a reasonable expectation of profits to be derived from the entrepreneurial or managerial efforts of others. Several times in the years since the DAO Report, the SEC has reaffirmed its reliance on the Howey Test and used Howey to establish a detailed framework to analyze whether cryptocurrencies are investment contracts. Somewhat complicating matters is the fact that SEC Division of Corporation Finance Director William Hinman, asserted in 2018 that Bitcoin and Ethereum are not securities. In contrast, in an action filed against Ripple Labs, the SEC has asserted that Ripple’s digital asset token, XRP, is a security. As a result, there is a lack of clarity on which cryptocurrencies or digital assets are securities, which has significant regulatory implications. It also means that there are instances in which the SEC will have no regulatory standing and that could leave a regulatory void to the extent other regulators don’t have the standing to step in.
Paulita Pike: That’s very helpful, Ed—thank you. Brian, can you tell us about what kind of guidance the SEC has given on cryptocurrency investment vehicles?
Brian McCabe: Well, for starters, to date the SEC has only allowed one registration statement to go effective under the 1933 Act for a registered fund that invests primarily in cryptocurrencies, and has specifically disapproved the listing of numerous Bitcoin-based exchange-traded products. Back in 2013, the Winklevoss twins sought to launch the first “physical” Bitcoin ETF. That process dragged out for a number of years, and in 2018, the listing for that ETF was disapproved by the SEC. Since that time, the SEC has disapproved several other Bitcoin filings, including one by Bitwise. The reasons cited for these disapprovals include the inability of the listing exchange to identify and deter fraudulent and manipulative acts and practices due in part to the lack of a surveillance-sharing agreement with a regulated market of significant size.
Around the same time as the Winklevoss disapproval, Division of Investment Management Director Dalia Blass issued a letter to SIFMA and the ICI raising a number of concerns relating to registered investment companies and cryptocurrencies. The Blass letter raised concerns regarding valuation, liquidity, custody, the ability of market participants to conduct arbitrage transactions for ETFs, potential manipulation and other risks. In addition, the letter addressed the SEC staff’s request that registration statements for Bitcoin futures-based ETFs be withdrawn.
So far, the only registration statement for a product primarily investing in cryptocurrency that the SEC has allowed to become effective is a closed-end interval fund that invests in Bitcoin futures and which is limited to an offering size of $25 million. In a speech, Director Blass explained that this fund was approved because it addressed the concerns set forth in her letter. She explained that the fund values its Bitcoin futures holdings at daily settlement prices reflected on a CFTC-registered futures exchange, and that the fund addressed custody issues by investing in cash-settled futures so that it will not hold digital assets directly. She also noted that, as a closed-end interval fund, the fund will not be subject to unexpected liquidity demands and its pricing will not depend on an efficient arbitrage mechanism.
Paulita Pike: Thanks for the helpful information, Brian. The regulation of crypto continues to evolve. Chairman Gensler and the SEC staff have also weighed in recently on Bitcoin and Bitcoin futures. Chairman Gensler recently said of Bitcoin, “It’s a digital, scarce store of value, but highly volatile,” adding that there are “investors that want to trade that, and trade that for its volatility, in some cases just because it [has] lower correlation with other markets. I think we need greater investor protection here.” In a recent staff statement on registered funds’ use of Bitcoin futures, the Division of Investment Management encouraged investors interested in investing in a registered fund with exposure to Bitcoin futures to carefully consider the risk disclosures, the investor’s own risk tolerance, and the possibility of loss. The SEC stated, “Investors should understand that Bitcoin, including gaining exposure through the Bitcoin futures market, is a highly speculative investment. As such, investors should consider the volatility of Bitcoin and the Bitcoin futures market, as well as the lack of regulation and potential for fraud or manipulation in the underlying Bitcoin market.” Noting that some registered funds are investing or seeking to invest in Bitcoin futures, the statement made clear that the SEC staff will closely monitor such funds’ ongoing compliance with the Investment Company Act and other federal securities laws. In addition, the statement notes that the SEC staff will closely monitor the impact of funds’ investments in Bitcoin futures on investor protection, capital formation, and the fairness and efficiency of markets. As part of this monitoring, the staff expects to (i) analyze the liquidity and depth of the Bitcoin futures market given regulatory requirements relating to mutual fund liquidity; (ii) they will also analyze funds’ ability to liquidate Bitcoin futures to meet daily redemption demands; (iii) monitor the efficacy of funds’ derivatives risk management and liquidity risk management programs; (iv) monitor funds’ valuations of Bitcoin futures holdings; (v) assess the ongoing impact of the potential for fraud or manipulation in the underlying Bitcoin markets and Bitcoin futures market; and (vi) consider whether the Bitcoin futures market could accommodate ETFs given that ETFs, unlike traditional mutual funds, cannot ordinarily reject purchase orders, and therefore could grow very large, which could affect liquidity in the nascent Bitcoin futures market.
Ed Baer: Alright. Now that we’ve discussed what the SEC thinks about cryptocurrency investments, we should talk about what potential investment opportunities are out there. To start with, there are eight Bitcoin ETPs on file with the SEC, and the listing exchanges for several of these have filed rule changes under Rule 19b-4. To date, however, the SEC has rejected the listing of all crypto ETPs, and it’s not clear that they’re going be approved in the near-term.
One way registered funds have obtained crypto exposure is to invest in over-the-counter (or “OTC”) trust vehicles, such as the Grayscale Bitcoin Investment Trust (ticker GBTC) or the Bitwise 10 Crypto Index Fund (ticker BITW). These funds sell new shares in Regulation D offerings to accredited investors only. Transfers of these restricted shares may only be made pursuant to Rule 144, and only after a holding period. Thereafter, the shares may be traded in the OTC market. There is no redemption mechanism, so these features impede arbitrage, which has led to significant premiums (sometimes in excess of 100%). Single asset trusts, like GBTC, are taxed like grantor trusts, while multi-asset trusts, like BITW, are taxed like partnerships. But there are some others ways for registered funds to gain exposure, right Brian?
Brian McCabe: That’s right. As we noted earlier, there are cash-settled Bitcoin and Ethereum futures contracts available on the CME, and there are other derivatives available, including “physically” settled Bitcoin futures contracts available through other exchanges, and cryptocurrency options and swaps available from a number of sources. Because these assets are similar to other types of derivatives, they don’t necessarily raise the same operational concerns—custody, valuation and liquidity—as “physical” cryptocurrencies. A number of fund sponsors have begun investing in these derivatives, and we expect that more firms will follow suit. Another way registered funds can gain exposure to cryptocurrency and related assets is through investments in ETFs and other funds. There are traditional ETFs that provide exposure to crypto or blockchain companies, as well as the closed-end interval fund we mentioned earlier that invests in Bitcoin futures. There are also private funds that invest in crypto assets. In addition to the risks of investing in crypto assets, these private funds may raise liquidity concerns, so it’s important for registered funds to understand the liquidity terms of these investments.
Additional possibilities include investments in Canadian crypto ETFs, investments in companies that have crypto exposure and direct investments in “physical” crypto. Canadian regulators have recently approved Bitcoin and Ethereum ETFs that may eventually be made available in U.S. OTC markets. Registered funds may also seek indirect exposure to crypto through investments in companies like Microstrategy that have significant investments in crypto assets on their balance sheets. Finally, while we are not aware of any registered fund that invests directly in cryptocurrency, it seems possible that funds might be able to address the SEC staff’s custody concerns with respect to “physical” crypto. In any event, investing in crypto using a derivative or through another fund or company doesn’t present the same challenges as attempting to hold “physical” Bitcoin through a qualified custodian.
Paulita Pike: Okay. Well, what’s clear from the SEC pronouncements and the disclosures that fund sponsors have made is that crypto investments raise a variety of operational, compliance and disclosure concerns. One of the principal challenges is custody. Custody concerns include potential cybersecurity risks, including the potential for theft or misappropriation of crypto assets, the availability of insurance in the event of such losses, and the processes for auditing and oversight of custody controls. Crypto trading is another potential concern, since there are questions regarding who has custody of crypto assets during the trading process. For instance, if the crypto exchange is not itself a qualified custodian or otherwise a registered entity, such as a securities exchange or broker-dealer, funds must consider the implication of transacting with an unregulated entity. In addition, funds must consider which crypto assets the exchange provides access to since not all crypto assets are available on each crypto exchange.
From a compliance standpoint, funds and sponsors have to consider the status of crypto under personal trading policies. For example, funds must consider whether cryptocurrencies are “covered securities” and whether reporting and pre-clearance requirements should apply. In addition, funds must determine how crypto assets fit under their liquidity risk management program and, if applicable, their derivatives compliance programs. Fund and adviser CCOs will need to develop and implement compliance controls to oversee any crypto investments.
Finally, funds must make adequate disclosure regarding the risks of investing in crypto. This will include not only registration statement and SEC filings disclosure, but also disclosure to fund boards regarding the crypto assets and other assets the funds will invest in. We expect that this board disclosure may involve significant educational efforts to respond to board questions about the risks of these investments and how crypto assets will be used by the funds. With the hype about cryptocurrency, as well as the regulatory uncertainty regarding the treatment of crypto assets, we expect that there will be increased challenges and opportunities for registered funds looking to provide exposure to crypto.
Ed Baer: That brings us to the end of the podcast. Paulita, Brian and I want to thank all of you for joining us on this discussion of how registered funds can invest in cryptocurrency or digital assets. For more information on the topics that we’ve discussed or other topics of interest to asset managers, please visit our website at www.ropesgray.com, where we have links to additional materials regarding these topics. To help you better understand the current asset management landscape, we will be issuing additional podcasts designed to provide a greater depth of analysis on important and timely issues. If you have any questions regarding the topics we addressed or anything else, please don't hesitate to get in touch with one of us or whoever you have a working relationship with at Ropes & Gray. You can also subscribe and listen to the series of podcasts wherever you regularly listen to podcasts, including on Apple, Google and Spotify. Thank you again for listening.
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