Dalia Blass, director of the Securities and Exchange Commission’s Division of Investment Management, all but put the kibosh on approving funds, such as exchange-traded funds, that hold cryptocurrencies until “significant outstanding questions” about investor protection issues are resolved.

In a Thursday staff letter to the Investment Company Institute and the Securities Industry and Financial Markets Association, Blass said that while IM “stands ready to engage in dialogue with sponsors regarding the potential development of these funds,” her division believes “there are a number of significant investor protection issues that need to be examined before sponsors begin offering these funds to retail investors.”

One outstanding question, Blass noted, is whether there are “particular challenges investment advisors would face in meeting their fiduciary obligations when investing in cryptocurrency-related funds on behalf of retail investors.”

The growth in cryptocurrencies and related products, she said, “has attracted significant attention, and we have seen interest among sponsors in offering registered funds that would hold these new digital products.”

Proponents “have identified a range of potential benefits,” Blass said, but she noted that critics have raised various concerns regarding “transparency of information, trading, valuation and other matters related to the nature of the underlying assets.”

Furthermore, Blass argued, the “innovative nature of cryptocurrencies and related products, as well as their expected use and utility in our financial markets, means that they are, in many ways, unlike the types of investments that registered funds currently hold in substantial amounts.”

Considering these concerns, IM has, “at this time, significant outstanding questions concerning how funds holding substantial amounts of cryptocurrencies and related products would satisfy the requirements of the [Investment Company Act of 1940] and its rules.”

Until the questions the IM division has can be “addressed satisfactorily,” Blass stated, “we 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, and we have asked sponsors that have registration statements filed for such products to withdraw them.”

Before moving ahead, Blass asked the ICI, SIFMA and others to provide feedback on the following areas as they relate to cryptocurrency funds: their valuation, liquidity, custody, arbitrage (for ETFs) and potential manipulation.

“The cryptocurrency markets are developing swiftly,” Blass stated, and “additional questions may arise from these developments.”

Here are some of the quesitons Blass wants answered:

On valuation: “How would funds develop and implement policies and procedures to value, and in many cases ‘fair value,’ cryptocurrency-related products?”

On liquidity: “What steps would funds investing in cryptocurrencies or cryptocurrency-related products take to assure that they would have sufficiently liquid assets to meet redemptions daily?” 

On custody: “While the currently available Bitcoin futures contracts are cash settled, we understand that other derivatives related to cryptocurrencies may provide for physical settlement, and physically settled cryptocurrency futures contracts may be developed.”

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?”

On arbitrage, Blass asked, for instance, “Are 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?”

On potential manipulation and other risks, Blass asked whether the trade groups have “discussed with any broker-dealers who may distribute the funds how they would analyze the suitability of offering the funds to retail investors?”

— Check out Massachusetts Halts Unregistered Sale of ICO Tokens on ThinkAdvisor.