This article summarizes the issues raised by the Securities and Exchange Commission (SEC) in a January 2018 no action letter, in which it refused to provide no action assurance relating to registration by two sponsors of their exchange-traded funds (ETFs) that would allow investors to trade shares of funds backed by cryptocurrencies and related products.
The no action letter described certain investor protection issues that the SEC believes must be addressed before cryptocurrency-related funds are offered to retail investors.
The investment community has placed a spotlight recently on cryptocurrency as a means of alternative investment, after Bitcoin’s record-breaking highs in 2017. Bitcoin surged more than 1300% in 2017 and prompted Chicago’s two largest derivatives exchanges (CME Group Inc and CBOE Global Markets Inc.) to launch bitcoin futures in December 2017.
In early February 2018, however, Bitcoin plummeted to more than half of its December 2017 peak due to factors including a global regulatory crackdown and a ban by most major U.S. credit card issuers on using their cards to buy Bitcoin or other digital currencies.
Such extreme volatility and the cryptocurrency markets’ unregulated nature contribute to significant investor risk and regulatory concern notwithstanding significant investor interest (due to the possibility of unparalleled return).
Cryptocurrency markets’ rapid growth is raising novel concerns over regulatory oversight and investor protection, with increasing number of enforcement actions taken by relevant government agencies such as the SEC and the Commodity Futures Trading Commission (CFTC).
Although these government agencies’ power to actively regulate cryptocurrency markets is currently limited, these agencies have been increasing their oversight authority over cryptocurrency markets.
In response to rising concerns over the risks digital currency poses to the financial system and to investors, the SEC has published numerous public statements in which it has emphasized potential risks of investing in cryptocurrencies and related products and has warned retail investors to beware of potential fraud and manipulation related to such investments.
No Action Letter
On Jan. 18, 2018, the staff of the SEC’s Division of Investment Management issued a no action letter to two fund sponsors (the Investment Company Institute (ICI) and the Securities Industry and Financial Markets Association (SIFMA)) who had proposed registration of ETFs that would allow investors to trade shares of funds backed by cryptocurrencies and related products.
In its letter, the SEC indicated that it could not provide no action assurance as to the sponsors’ applications for ETFs based on bitcoin futures, and raised significant questions for potential cryptocurrency-related ETF sponsors.
In its guidance, the SEC highlighted that discrepancies between the cryptocurrencies’ volatility and potential illiquidity and the funds’ needs to disclose daily fair market prices for their portfolios and provide adequate liquidity to investors must be addressed before sponsors may launch funds backed by cryptocurrencies and related products.
The SEC noted that the answers to its questions will be important to the ongoing analysis of filings for exchange-traded products and related changes to exchange listing standards, in the context of funds seeking to register cryptocurrency funds or related products under the Investment Company Act of 1940.
Issues raised by the SEC in its no action letter included the following series of questions relating to valuation, liquidity, custody, arbitrage and market manipulation.