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.
In connection with the requirement that mutual funds and ETFs calculate and provide daily fair market prices and net asset values (NAVs) for their portfolios, the SEC asked:
- Whether a fund would have adequate information to value cryptocurrencies or related products given:
- their price volatility,
- the fragmentation and general lack of regulation of cryptocurrency markets, and
- speculative trading volumes and shallow market depth
- How a fund would develop and implement policies and procedures allowing valuation of cryptocurrencies-related products (and how and when such policies and procedures would account for and factor significant cryptocurrency-related events (e.g., a “fork”, in which a blockchain diverges and creates a new cryptocurrency) into NAV)
- How a fund would develop and implement policies and procedures allowing identification and determination of eligibility and acceptability for newly created cryptocurrencies distributed for free to existing holders of particular cryptocurrencies (and how and when such policies and procedures would account for and factor such newly created cryptocurrencies into NAV)
- How a fund would develop and implement policies and procedures to account for various types of cryptocurrencies.
Mutual funds and ETFs are required to maintain sufficiently liquid assets so that the shares are redeemable on a daily basis. Funds also must classify their investment assets into one of four liquidity categories ranging from “highly liquid investments” to “illiquid investments” and may not invest more than 15% of their respective assets in illiquid securities. In connection with these requirements, the SEC asked:
- How a fund would develop and implement procedures to ensure that it has sufficiently liquid assets to meet redemptions daily
- How and on what basis a fund would determine the liquidity of cryptocurrency and cryptocurrency-related products and their classification; whether it would be able to conduct a meaningful market depth analysis; and whether it would need to assume an unusually sizable potential daily redemption amount
- How a fund would prepare for the possibility that its investment in cryptocurrency-related futures could potentially grow to represent a substantial portion of the cryptocurrency-related futures markets (and the subsequent impact on portfolio management and liquidity analysis)
The Investment Company Act of 1940 imposes safeguards (including standards regarding who may act as a custodian and when funds must verify their holdings) to ensure that registered funds maintain custody of their holdings. In connection with this, the SEC noted that it is currently unaware of any custodian that provides fund custodial services for cryptocurrency, and asked:
- If a fund were to hold cryptocurrencies directly, how it would satisfy the custody requirement and relevant rules; how it would validate existence, exclusive ownership and software functionality of private cryptocurrency keys on the custodian’s books and records; and how (and to what extent) potential cybersecurity threats and hacking would impact the safekeeping requirements
- Under what circumstances a fund holding cryptocurrency-related derivatives that are physically settled would have to hold cryptocurrencies directly, and how the fund would provide for the custody of the cryptocurrencies if it takes delivery of cryptocurrencies in settlement
Arbitrage for ETFs
ETFs are transacted at market price by retail investors and at NAV by authorized participants. In connection with arbitrage, the SEC asked:
- How an ETF would provide market price that would not deviate materially from its NAV, given the cryptocurrency marketplace’s fragmentation, volatility and trading volumes
- Whether there has been any discussion with any market makers and authorized participants in connection with this issue
- How volatility-based trading halts on a cryptocurrency futures market (or the shutdown of a cryptocurrency exchange) would affect the market price or arbitrage mechanism
Potential Manipulation and Other Risks
In connection with the provision by current cryptocurrency markets provide of substantially less investor protection than traditional securities markets, presenting a greater risk of fraud and manipulation, the SEC asked:
- How and to what extent potential fraud and manipulation affects valuation, liquidity, settlement and arbitrage issues
- How and to what extent a fund should consider potential fraud and manipulation in offering cryptocurrency-related funds retail investors; and whether retail investors would have sufficient information to assess the investment risks of cryptocurrency-related funds
- Whether there has been any discussion with any broker-dealers who may distribute the funds about their views on the suitability of offering cryptocurrency-related funds to retail investors, and whether investment advisers would face any challenges in meeting their fiduciary obligation when they invest in cryptocurrency-related funds on behalf of retail investors
The SEC also indicated that it would initiate actions to protect retail investors (including recommending a stop order to the SEC) if a fund sponsor tries to register a fund that invests substantially in cryptocurrencies or related products by utilizing the Securities Act rule allowing automatic registration of a new series of fund through filing of a post-effective amendment of a previously effective registration statement.
In addition to its concerns regarding investments in cryptocurrencies or related products, the SEC also has expressed reservations about initial coin offerings (ICOs), emphasizing that the form of transaction does not change its substance and that many ICOs in fact involve an offering of securities that should comply with applicable registration and other securities laws requirements.
Cryptocurrency has made notable progress in gaining acceptance among mainstream investors.
Notwithstanding this, obtaining government approval for cryptocurrency-based funds and related products remains one of the biggest challenges in unleashing the inflow of retail capital to alternative currencies.
The SEC’s no action letter (together with the SEC’s rejection of two bitcoin-based ETF proposals in 2017) evidences its skepticism as to whether funds tracking bitcoin and other cryptocurrencies could comply with securities laws enacted to protect retail investors.
Most of the SEC’s questions stem from the highly volatile and thinly regulated nature of cryptocurrency markets and are intended to result in appropriate protections being created for retail investors before fund sponsors begin offering cryptocurrency-related funds to such investors.
As such, it seems unlikely that registration of funds that plan to invest in cryptocurrencies or related products will be approved until the SEC has concluded that most or all of the concerns raised in its no action letter have been addressed satisfactorily.