Today, we offer our “Friday List,” an occasional feature summarizing a topic significant to investment management professionals interested in regulatory issues. Our Friday Lists are an expanded “Our Take” on a particular subject, offering our unique (and sometimes controversial) perspective on an industry topic.
Last week, the SEC’s Division of Investment Management asked sponsors to refrain from initiating registrations for funds investing in cryptocurrencies and related products. Dalia Blass, the Division Director, cited “significant outstanding questions” about how such funds could comply with applicable laws and regulations. In today’s Friday List, we describe the top 10 regulatory concerns raised by the Division of Investment Management. Despite these concerns, we believe that the SEC and the industry will work through these issues and develop rules and best practices that will ensure the growth of this market in a manner that engenders investor confidence.
Top 10 Cryptocurrency Fund Regulatory Concerns
- Valuation: The SEC asks whether funds could obtain sufficient information to properly value fund assets pursuant to current accounting rules especially given the “nascent state and current trading volume” in the futures markets.
- Liquidity: Could funds reduce crypto-assets to cash so as to meet daily redemption requests? How would funds classify assets under the SEC’s new liquidity rule (22e-4)?
- Custody: The SEC questions how a fund custodian could validate the existence and ownership of cryptocurrency assets, and how funds would address physical security where applicable.
- ETF Creation: Will the creation unit process operate in a way that ensures that funds and authorized participants limit arbitrage opportunities that harm investors?
- Volatility: The limited history and volume of the cryptocurrency markets could negatively impact fund operations and affect investors.
- Lack of regulation: Neither cryptocurrency markets nor providers/issuers are subject to prudential regulation.
- Market manipulation: The SEC cites Chairman Clayton’s concerns over market manipulation and potential fraud.
- Cybersecurity: Could a potential hack threaten ownership interests and valuation? What safeguards are in place?
- Disclosure: How would fund sponsors ensure sufficient risk disclosure and transparency in fund prospectuses and other shareholder communications?
- Suitability: How will broker-dealers and advisers ensure their suitability and fiduciary obligations when recommending crypto-funds to retail investors?
The SEC’s Division of Investment Management sent a letter to the ICI and SIFMA listing the “significant outstanding questions” concerning how proposed registered funds investing in cryptocurrencies and related products would satisfy the Investment Company Act. The letter, signed by Division Director Dalia Blass, warned potential fund sponsors against initiating fund registrations until these questions “can be addressed satisfactorily.” The letter questions how funds would value cryptocurrencies and related products given their volatility and lack of regulation. The Division also questions liquidity and whether funds could meet daily redemption requests. The letter also raises custody concerns, asking how funds could “validate existence, exclusive ownership, and software functionality.” ETFs pose additional questions related to authorized participant and arbitrage processes. The letter also asks about distribution and fiduciary duty. The Division expressed its willingness to “engage in dialogue with sponsors regarding the potential development of these funds.”
OUR TAKE: We believe that both the industry and the SEC have vested interests in coming to an agreement to allow cryptocurrency offerings. The industry should welcome prudent regulation, which gives investors the type of confidence that made mutual funds so successful. The SEC should get out in front of this issue to become the regulator of choice rather than cede its regulatory authority to offshore, non-U.S., and private markets.
The SEC obtained an emergency asset freeze against a fraudulent internet-based initial coin offering. According to the SEC, the Canadian respondents promised outlandish returns and made other significant misrepresentations as part of a scheme that raised over $15 Million from thousands of investors through offerings of a crypto-currency advertised on various social media sites. The SEC asserts that the offering of virtual tokens constituted an illegal offering of securities and that it was made available to U.S. investors through the internet. The SEC announced that this case is the first filed by its new Cyber Unit, which was created in September to focus on “misconduct involving distributed ledger technology and initial coin offerings, the spread of false information through electronic and social media, hacking and threats to trading platforms.”
OUR TAKE: Perhaps most significant is the SEC asserting (without much precedent or support) that an initial coin offering is an offering of securities subject to the securities laws. This view may lead to broader regulatory oversight of cryptocurrency offerings. Also, we expect that this first action by the Cyber Unit won’t be its last.