European Union: Lucy Frew's FinTech Column: February 2018

Last Updated: 12 February 2018
Article by Lucy Frew

Developments in regulation of cryptocurrency funds

The surge in global cryptocurrency markets over the last year has been remarkable. From a legal perspective, it is notable that the response of worldwide regulators is not only inconsistent but in flux.

Regulatory impact on price

There have been a number of regulations and policy statements from with the US, Asia and the EU, including the UK. Each represents a meaningful share of global participation in cryptocurrencies. The starting point has been currently that cryptocurrencies are generally unregulated. Interestingly, a major contributing factor in rapid price fluctuations in cryptocurrencies is the ongoing changes in regulation of cryptocurrencies throughout the world that impact investors' ability to buy and sell cryptocurrencies.

Although regulators are voicing concerns over the potential risks and challenges of investing in cryptocurrencies, in many cases they also acknowledge potential benefits. This tension between risk and benefit, together with the very real challenges of regulating this revolutionary new asset class, means that worldwide regulatory developments are not easy to predict. For the most part, regulators have been reluctant to introduce bans and in some cases have made marked efforts to be regarded as cryptocurrency-friendly. Overall, however, it is hard to imagine that there will not be a marked increase in government oversight and regulation of cryptocurrencies going forward. For now, at least, continuing volatility resulting from worldwide regulatory developments seems inevitable.

So where does that leave investment managers and advisors?

Volatility is not necessarily unwelcome for investment managers who have the expertise to incorporate it into their strategies. While cryptocurrency investment divides opinion between investment managers, cryptocurrency funds (in other words funds that trade in cryptocurrencies and related products) have generated very strong results in recent months and there has been an increasing trend in such funds being launched. We also are seeing a number of fund managers wishing to go a step further and accept subscriptions and offer redemptions in cryptocurrency.

Until now, however, there has been little specific regulation or guidance from regulators to assist investment managers, advisors and distributors (or their legal and compliance staff) on how to deal with cryptocurrency investment in practice. In the UK, managers and advisors are subject to regulatory requirements and must work out how these apply in the context of cryptocurrency and related investments.

Lead regulators' response

Although the UK's FCA has been at the forefront of regulating financial innovation in recent years, it is now the US Securities and Exchange Commission (SEC) that is taking the lead in developing a detailed regulatory approach to cryptocurrency investment. Throughout 2017, the SEC issued various investor alerts, bulletins and a statement on cryptocurrencies and ICOs.

On 18 January 2018, the SEC's Division of Investment Management issued a letter that addresses a number of granular issues arising from funds focused on cryptocurrency-related products. The letter suggests that the SEC remains open to cryptocurrency funds, especially beyond the retail market. However, before being willing to move ahead on cryptocurrency funds aimed at the retail sector, the SEC requires feedback from the industry on a number of specific questions relating to cryptocurrency funds including the valuation, liquidity and custody of their underlying assets. While the SEC raises questions rather than providing answers, these questions, some of which are discussed below, provide a good indication of the way the wind is blowing. The SEC's main concerns from an investment perspective are in the areas of valuation, liquidity and custody. These are likely to be where investors require assurance too.

Operational challenges

The legal and regulatory framework at the level of the cryptocurrency fund is the same as for other types of alternative investment funds (AIFs). Nevertheless, a cryptocurrency strategy does present particular administrative and operational challenges that must be addressed both in practice and in legal drafting. The concepts around the traditional hedge fund services of administration, audit, custody and prime brokerage all require rethinking to reflect the fact that cryptocurrencies are virtual assets. A small but ever increasing minority of service providers are offering specialised services to cryptocurrency funds. This is a fast developing area.

Custody

In particular, custody of assets for a cryptocurrency fund is very different to that for a standard fund. It is not, technically, cryptocurrency itself that is held in custody. Rather, it is the unique private key in respect of any cryptocurrency transaction that is the true asset. Loss of a private key is an unacceptable scenario for a fund manager as there is no other way of accessing the cryptocurrency. The SEC states that it is "not aware of a custodian currently providing fund custodial services for cryptocurrencies". However, in fact certain specialist custodians have established themselves as leaders in institutional custody of digital assets, although at this stage service offerings cover only a small subset of the universe of cryptocurrencies. Given the costs and limited nature of institutional custodianship, some fund managers in the space have opted for self-custody, but this is a complex and time consuming exercise.

The SEC asks:

"... how would a fund intend to validate existence, exclusive ownership and software functionality of private cryptocurrency keys and other ownership records? To what extent would cybersecurity threats or the potential for hacks on digital wallets impact the safekeeping of fund assets?"

Auditors of cryptocurrency funds need to be highly specialised, not only in audit but also blockchain technology, in order to be capable of verifying ownership of cryptocurrency.

Cryptocurrency derivatives

CME Group has recently launched bitcoin futures trading on its platform, aiming to get an early movers' advantage in the volatile but fast-growing asset class. The SEC states that:

"While the currently available cryptocurrency 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?"

At least some custody-related challenges may be overcome by investing in cryptocurrency-based derivatives rather than cryptocurrencies themselves.

Liquidity

The SEC asks:

"How would funds take into account the trading history, price volatility and trading volume of cryptocurrency futures contracts, and would funds be able to conduct a meaningful market depth analysis in light of these factors? How would a fund prepare for the possibility that funds investing in cryptocurrency-related futures could grow to represent a substantial portion of the cryptocurrency-related futures markets? How would such a development impact the fund's portfolio management and liquidity analysis?"

The SEC's concerns relating to liquidity arise primarily in the context of funds offering daily redemptions, which is uncommon outside the context of retail funds. Liquidity is also an issue outside the retail fund context, but there are a range of mechanisms available that are traditionally used by AIFs to manage this.

The role of exchanges

Rather than working with large banks and traditional prime brokers, it is necessary for cryptocurrency fund managers to establish relationships with exchanges. Some cryptocurrency exchanges function as gateways between the fiat currency and cryptocurrency universes, while others operate only within the latter. Many exchanges cater to retail, as opposed to institutional, needs so managers may need to consider also working with brokers for over-the- counter transactions. Managers will wish to carry out extensive due diligence and spread assets across numerous exchanges to reduce risks relating to cybersecurity and server failure.

Exchanges are an area where regulators are able to at least partially regulate the entry and exit points – in other words converting fiat currency (dollars, pounds, euros) to and from cryptocurrency – to the cryptocurrency marketplace from the perspective of anti-money laundering (AML) and counter-terrorist financing (CTF).

Valuation

Appropriate valuation is important because, among other things, it determines fund performance, what investors pay and what they receive when they redeem or sell. Funds must value their assets in order to strike a new asset value (NAV). Fund accounting and valuation are traditionally areas where an administrator provides expertise. The SEC asks:

"Would funds have the information necessary to adequately value cryptocurrencies or cryptocurrency-related products, given their volatility, the fragmentation and general lack of regulation of underlying cryptocurrency markets, and the nascent state and current trading volume in the cryptocurrency futures markets? How would funds develop and implement policies and procedures to value, and in many cases "fair value", cryptocurrency-related products?"

The role of fund administrator must also take into account that transactions are stored on blockchain. If it is intended that a fund should accept subscriptions and provide redemptions in cryptocurrency, more complex challenges need to be addressed and this is an area where administrators are showing caution.

Watch this space!

One of the many questions raised by the SEC is how would funds consider the impact of market information on cryptocurrency markets and potential for market manipulation. Regulatory developments have significant power to move cryptocurrency markets and "watch this space" in this context has real meaning.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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