By Jerri-Lynn Scofield, who has worked as a securities lawyer and a derivatives trader. She now spends much of her time in Asia and is currently working on a book about textile artisans.
The Securities and Exchange Commission (SEC) yesterday put the kibosh on plans to offer exchange-traded funds (ETFs) or other products based on bitcoin or cryptocurrencies to retail investors anytime soon.
In a Staff Letter: Engaging on Fund Innovation and Cryptocurrency-related Holdings, Dalia Blass, the SEC ’s Director of the Division of Investment Management, posed 31 detailed questions over how funds would value, store, and safeguard fund holdings, as well as concerns over whether investors understood the risk of these investments, and the potential for market manipulation. These concerns must be satisfied before the agency will endorse any plans to offer bitcoin-based products to mom and pop investors.
Over to the WSJ:
The Securities and Exchange Commission outlined its views in a letter to two Wall Street trade groups whose members envision the profits that could flow from selling exposure to bitcoin through popular investment vehicles such as ETFs and mutual funds. The SEC questioned how bitcoin’s volatility and potential illiquidity would fit with funds that must calculate a fair market price for their portfolio at the end of every trading day and allow investors to easily cash out their shares.
The SEC has been skeptical over pressure to launch bitcoin funds to appeal to retail investors, as well as expressed concerns over initial coin offerings, determining that the latter should be treated as securities sales and thus conform with existing investor protection rules, according to the WSJ. This scrutiny has increased under SEC chair Jay Clayton:
Last year, the SEC rejected two proposed ETFs that would directly own bitcoin, including one from Cameron and Tyler Winklevoss, arguing that the global market for the digital currency wasn’t transparent enough to support sufficient oversight.
Some fund companies hoped that the SEC might relent after two Chicago exchanges late last year launched futures contracts on bitcoin. Those contracts are regulated by the Commodity Futures Trading Commission, a smaller federal agency whose rules allow Wall Street to more easily market new products.
Just last week, the SEC confounded these expectations, by asking sponsors to withdraw proposals to offer ETFs based on bitcoin futures.
Just a smattering of points from the 31 questions that the staff letter raises, broadly addressing the issues of valuation, liquidity, and custody.
Mutual funds and ETFs must value their assets at the close of each business day to calculate a new asset value (NAV). The staff note that appropriate valuation is important, as it determines fund performance, what investors pay for mutual funds, what authorized participants pay for ETFs, and what they receive when they exit, among other issues. One key staff question:
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?
Daily redeemability is a key characteristic of open-end funds, which are required to maintain sufficiently liquid assets in order to provide daily redemptions. So, one staff concern is:
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?
US securities laws impose safeguards to ensure that funds maintain custody of their holdings. How, exactly, would this work with funds based on bitcoin or other cryptocurrencies, is another matter of staff concern:
These safeguards include standards regarding who may act as a custodian and when funds must verify their holdings. To the extent a fund plans to hold cryptocurrency directly, how would it satisfy the custody requirements of the 1940 Act and relevant rules? We note, for example, that we are not aware of a custodian currently providing fund custodial services for cryptocurrencies. In addition, 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 under the 1940 Act?
Clayton Concerns Over Market Manipulation
The staff letter noted that the SEC is concerned over the potential for fraud and manipulation in the cryptocurrency markets– a subject of a December statement by Clayton:
In a recently issued statement, Chairman Jay Clayton noted that concerns have been raised that cryptocurrency markets, as they are currently operating, feature substantially less investor protection than traditional securities markets, with correspondingly greater opportunities for fraud and manipulation. The Commission has also discussed concerns relating to the risk of fraud and manipulation in cryptocurrency markets in orders denying exchange proposals to list the shares of commodity trusts that would hold cryptocurrency.[In addition, a number of recent media reports have highlighted a range of possible vectors for potential manipulation of cryptocurrency markets. Although some funds may propose to hold cryptocurrency-related products, rather than cryptocurrencies, the pricing, volatility and resiliency of these derivative markets generally would be expected to be strongly influenced by the underlying markets [citations omitted}.
I’ll mention in passing a fanboy CNBC piece, What the US can learn from Sweden about how to launch a bitcoin fund. This suggests that the SEC and potential fund sponsors just cannot agree on how to launch a bitcoin fund– and thus need guidance from a Swedish company, that has used an exchange-traded note structure:
[Stockholm-based ETF Products] has successfully run a bitcoin exchange-traded product for the last two years that can be accessed by European investors in multiple countries, and the products have attracted more than $1 billion.
The thrust of the CNBC report is that the SEC’s concern is fixated on structure, rather than arises from a more bedrock concern about whether the agency wishes to make it easier for retail investors to enter a market that’s vulnerable to the fraud and manipulation Clayton has outlined. If the agency’s concern is indeed more basic, no amount of clever structuring is going to overcome this scepticism– or at least not in the near-term.
Industry Optimism: Hope Springs Eternal
Nonetheless, Reuters reports the reaction of one industry lawyer trying to make a silk purse out of the sows ear these detailed SEC concerns raise for those who seek to launch bitcoin-based retail products:
Jeremy Senderowicz, a lawyer who represented one proposal for a cryptocurrency product before the SEC, said the SEC statement is a “really big deal” by making public concerns that fund managers would have had to address on a case-by-case basis, behind the scenes.
“It shows that they’re going to have to take some time to consider the industry’s responses before they change their minds on it,” said Senderowicz, a partner at Dechert LLP.
“It gives a template for how to get to a yes.”
Blass’s letter concluded by strongly setting out the SEC staff’s continued objections to allowing sponsors to offer cryptocurrency funds:
Until the questions identified above can be addressed satisfactorily, 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. In addition, we do not believe that such funds should utilize rule 485(a) under the Securities Act, which allows post-effective amendments to previously effective registration statements for registration of a new series to go effective automatically. If a sponsor were to file a post-effective amendment under rule 485(a) to register a fund that invests substantially in cryptocurrency or related products, we would view that action unfavorably and would consider actions necessary or appropriate to protect Main Street investors, including recommending a stop order to the Commission.
Which, in SEC speak means no such funds will be offered to US investors anytime soon.