On January 18, 2018, the Securities and Exchange Commission's (SEC) Division of Investment Management broke its relative silence regarding the recent growth of cryptocurrencies and cryptocurrency-related products. While signaling that registration of funds intending to invest substantially in cryptocurrency and related products is not on the immediate horizon, the guidance arguably provided the beginnings of a much-needed roadmap for the future development of registered open-ended funds ("mutual funds") and exchange-traded funds (ETFs) linked to cryptocurrencies and related products.

In a letter (the "Staff Letter" and the SEC staff, the "Staff")1 addressed to the Investment Company Institute (ICI) and the Securities Industry and Financial Markets Association's Asset Management Group (SIFMA), the Director of the SEC's Division of Investment Management, Dalia Blass, said that it would not be appropriate to initiate registration of mutual funds and ETFs intending to hold substantial amounts of cryptocurrencies2 and related products until there is clarity regarding how such funds could satisfy certain requirements of the Investment Company Act of 1940, as amended, and its related rules (collectively, the "1940 Act"). In the Staff Letter, Director Blass identified several key questions intended to "facilitate the start" of a dialogue between fund sponsors and the SEC Staff, stating, "we invite you and any interested sponsors to engage with us in detail on these [issues]."

Acknowledging the recent growth in the cryptocurrency markets and public interest in cryptocurrency, the Staff Letter recognized that many fund sponsors desire to provide—and many members of the investing public (including retail or "Main Street" investors) would like to participate in—registered funds linked to cryptocurrency. Indeed, with both the Cboe Global Markets and CME Group successfully launching bitcoin futures in December 2017, some had speculated that the next major cryptocurrency-related milestone would be the SEC's approval of the registration of certain funds linked to cryptocurrency and related products.

Rather than announcing any such approval, however, the Staff Letter highlighted several key investor protection issues that sponsors will need to address in order to satisfy the requirements of the 1940 Act.3 The Staff's carefully articulated questions demonstrate that it has given significant thought to the novel challenges, risks, and potential rewards that the introduction of registered cryptocurrency funds and related products may present.

Valuation

By law, mutual funds and ETFs must value their assets on each business day in order to determine a net asset value (NAV). Appropriate valuation of fund assets is critical to calculating fund performance and determining what investors in mutual funds and authorized participants in ETFs pay to purchase fund shares (and what they receive when they redeem their holdings). The Staff Letter questioned whether funds holding substantial amounts of digital assets would have the information necessary to adequately value cryptocurrencies or cryptocurrency- related products in light of "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." In particular, the SEC posed the following questions to fund sponsors:

  1. How would funds develop and implement policies and procedures to value, and in many cases "fair value," cryptocurrency-related products? How would differences among various types of cryptocurrencies impact funds' valuation and accounting policies?
  2. How would funds' accounting and valuation policies address the information related to significant events relevant to cryptocurrencies? For example, how would they address when the blockchain for a cryptocurrency diverges into different paths (i.e., a "fork"), which could result in different cryptocurrencies with potentially different prices?
  3. How would a fund identify, and determine eligibility and acceptability for, newly created cryptocurrencies offered by promoters (e.g., an "air drop")? How might a fund account for those holdings if the fund chooses to claim such cryptocurrencies?
  4. How would funds consider the impact of market information and any potential manipulation in the underlying cryptocurrency markets on the determination of the settlement price of cryptocurrency futures?

Footnotes

1 Staff Letter (Jan. 18, 2018), available at: https://www.sec.gov/divisions/investment/noaction/2018/cryptocurrency-011818.htm.

2 A "cryptocurrency" is also commonly referred to as a "virtual currency," a "digital currency," or a "token." In FIN-2013-G001, FinCEN defines "virtual currency" as "a medium of exchange that operates like a currency in some environments, but does not have all the attributes of real currency." In contrast, FinCEN defines "traditional currency" as something that "[i] is designated as legal tender and that [ii] circulates and [iii] is customarily used and accepted as a medium of exchange in the country of issuance." Similarly, in IRS Notice 2013-21, the IRS defines a "virtual currency" as a "digital representation of value that functions as a medium of exchange, a unit of account, and/or a store of value" that in some environments would function "like 'real' currency ... but does not have legal tender status in any jurisdiction." Common examples include Bitcoin, Ether, and Litecoin.

3 In addition to the Staff Letter, the SEC and the CFTC enforcement directors issued the following joint statement on January 18, 2018, relating to investor protection:

When market participants engage in fraud under the guise of offering digital instruments – whether characterized as virtual currencies, coins, tokens, or the like – the SEC and the CFTC will look beyond form, examine the substance of the activity and prosecute violations of the federal securities and commodities laws. The Divisions of Enforcement for the SEC and CFTC will continue to address violations and bring actions to stop and prevent fraud in the offer and sale of digital instruments.

Available at: https://www.sec.gov/news/public-statement/joint-statement-sec-and-cftc-enforcement-directors.

To view the full article, please click here

Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

© Morrison & Foerster LLP. All rights reserved