So You Want to Manage a Cryptocurrency Fund? U.S. Regulatory Rules to Consider First
As of October 2017, the number of hedge funds that trade cryptocurrencies such as bitcoin reached over 100, according to new data from Autonomous Next, a leading financial technology (fintech) research provider. As more investment managers look to enter the cryptocurrency space, both additional regulation and increased enforcement of existing regulation can be expected. Many questions arise regarding which regulatory agencies have jurisdiction over this evolving market and what implications such regulation will have on the funds and managers that participate.
Are digital tokens securities under the jurisdiction of the U.S. Securities and Exchange Commission (SEC), commodities contracts over which the Commodity Futures Trading Commission (CFTC) has jurisdiction, or a different form of financial instrument subject to other regulations? The answer to these questions could trigger a host of regulatory implications for funds investing in bitcoin and other virtual currencies and the managers of these funds.
In late July 2017, the SEC issued guidance indicating that digital tokens can be regulated as securities under federal securities laws. The SEC provided this guidance in its Report of Investigation pursuant to Section 21(a) of the Securities Exchange Act of 1934, in which the SEC reported on its investigation of a 2016 offering of digital tokens sold by The DAO, an unincorporated online organization (the “SEC Report”).The DAO sought to raise capital by exchanging DAO tokens for other cryptocurrencies through an initial coin offering (ICO). ICOs are an increasingly popular, but (for now) largely unregulated, method used by start-ups and other ventures to raise capital through custom digital coin offerings. In an ICO, supporters of the venture purchase bespoke cryptocoins (referred to as “tokens”) using fiat, or as in The DAO case, virtual currency. These tokens are similar to the shares of a company which are sold to investors in an initial public offering (IPO). The tokens are intended to be used as a method of payment for the products or services being developed by the company issuing them; investors are motivated by the hope that their tokens will increase in value.
The SEC Report states that, depending on the facts and circumstances, the offer and sale of digital assets may be treated as trading securities and fall under the federal securities laws. If classified as securities, the issuers of the applicable digital assets must register offers and sales of such securities unless a valid exemption applies. The SEC did not create a blanket regulation that all tokens are securities, but rather stated that it will consider the facts of each situation on a case-by-case basis to determine whether an offering of a particular cryptocurrency qualifies as an offer and sale of a security. The SEC Report found that DAO tokens were securities and, therefore, subject to the federal securities laws. However, the SEC did not pursue any charges against The DAO for failure to register the offering of DAO tokens, but released its finding "to caution the industry and market participants" and advise those that use blockchain technology for capital raising to take the necessary steps to ensure compliance with the securities laws. The SEC Report sets a precedent for the entire blockchain industry.
How does the SEC Report impact investment managers looking to start and manage cryptocurrency hedge funds? While most funds will not be looking to launch an ICO, if the SEC treats cryptocurrencies as securities, managers of funds that invest in cryptocurrencies may need to register as investment advisers with the SEC under the Investment Advisers Act of 1940, as amended (the “Advisers Act”). The Advisers Act defines an investment adviser as any person or firm that for compensation is engaged in the business of providing advice to others, or issuing reports or analyses, regarding securities. A firm that meets the definition of “investment adviser” must register with the SEC unless certain exemptions or exclusions apply or it does not meet a minimize size threshold. If cryptocurrencies are treated as securities, investment advisers that invest in these products on behalf of their advisory clients must determine whether they are required to register with the SEC.
Moreover, the classification of cryptocurrencies as securities can create a unique compliance burden for SEC-registered investment advisers (RIAs) trading these instruments. RIAs are required to adopt a code of ethics which requires employees to report their personal securities trading activities to the RIA’s chief compliance officer and to provide brokerage statements and reports to confirm such personal trades. As tokens and cryptocurrencies are generally not traded on public exchanges or through registered broker-dealers, these trades cannot be confirmed in the traditional sense. An RIA that invests in cryptocurrencies, or whose employees make these personal investments, should update its code of ethics to address these issues.
In addition to RIA registration issues for investment managers, the SEC Report has regulatory implications for the private funds that invest in cryptocurrencies. Under the Investment Company Act of 1940, as amended (the “Company Act”), an investment company is generally defined as an issuer that is “engaged primarily, or proposes to engage primarily, in the business of investing, reinvesting, or trading in securities,” and owns or proposes to acquire “investment securities” having a value exceeding 40% of the value of such issuer’s total assets. If cryptocurrencies are considered securities, a fund that holds a significant amount of these instruments may be deemed an investment company, triggering regulation under the Company Act absent an applicable exemption.
While the SEC Report helps to clarify the SEC’s position on ICOs, it remains unclear where this leaves other regulators like the CFTC. Currently, the CFTC does not treat investments in bitcoins or other virtual currency units as "commodity interests" under the Commodity Exchange Act of 1936, as amended (the “CEA”). The CFTC, however, issued orders in 2015 and 2016 in which it found that futures, swaps, and other CFTC-regulated derivatives that reference digital currencies are “commodity interests” that (absent an applicable exemption) would require registration by a manager as a commodity pool operator (CPO) and commodity trading adviser (CTA) in order to trade such derivatives in a fund.
In September 2015, the CFTC released an enforcement action and settlement order (the “Coinflip Order”) against an unregistered online trading platform for facilitating the trading of bitcoin options and futures contracts without required registrations. The operator of the platform made available for trading, put and call option contracts in which bitcoin was the reference asset for the options contracts and the strike and delivery prices were denominated in U.S. dollars (premiums and settlement payments were to be made in bitcoin at the spot exchange rate).
In the Coinflip Order, the CFTC concluded that “bitcoin and other virtual currencies are [encompassed in the definition and] properly defined as commodities.” As a result, options contracts that reference a virtual currency qualify as “commodity options” and “commodity option transactions.”
The Coinflip Order provides that derivatives (including futures, options, and swaps) that reference cryptocurrency units will be treated as commodity interests (not the actual cryptocurrencies themselves). These instruments will, accordingly, count towards the CFTC Rule 4.13(a)(3)de minimis exemptions and may require a manager of a fund that invests in derivatives that reference cryptocurrencies to register as a CPO and possibly as a CTA. As the Chicago Mercantile Exchange (CME) and CBOE Futures Exchange have announced that they intend to launch bitcoin futures by the end of this year (or early next year) and Nasdaq recently announced that it intends to introduce bitcoin futures in the first half of next year, this issue will become more significant for fund managers.
In the event the CFTC determines that bitcoins or other virtual currency units fall within the definition of a “commodity interest” under the CEA, investment managers of funds that invest in such instruments may be subject to additional regulation under the CEA and CFTC. Such managers may be required to register as a CPO or CTA with the CFTC, become a member of the National Futures Association and be subject to additional regulatory requirements with respect to funds that they manage, including with respect to disclosure and reporting requirements.
Even if a coin or token is not deemed to be a security or a commodity interest within the jurisdiction of the SEC or CFTC, the instrument may still be treated as a security under state law and/or may be subject to other state laws. New York is currently the only state to implement regulations specifically designed to cover cryptocurrency activity. New York has established a BitLicense Regulatory Framework which requires certain participants in a “virtual currency business activity” to obtain a license to transact business within New York (and/or with New York residents). Under the regulations, “virtual currency business activity” covers transmitting, storing, holding, and maintaining control of virtual currency; buying and selling virtual currency as a customer business; performing exchange services as a customer business; or controlling, administering, or issuing a virtual currency. While New York’s BitLicense requirement may apply to investment managers who issue digital coins or otherwise act as an exchange platform depending on the facts and circumstances, it is unlikely to implicate an investment manager who is only buying, selling and holding cryptocurrency coins for the accounts of its clients. Nevertheless, such regulations demonstrate that states are beginning to look for ways to regulate the instruments.
Investment managers looking to launch an investment fund that invests in bitcoin and/or other virtual currencies will need to consider the regulatory impact on the fund and the investment adviser. The SEC has recently indicated that it may treat digital tokens as securities and the CFTC has issued orders finding that derivatives that reference cryptocurrency units are treated as commodity interests. In light of these pronouncements, investment managers should proceed with caution in launching these funds to ensure that the managers and the funds themselves are in compliance with all relevant regulations. As the cryptocurrency market continues to evolve, participants at all levels should expect the space to be subject to a higher degree of regulation and enforcement.
 Release No. 81207 / July 25, 2017.
 The public ledger on which bitcoin transactions are recorded.
 In the Matter of Coinflip, Inc., d/b/a Derivabit, and Francisco Riordan, CFTC Docket No. 15-29 (September 17, 2015).
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