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Thursday, 22 February 2018

US Regulator Explains The Challenges For Registered CryptoFunds

The Maltese and Swiss securities regulators were not alone in focusing on cryptocurrencies over the Christmas break, as staff at the SEC were also at it in Washington DC.  Importantly, none of these regulators have poured scorn on the notion of ICOs or even funds holding cryptographic assets. All are merely concerned to signpost issues to be resolved.

While the civil law Europeans were typically eager to be as definitive as possible in how they will treat ICOs (since they believe nothing is possible unless the government spells out how it can be done), the common lawyers in the US were more circumspect (as they abide by the maxim that the law must follow commerce), merely explaining "a number of significant investor protection issues that need to be examined before sponsors begin offering these funds to retail investors."

Yet similar issues arise in relation to ICOs as for funds investing in cryptographic assets, particularly those of "securitised tokens" or "asset tokens" which are analogous to equities, bonds or derivatives in their economic function, if not the rights that attach to them.

Specifically, the SEC's concerns relate to valuation, liquidity, custody, arbitrage for exchange traded funds (ETFs), potential manipulation and other risks. For instance:
  • do funds have enough information to value their crypto assets each day, including accounting for events like 'hard forks' or differences in types of currency and potential for market manipulation?
  • could open-ended funds support daily redemptions?
  • how would a fund arrange custody and validate the existence, exclusive ownership and software functionality of private cryptocurrency keys and other ownership records?
  • an ETF is required to have a market price that would not deviate materially from the ETF’s net asset value, so in light of the fragmentation, volatility and trading volume of the cryptocurrency marketplace, how would ETFs comply with this term of their orders?
  • 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, which feature substantially less investor protection than traditional securities markets, with correspondingly greater opportunities for fraud and manipulation. So:
  • Would investors, including retail investors, have sufficient information to consider any cryptocurrency-related funds and to understand the risks?
  • How would broker-dealers analyze the suitability of offering the funds to retail investors?
  • Could investment advisers meet their fiduciary obligations when investing in cryptocurrency-related funds on behalf of retail investors?
Assuming the industry can solve these problems, we'll be in a strange new world.