The SEC’s Division of Investment Management Staff has released a Staff Letter dated January 18, 2018 to the Investment Company Institute and the Securities Industry and Financial Markets Association in which the Staff identified a number of questions about how registered open-ended funds (mutual funds) and ETFs will comply with the Investment Company Act of 1940 and related rules as those funds trade in cryptocurrencies and cryptocurrency-related products.
The letter’s issuance follows the SEC’s previous request to sponsors of cryptocurrency funds that they withdraw their registration statements and highlights the concerns the Staff believes must be addressed before such offerings can be registered and brought to market.
The SEC’s questions focused on five broad areas: valuation, liquidity, custody, arbitrage (for ETFs), and the potential for manipulation and other risks, which are summarized below:
- Valuation: Given the need for mutual funds and ETFs to value their assets each business day to establish an NAV, the Staff asks whether funds have the information necessary, and relevant policies and procedures in place, adequately to value their cryptocurrency and cryptocurrency-related products, given volatility, market fragmentation and the general lack of regulation, and the nascent state of trading in the cryptocurrency futures markets; how the funds would address “forks” in the blockchain; how the differences in cryptocurrencies would affect funds’ valuation policies; and how the funds would address potential manipulation of the underlying markets in establishing a settlement price for cryptocurrency futures.
- Liquidity: Given the feature of daily redeemability for mutual funds and ETFs, and the requirements of the new fund liquidity rule (Rule 22e-4), the Staff asks how funds would address the requirement for them to have sufficiently liquid assets to meet the requirement of daily redemptions.
- Custody: Given the law’s requirements for how the assets of a registered fund must be custodied and who is eligible to serve as custodian, the Staff asks how the funds would satisfy those requirements, and notes that it is not aware of any custodian currently providing fund custodial services for cryptocurrencies.
- Arbitrage (for ETFs): Since ETFs trade throughout the day and are obliged to have a market price that does not deviate materially from the fund’s underlying NAV, the Staff asks how would a cryptocurrency ETF comply with that obligation in light of the fragmentation, volatility and trading volume of the cryptocurrency marketplace, and how would volatility-based trading halts in a cryptocurrency futures market impact the arbitrage mechanism.
- Potential for Manipulation and Other Risks: Noting Chairman Clayton’s recently-expressed concern about the substantial lack of investor protection in the cryptocurrency markets in comparison with traditional securities markets, and the greater opportunities for fraud and manipulation, the Staff asks whether fund sponsors have adequately considered those issues as they touch on valuation and liquidity, particularly in the context of retail investors who might invest in a cryptocurrency fund, and whether retail investors have sufficient information adequate to evaluate those funds and their attendant risks, and whether the sponsors have discussed with distributing broker-dealers would analyze the suitability of a cryptocurrency offering for a retail investor.
Having posed the questions and issues, the Staff then concludes its letter by saying that until those questions can be satisfactorily addressed, the Staff does not believe it is appropriate for fund sponsors to initiate registration of funds that plan to invest substantially in cryptocurrency and cryptocurrency-related products.
If you would like to discuss your firm’s participation in the cryptocurrency market as a fund sponsor or investor, please contact me at the address below.
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