This piece was written in collaboration with Chandni Patel, Director of Financial Services and member of Perficient’s Digital Assets Working Group.
Our Digital Assets Team has blogged in the past about the regulatory landscape facing cryptocurrency from a banking perspective (OCC Provides Roadmap for National Banks and Savings Associations To Conduct Crypto Activities, NY Federal Reserve Evaluates Stablecoin Frameworks, Highlights From Federal Bank Regulators’ Joint Statement on Cryptocurrency Assets , The Pros and Cons of a Potential U.S. Central Bank Digital Currency (CBDC)). However, in this blog, we will discuss the regulatory landscape surrounding cryptocurrency from an asset manager or fund manager perspective.
There is good reason for this shift in view; according to Marc Bernegger, co-founder of crypto fund AltAlpha Digital, “after last year’s explosion of crypto hedge funds around the globe, there are now over 400 active funds, excluding those focused on venture capital.” Mr. Bernegger added that the number of crypto hedge funds is growing daily.
For those wanting to start their own cryptocurrency fund, it’s important to be well informed about cryptocurrency regulations. U.S. Regulatory cryptocurrency regulations are most fluid at the state level. We’ll start therefore with a review of the latest state regulatory changes regarding cryptocurrencies. We’ll then move to the federal level, seeking regulatory guidance as to whether digital tokens are securities under the jurisdiction of the U.S. Securities and Exchange Commission (SEC) or commodities contracts over which the Commodity Futures Trading Commission (CFTC) has regulatory jurisdiction.
As the center of the American financial landscape, it is probably not surprising that New York was the first state to implement regulations specifically designed to cover cryptocurrency activity. Since 2014, New York has only allowed crypto companies to operate in the state if they obtain a BitLicense, and even then, licensed companies are limited in the types of digital assets they can sell. For instance, Coinbase can only offer about half the coins available on its platform to New York customers.
New York’s BitLicense Regulatory Framework requires participants in a “virtual currency business activity” to obtain a license to transact business within New York and/or interact 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. New York’s BitLicense requirement therefore applies to investment managers who issue digital coins or otherwise act as an exchange platform regardless of where the buyers are located.
In March 2022, Virginia passed bill HB 263, which, similar to the OCC requirements discussed in a previous blog, permits banks in the state to provide customers with crypto custody services “so long as the bank has adequate protocols in place to effectively manage risks and comply with applicable laws.” Prior to offering custody services, a bank will need to carefully examine the risks involved in offering the service, which includes meeting the following three requirements referenced in the bill:
- Implementing effective risk management systems and controls to measure, monitor, and control relevant risks associated with custody of digital assets;
- Implementing insurance coverage for such services; and
- Maintaining a service provider oversight program to address risks to service provider relationships.
Of particular significance is that in Virginia, banks may offer this service in either a fiduciary or non-fiduciary capacity. Acting in a fiduciary capacity, the bank will require customers to transfer their virtual currencies to the control of the bank by creating new private keys to be held by the bank, and the bank will have authority to manage virtual currency assets as it would any other type of asset held in such capacity. In the non-crypto world, this is equivalent to depositors placing their bonds in the safe deposit box in the bank’s vault.
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As a nonfiduciary, the bank will act as a bailee, taking possession of the customer’s asset for safekeeping while the legal title remains with the customer, meaning the customer retains direct control over the keys associated with their virtual currency.
It was way back in July 2017, that 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). In an ICO, supporters of the venture purchase cryptocoins or “tokens” using fiat, or as in The DAO case, virtual currency. These tokens are similar to the shares of a company that 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.
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 federal securities laws. When 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 when determining whether an offering of a particular cryptocurrency qualifies as an offer and sale of a security. The same SEC Report found that DAO tokens were securities and, therefore, subject to federal securities laws. Significantly, the SEC wrote that it 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, less than five years old as of the time this is written, set a precedent for the entire blockchain industry.
How does the SEC Report impact investment managers looking to start and manage cryptocurrency hedge funds? If the SEC considers and 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 minimum 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.
In addition, 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 that 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 and adjust procedures for checking, which will be far more challenging than reviewing a trade ticket or broker confirmation.
Finally, “cryptos=securities” has a regulatory implication 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 has been regulating crypto since 2017, many asset managers are also accustomed to taking regulatory direction from the CFTC. Consider, for instance, initial and variation margin requirements related to Dodd-Frank.
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, ahead of the SEC’s 2017 guidance letter, the CFTC released an enforcement action and settlement order against an unregistered online trading platform called the Coinflip Order.. The charge was for facilitating the trading of bitcoin options and future 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.
The CFTC concluded that “bitcoin and other virtual currencies are encompassed in the definition and properly defined as commodities.” As a result, option contracts that reference a virtual currency qualify as “commodity options” and “commodity option transactions.” Significantly, the Coinflip Order provides that derivatives (including futures, options, and swaps) that reference cryptocurrency units will be treated as commodity interests but not the actual cryptocurrency itself.
Further, in a landmark 2018 Memorandum to all employees, the CFTC determined that cryptocurrencies, such as Bitcoin, are commodities under the Commodity Exchange Act (“CEA”). Because cryptocurrencies such as Bitcoin are commodities, they are not prohibited interests. However, the ethics rules and regulations related to CFTC employee transactions in commodities will apply to your holdings and transactions in cryptocurrencies. Investment managers of funds that invest in such instruments may be subject to additional regulation under the CEA and CFTC and 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.
Investment managers who have been on the outside looking in at the multitude of launches of investment funds that invest in bitcoin and/or other virtual currencies will need to consider the regulatory impact on the fund and the investment adviser. While the OCC and Federal Reserve are regulating cryptocurrencies for banks, the SEC is regulating digital tokens as securities, and the CFTC has issued orders finding that derivatives that reference cryptocurrency units are treated as commodity interests. Together, investment managers will find their funds subject to federal regulators, and in addition, subject to changing regulations at the state level.
We strive to keep financial services clients informed of the rapidly changing regulations of cryptocurrencies and similar digital assets. Should you or your asset management firm need help in the space, reach out to us here.