Overview of Blockchain Based Digital Currency Investment Fund Structures
Bitcoin has recently been in the news again due to strong results over the last couple of months. Bitcoin and other digital currencies have been a bit of a fringe phenomenon in the investment management industry since inception. However, the power of the idea of distributed computing/ledgers has been evangelized in various parts of the tech industry and has attracted a significant amount of institutional investment into various digital currencies, and related infrastructure. It is not surprising then to see asset managers beginning to explore this space either through dedicated fund products, or through side pocket investments separate from more traditional products. This post discusses the various structural, regulatory, and operational issues that arise for managers who invest in these instruments.
Foundational Items – Definition
For purposes of this article, we make references to the term Bitcoin and digital currencies. These references will generally mean references to other blockchain-based currencies and/or digital tokens, which are sometimes referred to as cryptocurrencies or altcurrencies. There are various governmental agencies looking into how to define and regulate this space, and the CFTC has specifically defined the term “Bitcoin” in the following way:
Bitcoin is a “virtual currency,” defined here as a digital representation of value that functions as a medium of change, a unit of account, and/or a store of value, but does not have legal tender status in any jurisdiction. Bitcoin and other virtual currencies are distinct from “real” currencies, which are the coin and paper money of the United States or another country that are designated as legal tender, circulate, and are customarily used and accepted as a medium of exchange in the country of issuance. [See note 2 of the CFTC order discussed below.]
Another foundational item of this post is whether Bitcoin is a “security” under securities laws, or a currency under commodities laws, or both, or something else. We will discuss this issue in greater depth below under regulations, but for the general purposes of this article, we will take the position that Bitcoin is not a security regulated by the SEC nor state securities regulators. We will also take the position that Bitcoin is likely a currency that is subject (in some instances) to regulation by the CFTC.
Structural Considerations for Fund Formation
Although there are unique qualities of Bitcoin (it does not act like a security and it is debatable whether it acts like a commodity/currency), the big picture structural considerations for a fund manager in this space will not be significantly different than for a traditional hedge fund investing in securities and/or commodities.
• Hedge Fund or Private Equity Strategy. For the Bitcoin funds we have worked with, the strategies tend to be more hedge fund styled than private equity styled. This generally makes sense given the relatively “liquid” nature of the instrument. If a fund invests directly into operating companies in the digital currency ecosystem, or if a fund sets up operations to mine for Bitcoin, there may be the need for side-pocket private equity style sleeves within a larger liquid framework.
• Fund Terms. Normally we see standard hedge fund style terms; as well as expenses and fees that are generally similar to standard securities type fund programs (if anything, there may be greater management and performance fees because of the novel strategy / managers tend to have deep backgrounds in cryptography, mathematics and coding). Contribution provisions will also be standard. However, we tend to see greater attempts to limit withdrawals. Such measures could include longer withdrawal periods with longer notice provisions (60-90 days), and the use of investor level or fund level gates. Custody is a big issue, and valuation has the potential to be an issue as well. The use of leverage does not tend to be a major part of this investment strategy.
• Onshore / Offshore Structures. As with other non-traditional hedge funds, the structure will be influenced by the taxation of the underlying investments and the nature of the investors. As of right now, we are not aware of any adverse tax consequences with respect to digital currencies for U.S. based investors; therefore, a standard domestic Delaware limited partnership structure should be sufficient. If the fund will have U.S. tax exempt investors, the domestic structure should be sufficient if the fund does not utilize leverage. To the extent the tax code changes in the future to tax digital currencies specifically, the structural considerations may change.
If the fund complex intends to have non-U.S. investors, the manager will choose between a mini-master structure or a master-feeder structure. Jurisdiction of any offshore structure will likely be the Cayman Islands or the British Virgin Islands. We have not seen and do not necessarily believe there would be a reason for a fund complex to introduce SPV structures to accommodate digital currency investment, but if that occurred, such structuring discussions would be based on normal factors like jurisdiction of the underlying asset, corporate necessity, etc.
Regulatory and Other Considerations for Bitcoin Investment Managers
There are a number of instrument-related issues which arise for fund managers who are investing in this space. Because of the relatively nascent stage of these instruments, managers and service providers are working out the below issues, and the way these issues are handled should become more standardized in the near future.
• Federal & State Regulatory System.
SEC – Bitcoin and other digital currencies are most likely not securities; but, the SEC is currently examining how to deal with Bitcoin and other digital currencies. The biggest question is whether these instruments are securities or some other kind of asset subject to (or not subject to) regulation. If these digital currencies are securities, then the SEC will have jurisdiction to regulate the instruments, as well as the transfer of such instruments (including the regulation of any exchange facilitating such transfer). Because the SEC has not released any definitive guidance on the issue, Coinbase, a large Bitcoin wallet and exchange platform, has released the following discussion about how digital currencies fit into the SEC regulatory landscape (see Securities Law Framework for Bitcoin). Until we receive definitive guidance, or even informal guidance, from the SEC, the Coinbase framework discussion is probably the best reference material with respect to this particular issue.
CFTC – While it is clear that Bitcoin is fundamentally different from normal currencies traded on the Interbank or forex markets, what is less clear is whether and to what extent the CFTC has jurisdiction over the instrument and the exchanges on which they are traded on. Unfortunately, the answer is not exactly clear and the uncertainty, in part, comes from parts of the Dodd-Frank Act which provided the CFTC with new jurisdiction over parts of the currency trading systems in place in the United States. Because of certain the technical aspects of trading currencies both on the spot (interbank) and futures markets, and how those technical aspects inform the jurisdictional reach of the CFTC post Dodd-Frank, some part of this discussion is theoretical (what is delivery of a digital currency? what is custody of a digital currency and is this different from custody of a password?). While our law firm is currently in discussion with the CFTC as to whether a straight digital currency (as opposed to a digital currency forward or future) is a contract subject to CFTC jurisdiction, we currently believe that a private fund’s purchase of a Bitcoin or similar digital currency would not be subject to CFTC oversight (which would require the private fund manager to register as a CPO and CTA, or fit within exemptions). Notwithstanding the above, some types of instruments involving Bitcoin are commodities subject to CFTC oversight—please see Coinflip CFTC Order. In this order, there were a number of issues that led to the finding of regulatory oversight (products were deemed to be swaps; CFTC specifically mentioned OTC Bitcoin forward contracts as other contracts which may be subject to CFTC jurisdiction, see note 4).
CFTC and SEC? – In the future, it is likely that we will begin to see products linked to and based on Bitcoin, which have both the characteristics of a security and a futures product, thus subjecting such future instruments potentially to both CFTC and SEC jurisdiction. We would expect to see future legislation enacted both to define the nature of digital currencies, and any derivatives thereon, and also to define the scope of the CFTC and SEC’s jurisdiction over such products.
State – We have not heard of any state orders, actions or interpretations involving Bitcoin. We would expect the regulation of such assets to be driven by federal authorities, but we do not discount the fact that many state securities regulators (especially on the west coast) can take aggressive positions regarding new products.
• Regulation of Management Company. Depending on where the manager fits within the regulatory spectrum discussed above, the manager may be subject to oversight and regulation. If the manager is deemed to be an investment adviser, or CTA and/or CPO, based on the above, the manager would be subject to the normal registration and compliance frameworks associated therewith. Managers who invest in other Bitcoin or cryptocurrency funds are definitely investing in securities (a private fund is a security), so a bitcoin fund of funds manager is deemed to be an investment adviser and would need to be registered (or fall within an exemption from registration) with the SEC or state securities commission. While we have seen some significant investment into the space, we acknowledge that the sector is still in its infancy and that we will probably begin to see more institutionalization among managers in this space.
• Custody. Perhaps the biggest issue with respect to these instruments is how and where they are custodied, and also how and where the passwords, keys or other information related to the proof ownership are custodied. We believe that each manager needs to develop their own methods to deal with the custody issue, and that these methods will need to address the associated risks of ownership or the particular currency (as discussed in the Securities Law Framework for Bitcoin, each instrument has unique characteristics). In addition to the managers we have worked with, we have heard anecdotal stories about the many different ways managers store and protect the fund’s ownership and evidence of ownership of the digital currencies, including the use of thumb drives and bank safety deposit boxes.
• Risks. A fund in this space will need to focus of the normal risks inherent for any private investment vehicle, but there are additional risks to consider related to the strategy, including: general risk of digital currencies, liquidity, ability to hedge, volatility, loss of private keys, technology and security issues, risk of exchanges (e.g. Mt. Gox), lack of FIDC or SIPC protection.
• Service Providers. The typical service providers in this space (lawyers, administrators and auditors) have been working together to figure out how to deal with the novel and unique issues presented from these instruments.
• Other Issues. There are a host of other issues which arise in this space that will continue to be flushed out over time. These include IT infrastructure for managers and general security over passwords. Valuation has the potential to be an issue depending on the exact nature of the digital currency, and whether the currency is fungible and traded on different exchanges that have different pricing. Valuation also may be an issue if it is determined that there is no public market or exchange for the instrument. Taxation of the gains on these instruments may also change in the future (right now, they presumably are taxed under IRC Section 988). Additionally, there may be capacity constraints as a large number of investors begin to pile into these investments, including when the derivatives markets take hold.
We have worked with a number of groups in this space over the past two years, and have seen an uptick in interest in managing a private fund to invest in Bitcoin and digital currencies. We believe the interest stems from the strong returns of Bitcoin, as well as the public’s growing acceptance of alternative currencies. We also think that a general increase in exposure of Bitcoin has contributed to an interest in being able to invest in digital currencies. As these investments become more standardized and regulated, we believe we will continue to see growth in this area.
Bart Mallon is a founding partner of Cole-Frieman & Mallon LLP. Cole-Frieman & Mallon has been instrumental in structuring the launches of some of the first digital currency-focused hedge funds. For more information on this topic, please contact Mr. Mallon directly at 415-868-5345.