Common Questions Related to Cryptocurrency Funds
[Note: information posted on May 19, 2017. Certain areas below will be updated periodically and we will update the timing of the information in each particular section.]
We recently wrote an overview of bitcoin/altcoin hedge funds. That post led to a number of conversations with current and future cryptocurrency managers which yielded a number of questions regarding the business and regulatory issues applicable to these fund structures. Some of the items we discussed are issues of first impression. Some of the items probably don’t have “for sure” answers and instead we look to industry best practices for guidance. While there will be a lot of “grey areas” and “probablys” and “I don’t knows” in this space as the regulators start to become more involved, I have tried my best to address these items below in my answers to these common questions.
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Are Bitcoins and other Cryptocurrencies “securities” under the Securities Act of 1933?
Many of the very large cryptocurrencies like Bitcoin and Ethereum are probably not “securities”, and can probably be classified as “digital currencies” for now. Other cryptocurrencies or tokens would need to be examined on a facts and circumstances basis. For such an inquiry, I believe the Coinbase Securities Law Framework (See Appendix A) is a great place to start.
Why does it matter?
If a hedge fund invests in or buys a cryptocurrency, and that cryptocurrency is deemed to be a security, then the fund’s management company (general partner) will be, by definition, an investment adviser under federal law and most likely the laws of the state where the management company operates (where the sponsor/owner of the management company is physically located). If the management company is an investment adviser, then the management company will need to register with the SEC (upon reaching certain asset levels, generally $150M) or with a state securities commission. Some states may have exemptions from registration, like the Exempt Reporting Adviser (ERA) regime. (See here for information on the SEC ERA regime and here for California’s ERA regime.) If a management company registers as an investment adviser or ERA, the manager will be required to have the fund undergo an annual audit, and there will also be a requirement that performance fees be charged only to qualified clients. Additionally, regardless of manager’s registration status (SEC, state or is an ERA) the manager will be subject to the anti-fraud provisions of Section 206-4 of the Investment Advisers Act which generally governs the manner in which the adviser communicates with the public.
If a cryptocurrency is deemed to be a security, then the fund would also technically be subject to the Investment Company Act of 1940. Most hedge funds utilize either the 3(c)(1) or 3(c)(7) exemption from registration under the ICA. In general this will not wildly change the fund’s offering documents, but it will be an item that needs to be addressed.
What if the cryptocurrencies are not deemed to be securities?
If the fund only invests in assets that are not securities, then the investment advisory regulatory regime does not apply. This means there would be no regulatory requirement for an audit (assuming no CFTC regulations apply) and the manager could charge performance fees to non-qualified clients. The Investment Company Act would also not apply which means that the fund would be able to have more than 99 investors. The fund would, however, still be limited to 35 non-accredited investors over the life of the fund to maintain the 506 exemption under the Securities Act.
What about state regulations and New York’s BitLicense registration requirement?
Outside of the investment advisory regulations that would be applicable to a manager if the cryptocurrency or token was deemed to be a security, the states don’t really have regulations applicable to bitcoin managers.
With respect to New York’s BitLicense requirement, we believe that currently these regulations are not applicable to the standard bitcoin hedge fund manager who is only buying and selling bitcoin (and other tokens/altcoins) for the fund’s account. The BitLicense requirements may apply (depending on facts and circumstances) to managers who engage in other aspects of the cryptocurrency industry – such as issuing coins or otherwise acting as an exchange platform. We expect other states to develop legal and regulatory frameworks similar to New York in the future, and in the event the SEC attempts to shoehorn bitcoin managers into the definition of investment adviser, we believe the states would shortly follow suit.
What about an auditor? If I have to have an audit, what will that be like and how much will it cost?
In the event a manager engages an auditor, the auditor will be able to discuss the process and procedures that will be employed. Because there is additional work involved in a bitcoin launch, it is likely that an audit will be more expensive than for a similarly sized fund investing only in publicly traded securities.
There are not many groups who can audit funds in this space. Some groups can audit in this space, but can only audit major cryptocurrencies. As more groups get into the space and procedures become more defined, we expect that audit prices will eventually come down a bit.
Cryptocurrencies present a number of issues for audit firms including: (1) existence of the asset/currency, (2) control of the asset/currency, and (3) custody. For many altcoins, the first two issues can be addressed with a review of the blockchain and the manager showing control of the asset by moving it on the blockchain in some manner. The last issue is potentially more problematic in that the investment management industry is used to a certain definition of custody (holding something) that may not fit within the digital asset space, where control and the ability to utilize an asset is really more of the applicable context.
What about an administrator?
A hedge fund administrator provides certain accounting and other operational functions for the fund like subscription document processing. Normally the fund administrator will be responsible for calculating NAVs on a monthly/quarterly basis and when investors enter and exit the fund. They also compute management and performance fees. Having an administrator is not a regulatory requirement for a cryptocurrency fund, but it is a best practice. We will note that all of the cryptocurrency funds we have worked with have decided to engage an administration firm.
What about bank accounts?
One to two years ago, there was no issue for a manager to get a bank account for a bitcoin hedge fund. Since then, bitcoin has become a risk for banks and over the last six months we’ve seen banks fully eschewing this space. Groups who previously banked bitcoin funds will not bank new funds (although they would continue to maintain existing accounts) and groups who were not in the space are completely staying away. We have fortunately been introduced to a couple of banks who are now more comfortable with banking cryptocurrency clients. While these banks can provide the very basic subscription account for funds, there also may be value-added services, especially with respect to transfers to and from exchanges, as well as API integration.
The process to get a bank account is going to be a little longer than for a traditional hedge fund because the bank will complete more due diligence than for a normal fund (i.e., look into the business background of the manager, the proposed investment program, who the investors are, etc). While these groups are comfortable with the cryptocurrency space in general, they likely will not bank groups who pose even the slightest reputational risk or groups who have had regulatory issues in the past.
What about compliance and outside compliance consultants?
Right now compliance really only applies to the fund structure (as opposed to the manager as would be the case if the manager was an investment adviser). Fund compliance really just involves the legal requirements related to the Regulation D 506 offering applicable to the issuance of fund interests (e.g. Form D filings, annual updates and amendments, blue sky filings, etc).
Compliance related to the management of a cryptocurrency portfolio is really nonexistent. We would expect that the managers would adhere to normal anti-fraud provisions, and a best practice would be to have certain business continuity plans and other standard fund management policies and procedures, even if there is no outside regulatory requirement. Some groups have asked us about setting up compliance programs in anticipation of future compliance needs and we think this is a good idea. Either a law firm or a compliance consulting firm would be able to draft a compliance manual for the needs of a cryptocurrency fund manager.
What about ICOs?
As of right now, there are no extra regulatory requirements around participation in initial coin offerings (ICOs). We believe that this will change in the future.
What are some common terms of bitcoin funds?
The biggest questions are around lock ups and liquidity. In general most managers will tend to want to provide less liquidity than investors are looking for and some managers have thought about instituting gate provisions, especially if the investment program is focused on smaller altcoins that may have less liquidity. We are also seeing a number of managers who would like to allow in-kind contributions and distributions, which will implicate certain tax regulations.
How is bitcoin taxed?
The IRS addressed this issue in 2014 when it released Notice 2014-21, IRS Virtual Currency Guidance. Right now most cryptocurrencies (and other “virtual currencies”) are treated as property and subject to the normal tax principles regarding property. This means that dispositions of virtural currencies will result in short-term or long-term capital gains or losses and not foreign currency gains or losses. Standard ways to determine gain or losses at disposition will apply (for most cryptocurrencies), and we would look to the various exchanges to determine a price of a cryptocurrency at any particular point in time. This would be important if a manager or other investor in a fund decided to invest in a fund through an in-kind cryptocurrency contribution.
According to Notice 2014-21, bitcoin is deemed to be a “convertible” virtual currency because it has an equivalent value in real currency. Early this year bitcoin became legal tender in Japan.
What about separately managed accounts or prop trading?
As of right now we do not know of any way to create a traditional separately managed account structure for an investment in cryptocurrencies. In a SMA structure in the traditional securities space the client will typically establish a brokerage account at a large broker (Schwab, Fidelity, etc) and the manager will be given power of attorney to trade the account. The relationship is governed by some kind of advisory agreement laying out the fees and term of the relationship. Typically the brokers will have a way for the manager to have trading only access to the client’s account. We do not believe that any of the exchanges currently have this functionality. We anticipate that sometime after the regulatory agencies implement a regulatory structure that the exchanges will create mechanisms to implement such relationships on their platforms.
Other Items
We anticipate writing about the following soon in some fashion:
- Creating structures to allow funds to invest on exchanges that do not allow U.S. persons
- Creating structures to allow funds to invest on exchanges that do not allow New York persons
- Third party marketing in the cryptocurrency space
- Using the ICO process to launch a private fund
- Issues around Regulation D, including the Bad Actor regulations
Final Notes
Please reach out if you have questions on any of the above. We will continue to update as we run into more issues and common questions.
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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.