In 2021, cryptocurrencies came into their own as a potential investment option for mutual funds, helped by expansion of the market for bitcoin futures contracts and the launch of the first bitcoin futures-based exchange-traded funds. There has been increased demand from both retail and institutional investors to gain exposure to cryptocurrencies, and this article explores the factors that should be considered by the board of a registered investment company considering investments in cryptocurrencies.
After briefly discussing cryptocurrencies and the value proposition they may provide to a fund, this article discusses three potential means of achieving exposure to such assets and the associated risks and operational issues for board consideration.
Generally speaking, a cryptocurrency is a unit of value that has three main features that distinguish it from other traditional, or “fiat” currencies (e.g., the dollar or yen). First, cryptocurrency is generally designed to be scarce, meaning that the number of units that will be issued is capped at a predetermined amount. For example, only 21 million bitcoin will ever be produced and will be released at increasingly lower rates over time. Second, cryptocurrency is “trustless,” meaning that transactions in a cryptocurrency do not rely on a trusted third-party intermediary (such as a bank or government), but instead rely on the consensus of users of the applicable network. Finally, a cryptocurrency is decentralized; anyone with a computer can participate. Given that bitcoin is the largest cryptocurrency, has the most available options for obtaining exposure, and is the cryptocurrency to which the Securities and Exchange Commission has devoted the most focus, this article focuses primarily on bitcoin and the various means by which registered funds may obtain exposure to it.
That cryptocurrencies such as bitcoin present a new way of holding and transmitting value is undisputed; that cryptocurrency is currently more often used for speculative activity than as a medium of exchange is equally accurate. Whether any cryptocurrency will become widely adopted as a unit of exchange is an open question. Nevertheless, investments in cryptocurrency remain popular for reasons beyond the sheer speculative value. For example, the potential that a particular cryptocurrency will become accepted as a unit of exchange or, because the number of units of cryptocurrency generally are capped, it may serve as a useful inflation hedge, but without the costs associated with moving and storing physical precious metals.
SEC Stance on Cryptocurrency
With the increasing development of cryptocurrency, the SEC’s positions on exposure to the asset have softened significantly. In a January 2018 letter, the then-head of the SEC’s Division of Investment Management enumerated several issues of concern the SEC staff had regarding a registered investment company’s exposure to cryptocurrencies, including valuation, liquidity, custody, arbitrage (for ETFs) and potential manipulation, and other risks. At that point, the SEC’s position stated in the letter was that registration statements should not be filed for funds that would invest significantly in cryptocurrencies, including bitcoin (whether directly or indirectly through means such as futures contracts), until the various concerns raised by the SEC were addressed to the SEC’s satisfaction.
Subsequently, in May 2021 the SEC staff noted that the bitcoin futures market had grown and developed significantly since the 2018 letter. The staff thus took a more lenient approach toward the possibility of mutual funds investing in bitcoin futures, though the staff specified that such investments should only be made by mutual funds “with investment strategies that support this type of investment and with full disclosure of material risks.” The staff also noted that they would continue to monitor the liquidity and depth of the bitcoin futures market, the ability of mutual funds to liquidate bitcoin futures to meet redemption requests, the valuation of bitcoin futures, liquidity classifications for the purposes of liquidity risk management programs, and the impact of any fraud or manipulation in the underlying bitcoin markets on bitcoin futures. Importantly at the time of the May 2021 letter, the SEC staff was still considering whether the bitcoin futures market could accommodate ETFs.
Shortly thereafter, in August 2021, SEC Chair Gary Gensler expressed his interest in reviewing filings for ETFs that invest in bitcoin futures, in a speech that the industry widely regarded as giving the green light to bitcoin futures-based ETFs. Within three months, the first futures-based bitcoin ETFs had launched.
Fund Exposure to Cryptocurrency
In light of the increased attention cryptocurrencies have received as an investment vehicle, as well as the SEC staff’s somewhat softened stance to the asset class, fund boards may want to be prepared to consider their oversight role in the event that an adviser wants to initiate a fund’s exposure to cryptocurrencies. Although a basic understanding of cryptocurrencies is helpful, board members should not feel compelled to become experts on the subject any more than they would with respect to other asset classes in which their fund may invest. To execute their oversight role, board members should understand (including through discussion or by requesting additional information, if necessary) the following:
- The role of the cryptocurrency in the fund’s investment strategy, and the ability of the fund’s investment adviser to oversee and implement an investment strategy involving cryptocurrency;
- The various risks of an investment strategy involving cryptocurrency, including under different market conditions; and
- The fund’s disclosure regarding the investment in the cryptocurrency—both the role in the fund’s investment strategy and related risks.
In relation to these threshold oversight matters, a board’s initial consideration is how the fund will achieve its exposure to cryptocurrency. Funds currently may do so with respect to bitcoin in three ways: (1) by holding “physical” bitcoin directly, (2) by investing in bitcoin futures contracts, or (3) by investing in other bitcoin funds. Each of these methods is discussed below, along with potential issues and operational matters that a board should consider.
Physical cryptocurrency currently is not a viable option for registered investment companies for several reasons, the most important of which is custody. Although options for custody of crypto assets are increasing, most major custodians have not yet started offering custody services to registered investment companies for cryptocurrencies. This may change, as Chair Gensler noted in his August 2021 speech that the SEC was “seeking comment on crypto custody arrangements by broker-dealers.” Accordingly, a registered investment company would need to either (i) engage the services of a custodian that may not have experience with registered funds or which may lack the resources of an established custodian, or (ii) engage in self-custody, which boards may consider too risky due to the high price volatility of cryptocurrency or the risk involved with safeguarding the private keys that grant access to the cryptocurrency.
Taxation is the second hurdle for a registered fund to consider with respect to holding physical cryptocurrency. Income from cryptocurrency (at least from bitcoin) would generally not be considered income derived from securities (colloquially referred to as “good income”) for the purposes of the source-of-income requirements for a fund to qualify as a “regulated investment company” under the Internal Revenue Code, which almost all mutual funds and ETFs strive to qualify as. Potentially, this would subject the fund to a second level of taxation at the fund level, which could be a massive disincentive for potential investors.
In addition, the SEC has expressed concerns about the liquidity, valuation and—most importantly—manipulation of cryptocurrency, all of which would need to be addressed by a fund intending to hold physical cryptocurrency. The SEC has refused to permit the offering and listing of ETFs that hold cryptocurrency directly, primarily due to concerns about potential manipulation of the spot markets for cryptocurrency.
Many of the concerns discussed above with respect to physical cryptocurrency are largely addressed by cryptocurrency futures. Currently, futures contracts on bitcoin are traded on CME. Custody concerns are addressed by Rule 17f-6 under the 1940 Act, which permits custody of margin with a futures commission merchant, and valuation is addressed because futures contracts are valued at a closing price on the futures exchange. In addition, although income from futures contracts would not qualify as “good income” for the purposes of the Internal Revenue Code, there is an established framework for holding futures contracts in an offshore subsidiary that satisfies the good income requirement.
Board considerations when assessing a fund’s intention to invest in bitcoin futures likely will include the following specific topics, among others:
- Liquidity: The fund’s holdings in cryptocurrency futures will need to be classified under the fund’s liquidity risk management program. Specifically, how will the liquidity risk management program address changes in trading volume, margin requirements, position limits, and—if applicable—investments in reverse repurchase agreements used to obtain additional exposure to cryptocurrency futures?
- Valuation: How will fair valuation processes address any market problems for cryptocurrency futures (e.g., trading halts), particularly once new Rule 2a-5 takes effect?
- Derivatives: How will the fund comply with all the requirements of Rule 18f-4 for any cryptocurrency-related derivatives, including bitcoin futures contracts?
- Disclosure: Among other topics, the fund’s disclosure must address risks related to liquidity, valuation, and derivatives but must also discuss “contango,” which is the risk that the fund will pay more for longer-term futures contracts than it receives in proceeds for liquidating shorter-term futures contracts, thus eroding the fund’s assets and leading to a potential discrepancy between the value of the bitcoin futures contracts held by the fund and the spot price of bitcoin.
- CFTC regulation: Depending on the magnitude of futures holdings, the fund might be classified as a “commodity pool” under CFTC regulation, and the adviser would need to register as a “commodity trading adviser” or “commodity pool operator.”
In addition to the foregoing, a board will want to carefully consider how the proposed investment in cryptocurrency futures affects the fund’s other policies and procedures, as well as the fund’s existing disclosures.
The third method of gaining exposure to cryptocurrencies is through investment in cryptocurrency ETFs, privately offered cryptocurrency funds, or foreign cryptocurrency funds. Pertinent aspects of each investment vehicle are considered below.
- Cryptocurrency ETFs: Several futures-based bitcoin ETFs have recently launched in the United States. Although buying and selling shares in such ETFs is easy, funds will have to comply with Rule 12d1-4, the new “fund-of-funds rule,” when making investments. In compliance with the fund-of-funds rule, the adviser must make “fund findings” on the part of acquiring funds, including findings that the structure is not overly complex and fees are not duplicative. In addition, the acquiring fund must enter into an agreement with the acquired fund if investments will exceed 3% of the acquired fund’s outstanding voting securities. The acquired fund may decline to enter into such an agreement—thus effectively capping the acquiring fund’s investment at 3% of the acquired fund—due to concerns about its own capacity constraints.
- Privately offered cryptocurrency funds: A number of privately offered funds invest directly in bitcoin, the largest and most prominent one being the Grayscale Bitcoin Investment Trust (GBTC). Although exposure to physical bitcoin through a vehicle such as GBTC may be attractive to a fund, there are several features that should be considered. Interests in GBTC are quoted through OTC Markets, but they only are available for secondary trading through the Rule 144 underwriter exemption (requiring at least a six-month holding period). Moreover, Grayscale is not permitted to offer redemption of units of GBTC under the rules of the Securities Exchange Act of 1934, as amended. For that reason, interests in GBTC would be classified as illiquid under Rule 22e-4 (known as the “liquidity rule”), effectively limiting the amount that a mutual fund may invest in GBTC. These features have led to premiums and discounts between the market price and the net asset value of GBTC interests based on swings in supply and demand for GBTC interests. In addition, income from GBTC does not qualify as “good income” for tax purposes.
- Foreign cryptocurrency funds: Canadian regulatory authorities have permitted several ETFs that hold physical cryptocurrency directly. However, Canadian regulations impose limits on foreign ownership of Canadian ETFs, which may prevent them from being used at substantial scale by U.S. funds. In addition, the ability of U.S. funds to invest in Canadian ETFs may be limited by the SEC; several of the recently launched U.S. bitcoin futures ETFs initially reserved the right to invest in Canadian bitcoin ETFs but removed this ability at the behest of SEC staff.
The number and types of cryptocurrency funds have been expanding rapidly, including several recent filings for physical bitcoin ETFs and leveraged bitcoin ETFs, none of which have received SEC approval.
Regardless of the means through which a fund achieves exposure to cryptocurrency, a board’s oversight of a new fund investment strategy involving cryptocurrency will involve a host of considerations—many familiar to oversight of any new investment strategy, but others perhaps more unique due to the innovative nature and continuing evolution of cryptocurrencies. But even if a fund has no current plans to invest in cryptocurrency, a board may wish to consider taking steps to better understand such assets and the means by which a fund may gain exposure to them, as one easy 2022 prediction is that cryptocurrencies and ways to invest in them will continue to be of interest to investors.
Jeremy I. Senderowicz (pictured above, left) is a shareholder in Vedder Price’s New York office and a member of the firm’s Investment Services practice group. He focuses his practice on advising registered investment companies, private funds, and their investment advisers on a variety of matters pertaining to the Investment Company Act of 1940, the Investment Advisers Act of 1940 and other securities laws. He is a leading practitioner in the area of ETFs and also has advised numerous clients in matters relating to cryptocurrency and blockchains, including proposed offerings of bitcoin ETFs and other issues relating to funds that invest in cryptocurrency and the use of blockchains by asset managers and in securities offerings.
John M. Sanders (pictured above, right) is an associate at Vedder Price and a member of the firm's Investment Services group. He focuses on advising a wide range of issuers, including open- and closed-end funds, ETFs, crypto funds, and ETFs and their advisers, as well as public and private companies.