Fund directors: Making heads or tails of blockchain

October 25, 2018

By Jay G. Baris and Nathan J. Greene, Shearman & Sterling

Blockchain has been likened to the “second generation” of the internet. The technology, including digital assets such as coins, tokens and related derivatives, has the potential to disrupt traditional business models and investment paradigms.


With more and more large financial institutions already involved with bitcoin and similar assets, it may not be long before mutual funds jump on the blockchain bandwagon. In the not-too-distant future, funds may invest in blockchain-related assets, such as cryptocurrencies or related derivatives, or fund service providers may use blockchain technology.


To stay current with these market developments, fund directors should understand the basics of blockchain, digital assets and cryptocurrencies. In this article, we summarize some of these basics and questions you should consider asking.


What is Blockchain?

Blockchain (also known as distributed ledger technology, or DLT), in theory, allows almost anyone with a computer, an internet connection and the right computer program to effect and verify a transaction on a “public ledger.” Before this technology was available, a single trusted record keeper, such as a bank or a transfer agent, would maintain a single master ledger (a “golden copy”) to effect and record a transaction. For example, when an investor wires money to a financial intermediary, which in turn wires the purchase proceeds to a fund’s distributor to buy shares of the fund, a ledger exists at each step. The outgoing wire creates a ledger entry, the receipt creates a ledger entry, and the sale of shares creates a ledger entry. These ledgers are all, however, privately maintained, often with interfaces for outsiders.


In contrast, you can think of a public blockchain as a giant, decentralized, publicly available database that is a different kind of master ledger, but one that the whole world can access. Transactions are recorded on the ledger through encrypted codes in “blocks.” Each block is aggregated with each previous block, which forms the “blockchain.” In effect, anyone can enter a transaction that becomes, for all practical purposes, immutable and verifiable. Anyone with access to the computer protocol can see the blockchain entry. A private, or permissioned, blockchain is similar to a public blockchain, but access is limited to authorized users.


You need two keys to effect a transaction on a public blockchain: a “public key,” which is recorded on the public ledger, and a private key that is particular to the sender and the receiver. Everyone can view the public key, but the private key allows for anonymity of the individual participants. The private key is similar in concept to a second key required to open a safe deposit box (but anonymous). The blocks are arranged in chronological order, and a transaction represented by a “block” of data cannot be changed.


This technology has been characterized as “disruptive,” because it effectively eliminates the need for a middleman (e.g., a transfer agent or other master ledger keeper) in order to effect a transaction.


Bitcoin vs. Blockchain

What is the difference between bitcoin and blockchain, and how will it affect the fund business? When many people think of blockchain, they think of bitcoin. Bitcoin is a “digital currency” that is simply one application of the blockchain technology. The bitcoin blockchain was created to provide a decentralized ledger to effect bitcoin transactions without a central bank or other financial intermediary.            


What are digital assets?


Digital assets include cryptocurrencies and various kinds of tokens, or coins. Digital currencies (also known as virtual currencies) represent a store of value. Unlike “fiat currency” such as dollars or euros, digital currencies are not issued or backed by any government, and so they are not “legal tender.” Rather, digital currencies exist as computer code entries on a digital ledger (e.g., blockchain) and are worth only the value that someone will pay for them. As digital currencies become more commonly accepted, they can be used to pay for goods and services without the need of opening a bank account.


Bitcoin is the most widely recognized digital currency. Over the past couple of years, the value of bitcoin has fluctuated wildly, giving rise to a market not only for bitcoin but for derivative instruments, such as futures contracts or swaps, that track the price of bitcoin. At the outset, it is possible that funds wanting exposure to this asset class will invest in derivatives that provide some degree of economic exposure without the need to invest directly in the cryptocurrency itself.


“Utility tokens” generally refer to digital coins or tokens that serve a particular function, or provide rights or access to goods, licenses or services. “Investment tokens” or “securities tokens” are digital assets that have characteristics of investment contracts, or traditional securities. The Securities and Exchange Commission has said that it would regulate these kinds of tokens as securities.


How would funds invest in digital assets?


Of course, individuals can invest directly in bitcoin and other digital assets. Registered investment companies (including exchange-traded funds) that invest primarily in digital assets do not yet exist, and the first step in their organization would be to file a registration statement with the SEC that describes the investment program. So far, the SEC has not allowed these products to reach the market, citing concerns about valuation, liquidity, safekeeping (custody) of assets, and potential market manipulation, among others. And, while still uncommon, the most popular way for a registered investment company to invest in bitcoin-related assets is to invest in private funds that invest in those assets—and to do so only as a modest component of a broader investment program. Generally, those funds are not publicly traded and are available only to “qualified purchasers”.We expect it will be some time before mutual funds invest directly in bitcoin and other digital assets.


How will fund service providers use blockchain technology? 


Blockchain technology can provide many uses, and slowly traditional financial institutions are embracing this technology. For example, the State of Delaware, beginning August 2017, enacted laws that allow companies to create and maintain corporate records, including their stock ledgers, on a blockchain. Thus, rather than use a traditional transfer agent, a corporation would be able to use a network of private databases (e.g., a blockchain) to assume the administrative function of maintaining its stock ledger. This technology has potential implications for investment companies that employ service providers such as broker-dealers, transfer agents administrators and custodians, that embrace this technology.


Blockchain-based ledgers also are being used to test new modes of trading “paper-intensive” instruments like loans and trade claims. Thus, certain asset classes that traditionally involve cumbersome transaction procedures may become easier to trade when the technology results in more efficiencies.


Regulatory Landscape

Federal and state regulators have reacted to the rapid growth of digital assets by stepping up their oversight. This regulatory activity appears as the regulators struggle to determine how to apply old laws to this new investment class. The SEC, Commodity Futures Trading Commission, FINRA and the federal and state banking regulators each claim jurisdiction over some aspect of the market of digital assets. While the boundaries of jurisdiction (that is, which regulator regulates what aspect of a digital asset) are becoming clearer, there is still some overlap and potential for regulatory turf wars and redundant regulation.


The SEC and its Division of Investment Management. On Jan. 18, 2018, Investment Management Division Director Dalia Blass raised significant questions about how funds holding significant cryptocurrencies and related products would satisfy the requirements of the Investment Company Act of 1940. The letter raised concerns, not surprisingly, about valuation, liquidity, custody, arbitrage for ETFs, cybersecurity and potential for market manipulation. Among other things, the SEC staff said that custody of digital assets presented unique challenges. For example, digital assets appear only as coded entry on a blockchain. How would the adviser and the custodian validate the existence and exclusive ownership of private cryptocurrency keys?


In 2018, consistent with the staff positions and with public statements by SEC Chair Jay Clayton, the SEC disapproved of a proposed exchange rule change that would have allowed several bitcoin-related ETFs to list and trade shares. Although the SEC cited technical reasons, the denials sent a clear signal that the SEC did not believe that the market for the underlying assets was sufficiently mature to justify investment by retail investors through ETFs.


At least one SEC commissioner has said that by withholding approval of bitcoin-based ETFs, the SEC stifles innovation, which in turn adversely affects capital formation and even investor protection.


The SEC also has actively pursued sponsors of digital asset offerings that they consider to be offerings of securities. For example, the SEC will apply the federal securities laws when it believes that an “initial coin offering” involves securities. Similarly, the SEC has gone after promoters when it believes the offerings involved fraud.


To be sure, the rapid growth of blockchain-related investments presents great challenges for the SEC as it attempts to balance its three stated goals: protecting investors; maintaining fair, orderly and efficient markets; and facilitating capital formation. These challenges include protecting investors from fraud while allowing room for innovative products. Other federal and state regulators face similar challenges.


Oversight: Questions for Fund Directors

It is not too early for fund directors to think about how their funds will invest in digital assets or hire services providers that use blockchain technology. Here are some questions to ask the adviser:


  • What are the fund’s plans to invest in digital assets, such as bitcoin or other cryptocurrencies, tokens or related derivatives?
  • Do the adviser and portfolio managers have sufficient knowledge and understanding of the market for digital assets?
  • Are the fund’s custody arrangements sufficient to protect the fund’s digital assets?
  • How will the fund and the adviser change their compliance policies and procedures to address the challenges presented by investment in digital assets (e.g., limitations on personal trading by access persons)?
  • Is the market for the digital assets in which the fund would invest sufficiently liquid?
  • Is the underlying market for digital assets sufficient to allow for the ETF arbitrage mechanism to work effectively (i.e., to ensure that the spread between the ETF’s net asset value and the market price of its shares is appropriate)?
  • Will the funds contract with service providers that permit them to utilize blockchain technology? What safeguards will those service providers establish to ensure that the fund’s operations comply with relevant laws and that the fund’s assets are protected?


Like it or not, digital assets are here to stay. Neither the recent gyrations in the price of cryptocurrencies nor the uptick in SEC enforcement cases is likely to slow the momentum of the growing market for digital assets, especially with larger financial institutions now tiptoeing into this new area. Registered fund directors can prepare for this eventuality by beginning to understand the basics of blockchain technology early on.

Jay G. Baris (pictured, above left) is a partner in the Investment Funds practice at Shearman & Sterling where his work with registered funds spans mutual funds, closed-end funds, exchange-traded funds and business development companies. He is widely recognized for his breadth of experience representing registered funds, investment advisers, financial institutions, broker-dealers and independent directors on the full spectrum of financial services regulation, transactions and governance matters. Baris chairs the Task Force on Blockchains, Cryptocurrencies and Investment Management of the American Bar Association’s Federal of Regulation of Securities Committee.



Nathan J. Greene (pictured, above right) also is a partner in the Investment Funds practice where his work includes the formation and representation of U.S. and foreign investment companies, sponsors, advisers and directors, including SEC registration, exemptions, inspections and investigations; fund formation, distribution and marketing; fund board and governance matters; compliance manuals and testing; and high-profile corporate transactions involving asset management businesses.

For a more complete description of blockchain and digital assets, click here to read "Blockchain Basics for Investment Managers: A Token of Appreciation" by Jay G. Baris and Joshua Ashley Klayman, (The Review of Securities & Commodities Regulation, March 21, 2018).



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