The growth of the digital asset space in recent years has naturally led to the advent of “cryptocurrency hedge funds” and other investment management firms that make digital asset investments on behalf of their clients. Among the many unsettled regulatory questions that currently surround cryptocurrency and other digital assets is how the Investment Advisers Act of 1940 (“Advisers Act”) applies to these digital asset-focused investment management firms.
On January 18, 2018, the SEC’s Division of Investment Management issued a letter ("Staff Letter”) to the Investment Company Institute ("ICI") and the Securities Industry and Financial Markets Association ("SIFMA") that offers some degree of insight into how the SEC staff views certain compliance obligations that are applicable to registered investment advisers. Although the Staff Letter generally focuses on mutual funds and exchange-traded funds (“ETFs”) that invest in cryptocurrency, some of the regulatory compliance issues discussed in the letter are relevant to any registered investment adviser that invests client money in digital assets.
This Alert provides an overview of two compliance issues the SEC staff discussed in the letter - valuation and custody - and explains why these compliance issues should be assessed not only by sponsors of cryptocurrency-focused registered funds but also by other investment advisers that invest in the digital asset space.
Valuation Discussion in the Staff Letter
The Staff Letter highlights outstanding questions the SEC Staff has concerning how mutual funds and ETFs holding substantial amounts of cryptocurrencies would satisfy the requirements of the Investment Company Act of 1940 (“Investment Company Act” or “IC Act”).
The first question discussed in the Staff Letter relates to valuation. Mutual funds and ETFs are required to value their assets each business day to strike a net asset value (“NAV”). The Staff Letter emphasizes the importance of valuation in that it determines fund performance, what investors pay for or receive for mutual fund shares, and what authorized participants pay for or receive for ETF shares. With this background in mind, the Staff Letter asks the following questions about how registered funds would value cryptocurrency assets they hold:
- Would mutual funds and ETFs have the information they need to adequately value cryptocurrencies? How would these valuations approach or account for volatility, the general lack of regulation of underlying cryptocurrency markets, and the current trading volume in the cryptocurrency futures markets?
- How would registered investment advisers develop and implement policies and procedures to value and, in many cases, "fair value" cryptocurrencies and cryptocurrency-related products?
- How would these policies and procedures address the occurrence of significant events relating to cryptocurrencies? As an example for such an event, the Staff Letter points to instances when the blockchain for a cryptocurrency diverges into different paths (sometimes referred to as a “fork”), which may result in different cryptocurrencies with different prices.
- How would registered funds account for any holdings they have of newly created cryptocurrencies offered by promoters (e.g., an "air drop”)?
- How would differences among types of cryptocurrencies affect registered funds' valuation and accounting policies?
- For registered funds that invest in cryptocurrency futures, how would these funds consider the impact of market information and potential manipulation in the underlying cryptocurrency markets when determining the settlement prices of cryptocurrency futures?
Valuation under the Advisers Act
Unlike mutual funds and ETFs, investment advisers to private funds or separately managed client accounts (“SMAs”) are not technically required to value assets each business day and do not generally strike a daily NAV. However, valuation is important for private funds and SMAs for two general reasons: first, the adviser's fee calculations are typically dependent upon the prices assigned to assets held in these client accounts; second, for open-ended private funds, NAV is generally calculated on either a monthly or quarterly basis and that NAV determines what investors pay when making new subscriptions to a fund and what investors receive when making redemptions from a fund.
To the extent that private fund and SMA managers calculate NAVs of client assets on a monthly or quarterly basis, the digital asset valuation issues discussed in the Staff Letter still apply. For example, when determining the value of digital assets, managers need to take into account the relatively high volatility of these assets as well as the general fragmentation of digital asset markets.
Rule 206(4)-7 under the Advisers Act requires a registered investment adviser to adopt compliance policies and procedures reasonably designed to prevent violations of the Advisers Act by the adviser or its supervised persons. In the adopting release for Rule 206(4)-7, the SEC noted that an adviser's compliance policies and procedures should, at a minimum, address certain areas to the extent they are relevant to that adviser's operations, including processes to value client holdings and assess fees based on those valuations. The adopting release also stated that "each adviser, in designing its policies and procedures, should first identify compliance factors creating risk exposure for the firm and its clients in light of the firm's particular operations, and then design policies and procedures that address those risks." Managers that plan to invest in digital assets should, therefore, ensure that their valuation procedures are tailored to address the particular types of issues that arise in the digital asset valuation process.
The Staff Letter sheds insight on the SEC’s expectations regarding what should be addressed in the valuation policies and procedures that cryptocurrency mutual funds and ETFs adopt and implement. To the extent that private fund and SMA managers need to address the same valuation issues as discussed in the Staff Letter, it is fair to anticipate SEC Staff would have similar expectations as to such managers’ policies and procedures. As such, private fund and SMA managers that invest in the digital asset space should consider the Staff Letter’s discussion about valuation when developing or updating valuation procedures.
Custody Discussion in the Staff Letter
The IC Act and the rules thereunder impose custody requirements with respect to the assets held by registered funds. Among these requirements are certain standards regarding who may act as a custodian of a registered fund’s holdings and when registered funds need to verify their holdings.
The Staff Letter asks the following questions regarding compliance with the IC Act custody requirements:
- How would registered funds that hold cryptocurrency directly satisfy these custody requirements? The SEC staff noted that they are not aware of any custodian that currently provides fund custodial services for cryptocurrencies.
- How would a registered fund intend to validate existence, exclusive ownership and software functionality of private cryptocurrency keys and other ownership records?
- To what extent would cybersecurity threats to digital wallets impact the safekeeping of fund assets under the Investment Company Act?
- If a registered fund plans to hold cryptocurrency-related derivatives that are physically settled (rather than cash settled), under what circumstances would the registered fund need to hold cryptocurrency directly? If the registered fund takes delivery of cryptocurrencies in settlement, how would it provide for the custody of the cryptocurrencies?
Custody under the Advisers Act
Registered investment advisers that do not manage registered investment companies are not governed by the Investment Company Act. The Staff Letter’s discussion about Investment Company Act custody requirements, therefore, is not directly relevant to these advisers. However, all registered investment advisers are governed by Rule 206(4)-2 under the Advisers Act, commonly known as the Custody Rule, which raises questions about digital asset custodial arrangements that are similar to the questions posed in the Staff Letter.
The Custody Rule requires advisers with custody of “client funds and securities” to maintain those client funds and securities with a qualified custodian. For practical purposes, only banks and registered broker-dealers are considered qualified custodians. Managers of private fund vehicles typically have custody of those vehicles’ funds and securities because the manager or its affiliate serves as the general partner or managing member to the fund.
A registered investment adviser to a digital asset-focused private fund may, therefore, be deemed to have custody of any funds and securities held by that private fund. To the extent the digital assets held by the fund are considered “funds or securities,” such digital assets will be required to be maintained by a qualified custodian. Currently, there are only a limited number of qualified custodians who provide custodial services for digital assets.
The SEC’s Report of Investigation Pursuant to Section 21(a) of the Securities and Exchange Act of 1934: The DAO in July 2017 and subsequent SEC publications offer guidance on what types of digital assets constitute “securities” under the Securities Act of 1933. This guidance is relevant when determining whether a digital asset is a “security” under Advisers Act regulations, including the Custody Rule. The question of which digital assets constitute “funds” for Custody Rule purposes is more unsettled. Given the functional similarities between virtual currencies like Bitcoin and fiat currencies like US Dollars, which are considered “funds” that must be maintained by a qualified custodian, the SEC staff could plausibly take the position that certain virtual currencies are “funds” within the meaning of the Custody Rule.
Investment advisers to private funds generally comply with the Custody Rule by arranging for an independent public accountant to audit the funds on an annual basis. The audit reports must be issued in accordance with generally accepted accounting principles. Given the custody and valuation issues noted above, including the challenges frequently faced in independently verifying digital asset valuations, managers of digital assets may have difficulty procuring an unqualified opinion from an independent auditor. The transparency and evidence of the transaction detail will be important to the asset verification process. Valuation will also prove challenging as independent auditors will need to determine the appropriateness of an asset manager’s valuation methodology and pricing hierarchy.
Moreover, the SEC, in its Rule 206(4)-7 adopting release, listed the safeguarding of client assets among the areas that should be addressed by compliance policies and procedures. An adviser’s policies should cover both internal risks such as inappropriate activities by advisory personnel, and external threats from third parties. The numerous recent and well-publicized thefts of digital assets may heighten expectations that digital asset-focused investment advisers include controls in their policies and procedure to help safeguard client digital assets from cybersecurity threats.
The digital asset space continues to grow at a rapid pace. There were an estimated 125 digital asset-focused hedge funds operating at the end of 2017. The SEC has made clear its expectations regarding the need for robust compliance policies and procedures tailored to address the nuances of the digital asset space. Advisers that manage digital assets should also be prepared for timely SEC examinations.
ACA is aware of newly registered investment advisers that manage digital assets and have been visited by SEC examination staff within months of becoming registered. In addition, the SEC’s Office of Compliance, Inspections and Examinations issued the 2018 National Exam Program Examination Priorities, naming cryptocurrency, initial coin offerings, secondary market trading, and blockchain as one of the priorities.
For More Information
For more information or to ask questions about this alert, please contact ACA's Jason Rosenberg or your ACA consultant.
For more information on ACA's cybersecurity services, please contact Henry Lindemann.
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