Potential for Crypto Funds, Suitability & Regulatory Hurdles

By Cory Roberson, Principal at FIN Compliance and FIN Lancer

Emergence of Crypto Funds and regulatory hurdles with listed ETF’s

Cryptocurrency is growing into a viable alternative asset class.  The earliest adopters, mostly FinTech entrepreneurs, alternative hedge fund managers and/or VC investors, are pouring money into crypto exchanges, blockchain based businesses, and now private funds.

These new digital assets, known by keywords such as, decentralized technology, Blockchain, algorithms, utility tokens, or security tokens, has prompted a surge in pooled investments in cryptocurrency (“Private Crypto Funds”).

Autonomous Next, a fintech research firm, estimates that the current number of global private crypto funds to be more than 250.  https://next.autonomous.com/cryptofundlist

The level of crypto interest is also growing on the retail side.  In the last year alone, the surge in crypto enthusiasm can be correlated to the wild (10X) swing in bitcoin prices from $2k to nearly $20K (bitcoin prices are tad below the $7,000 mark as of this post on 6/19/18).

In 2017, global investor capital prompted a surge in crypto-based fundraising activities, such an initial coin offerings (ICO’s) and/or security token sales (STO’s).  

Ethereum, the second largest cryptocurrency by market cap, is a programming language that allows developers to run or create applications on its blockchain-based algorithm.  In short, Blockchain is a distributed ledger technology that can send data/transactions from one party to another.  Traditionally, in the financial markets, transactions are processed through an intermediary (centralized network).  Blockchain, in its decentralized capabilities, is causing a major paradigm shift in terms of potential applicability on a massive scale. 

Are Crypto funds only open to Private investors?

Short answer: Yes.  In the U.S, private (accredited investors) are allowed to purchase into a crypto-structured fund(s) through a securities exemption known as Regulation D. 

Reg. D enables entrepreneurs or fund managers to sell/market a structured securities exempt product “Private Crypto Funds” without going through the scrutiny (or current futile attempts) of registering as a mutual fund or ETF. 

In June 2018, Coinbase, the largest U.S. cryptocurrency exchange, announced its plans to launch a crypto index fund for accredited and institutional investors. 

Definition.  Regulation D of the Securities Act, an accredited investor is a: 

Financial Institution (e.g. Banks, broker-dealers, SEC registrants);

Business Development Company;

Non-Profit or Trust (with assets of more than $5 million);
Net Worth (single/joint) (> $1 million);

Natural Person with $200K income (last two years);

Joint couple with $300k income (last two years);

Private crypto fund investments should continue to grow without further regulatory and/or  registration hurdles.

Are Crypto Funds closed to Public investors?

Short answer: Yes.  Innovation comes with regulatory roadblocks.  In 2013, Winklevoss Twin’s Bitcoin Trust ETF, was the first of such attempts made for a registered crypto investment fund.  Ultimately, the SEC blocked this filing in a March 10, 2017 ruling.

According to Bloomberg, other ETF players such as Direxion, Exchange Listed Funds, ProShares, and VanEck also dropped its attempts of fund registration.  The article also noted that more than 15-crypto based ETF registrations were filed during this period.  Notably, all attempts of crypto-based ETF’s were blocked by the SEC. 

The retail market can still purchase cryptocurrency without a fund.  Over the last year, retail investors flocked to open crypto brokerage accounts on a number of global exchanges, including Coinbase.  Last November, Coinbase’s user base exceeded popular equities-brokerage firm, Charles Schwab (10.6 million v.11.7 million users).  

Interestingly, crypto brokerage accounts are not regulated in the same fashion of traditional brokerage accounts (SEC/FINRA/SIPC/MSRB) in the U.S.

Crypto investments for advisors and broker-dealers

Viable asset class doesn’t necessarily equate to a suitable one.  The emergence of Crypto assets poises a suitability challenge for traditional financial institutions (e.g. mutual funds, broker-dealers, investment advisors).  Crypto market volatility, as seen over the last year, is off the charts.  For most advisors, making a client recommendation into this market is out of the question. 

Secondly, the underlying value of these instruments are not based on traditional securities performance metrics, such a P.E., Price to Book, Debt-equity, or even those metrics of other alternatives, such as commodities.  With that said, some advisory/broker-dealer networks are looking for a workaround to gain exposure to the underlying blockchain technology. 

In May 2018, LPL Financial launched a separately management account product “Blockchain Innovators Portfolio,” to provide its investors a means to purchase equities in companies that are adopting blockchain technology. 

Crypto investments may turn out to be a viable alternative space for an advisor or brokers accredited investor, extreme risk tolerant, and/or wealthy investor base.  As it seems, the appetite for risk could not be higher for some private investor markets. 

Determining Suitability

Using FINRA Rule 2111 as an example, broker dealers are required to use a risk-based assessment for making recommendations in securities products based on:

Reasonable Basis – are the risks/rewards appropriate given the client’s objectives.

Customer Specific – are the recommendations specific to the customer.

Quantitative – does the costs/fees outweigh benefits for the clients. 

Both advisors and broker-dealers must provide documentation to justify any recommendations made to its clients.  Among other things, this documentation comes in the form of an investment policy statement and/or collection of the following:

Financial status - What is the client’s debt/income ratio?

Existing assets – Total list (e.g. house, stocks, bonds, income producing vehicles),

Tax status - Future/current tax obligations?

Age – Is the client near or far from retirement?

Investment objectives – Is client seeking an aggressive, growth, or passive portfolio?

Liquidity requirements – Does client need access to money (“fiat currency”) sooner or later?  

Time horizon – When does client expect to achieve results?

Risk tolerance – Does client like safe investments, in-between, or like to live on wild side?,

Investment experience – How familiar is client with securities products/investing?

Eyes on the first Cryptocurrency ETF approval in the U.S.

The first SEC-approved Crypto ETF seems like a reasonable assumption given the commissions announcement in hiring “Crypto Chief” Valerie Szczepanik to Associate Director of the Division of Corporation Finance and Senior Advisor for Digital Assets and Innovation.  

Ms. Szcepanik’s role will include providing an operational and regulatory framework of crypto applicability within U.S. securities laws.

In a June 8^th interview with ETF.com, John Hyland of Bitwise Asset Management, believes that the Securities and Exchange Commission (“SEC”) is close to the launch of the first U.S. listed crypto ETF.

Notably, Mr. Hyland was a major player in the first oil and commodity-based ETF’s to hit the market in the U.S.  His firm already opened a private cryptocurrency fund for accredited investors.  http://www.etf.com/sections/features-and-news/hyland-1st-bitcoin-etf-closer-reality

SEC Chairman’s thoughts on Crypto for the public

In a December 2017 press release, SEC chairman Jay Clayton expressed a cautious, but optimistic tone for the emerging crypto/ICO space and its underlying blockchain technology. 

In an exercise of caution, Clayton expressed a need for providing mechanisms to protect retail investors from the inherent risks of the new technology, such as hacks, data thefts, and scam operations.

Overall, the SEC recognizes the need to support innovation and entrepreneurial growth.  Over the last few years, the SEC has provided main street investors with an opportunity for exposure to innovative investment vehicles, such as crowdfunding.  In doing so, the commission extended its Reg D. definitions, which previously served only accredited investors, to allow the general public to invest in other businesses and/or startups (Reg. CF and Reg. A+).

Summary: Lastly, the regulatory future is uncertain, but the SEC will likely push ahead in its crypto oversight initiatives for investor protection and to foster growth in blockchain industry.  Based on congressional initiatives such as H.R. 835, an ETF and/or other alternative crypto product(s) may show up sooner than we think.  In its current form, crypto volatility and market risk provides little incentive for a traditional investment manager to recommend these products to most of its client base. 

Moreover, alternative investment managers, who offer these products to its accredited investor base should provide (or obtain) full disclosures of the crypto’s inherent risks and divergences between other private/alternative securities.  Given its popularity, more private fund products should be in the pipeline for this investor base. 

In other blogs, we will discuss future considerations in the blockchain space, such as AML, KYC, crypto fund registration, cybersecurity, and more. 

Disclaimer: Investing in cryptocurrency carries inherent risks.  This article is not intended to be an endorsement for investing in any securities or crypto investments, but rather a presentation of an emerging asset class for illustrative purposes only.  This disclaimer also serves as a reminder that past performance of cryptocurrencies is not indicative of future results.  We recommend that you consider referring to a qualified investment professional for future insight into crypto funds, suitability, and its inherent risks.  We serve many qualified investment professionals that can help you to build a viable investment strategy. 

Check our blog: www.mycomplianceblog.com for more compliance-related news.

For more inquiries, please contact:

Cory Roberson

Roberson Ventures Group, LLC.

2950 Buskirk Ave, Suite 300, Walnut Creek, CA 94597

Phone: 650-305-2688

Email: cory@robersonconsults.com or cory@riareview.com

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FIN Compliance (FINCompliance.io) is a consortium of compliance services including: RIA Consults-Roberson Consults Group, a compliance consulting firm, RIA Review, a compliance-management software tool (SaaS), B-D Review, a RIA/Broker-Dealer compliance management software tool, and FINLancer is a business management portal featuring:  E-signature tools; Invoicing integration, Vendor Directory, continuity directory*, business client document portal, and more (available by Q3 2019).  Access all services on one site: FINCompliance.io.

Impact

FIN Missions (FINmissions.com) provides business support group sessions for other entrepreneurs.  In addition, Cory has volunteered for more than fifteen youth programs in locations such as like S. Korea, China, S. Africa, Thailand, and India.