Top 10 Issues to Consider When Registering a Digital Asset Fund
Since the dog days of summer, crypto connoisseurs have been tracking the launch of registered investment companies that trade in futures on cryptocurrencies. Since then, the market has seen the launch of the ProShares Bitcoin Strategy ETF (BITO) on October 18, 2021, and the IDX Risk-Managed Bitcoin Strategy Fund (BTIDX) on November 12, 2021, among other products. The novelty of these products and their potential risks mean they must undergo regulatory scrutiny by the SEC’s Division of Investment Management, which reviews all new mutual fund and ETF filings. To meet these regulatory requirements, the fund’s sponsor, its legal counsel, and other service providers must respond to numerous comments and requests for information from the SEC and its staff. This post summarizes the key issues registrants are likely to encounter as they navigate the regulatory gauntlet.
1. Fund Name and Strategy
Investments in certain asset classes do not always fit nicely with the framework established by Rule 35d-1 or Section 35 of the Investment Company Act of 1940. A reference to a digital asset such as Bitcoin, Ethereum, Solana, or other cryptocurrencies (or related futures contracts) requires that the fund invest a certain percentage of its assets in that asset. In fact, using the digital asset in your name may require that your fund have a concentration policy to invest at least 25 percent of its total assets in that asset class (see below for more discussion on concentration policies).
There's no clear rule on what percentage of your fund’s total assets must be invested in the reference asset. Section 35 of the Investment Company Act simply says that your name cannot be misleading. The number is usually above 50 percent and must be viewed over a normal market cycle. In other words, your fund’s average exposure to the referenced asset should be above 50 percent during a full market cycle, including defensive periods.
As part of this conversation, you'll need to discuss the factors that your fund’s board considered when implementing this strategy in an open-end management company (i.e., mutual fund or ETF). Be sure that your board materials align closely with your registration statement.
2. Investments in Other Pooled Investment Vehicles
The SEC is still collecting data and information on the number and types of pooled investment vehicles, including U.S. and foreign private funds, that invest in digital assets. If your fund intends to invest principally in other pooled investment vehicles, then be prepared to provide detailed information on the specific vehicles in which you plan to invest. To date, the staff has objected to funds that invest in Canadian exchange-traded funds or Grayscale Bitcoin Trust (GBTC).
3. Liquidity and Capacity Constraints
I know—this is technically two issues. But they are so closely related that I couldn't talk about one without the other. Liquidity issues take two forms when it comes to digital assets: market liquidity and fund liquidity. Given the concerns the SEC has over market liquidity, the staff frequently asks if a fund has any inherent capacity constraints. Thus, your reply to one issue will almost certainly reference the other issue.
To better understand the underlying markets, the SEC is asking for information on market liquidity. For example, if you're trading in digital asset futures, you'll need to provide information on the spot position limits and position accountability level for the exchanges on which the fund will trade. Be prepared to provide robust discussion on your target markets along with information on other related markets (e.g., foreign exchanges). Information on global trading levels is also helpful. You will also need to disclose the trading times of your underlying market. If the market trades 24/7/365, you'll need to provide risk disclosure that discusses the dislocation that can occur between U.S. trading times and the underlying market’s trading times.
At the same time, you'll need to discuss how your fund will comply with Rule 22e-4, the liquidity risk management rule. Note that given the always-available nature of many digital asset markets, your fund liquidity program will need daily assessments of the fund’s positions. The SEC will want to know which service providers are involved in the liquidity risk management process.
Also, capacity constraints may arise during your engagement with the staff. Given the limited liquidity of some digital asset markets and the increase in funds participating in those markets, the staff may ask if the fund or its investment adviser has any plans for managing the fund’s capacity if certain market conditions occur. If this issue arises, you'll need to provide supporting market and technical data to support your strategy. Relatedly, you may need to disclose the risk of capacity limits to investors.
The SEC is taking the position that certain digital assets fall within the concentration policy under Section 8(E) of the Investment Company Act. Arguing that the asset is currency, security, or something other than an industry or group of related industries will not get you far—at least, not right now. So be prepared to adopt a concentration policy that complies with the Investment Company Act.
Even if the digital assets in which the fund will invest have market prices, you'll need to discuss your fair value process. Many digital assets don't trade on a centralized exchange, so there's no single market price. Be prepared to discuss when your fund will use fair valuations and what the process is for determining those prices. Include in this discussion how the fund will fair value the reference asset in its primary market closes. For example, will you rely on another market for comparison or review spot prices and average premiums or discounts during a period and apply those adjustments to the current spot price?
Investments in certain digital assets or futures on digital assets may include a degree of leverage. If so, be sure to disclose the risks related to those levered positions and the related costs (e.g., margin requirements).
7. Roll Strategy (Futures Funds Only)
Since futures markets for digital assets are new (at least in the United States), the SEC has concerns about the roll strategy used by funds. Part of that concern relates to the possibility that too many funds can have the same or similar roll strategies, which creates risk market alignment. Be prepared to explain your fund’s roll strategy and why the market’s liquidity (discussed earlier) can support it. Also, be ready to provide the staff with estimates on your roll costs and how significant those costs are related to the fund’s total operating expenses. These responses will require supporting market data.
8. Extreme Market Conditions
If the digital assets in which you plan to invest have recently experienced stressed market conditions or extreme volatility, then you'll need to address how your proposed fund will perform under similar conditions. If you can, refer to composites, models, or other accounts using a similar strategy and discuss how they performed under the extreme market conditions.
9. Derivatives Risk Management
If your fund will use derivatives such as futures on digital assets, be ready to discuss your derivatives risk management program under Rule 18f-4. As part of your discussion, you'll need to consider your methodology for tracking exposure (e.g., relative VaR) and provide your designated index.
10. Environmental Impact
Certain digital assets, particularly cryptocurrencies, are electricity or resource intensive to create. The SEC has started asking funds to disclose the environmental impact of Bitcoin mining and other similar activities.
As always, our experts at Joot are here to help you navigate this new terrain. Get in touch with any questions you have.
This blog post was adapted from an article previously published by Strauss Troy.