Email

Pop Quiz! How Will Cryptocurrency Funds Make it Past the SEC?

0 | By Shah Gilani

The Securities and Exchange Commission is always one to mince words.

While millions of investors are pumped to start playing cryptocurrency, the SEC just threw two Wall Street trade groups for a loop. They were angling to be able to sell cryptocurrency ETFs and mutual funds to the public before they received a Staff Letter from the Director of the SEC’s Division of Investment Management asking how sponsors of crypto ETFs or mutual funds could safeguard public investors.

This is the real meat of the cryptocurrency discussion. If crypto is going to blossom and bloom into a game anyone can play, then the powers that be need to know that this ring toss isn’t a trap for the average Joe.  As the letter states, “many of America’s Main Street investors rely on registered funds to help them build toward education, retirement and other important goals.”

Of course, that doesn’t mean that the SEC spelled it out for the ETF-selling hopefuls. Instead, they did what they always will – couch the hard-hitting questions in jargon and complicated reference material.

If you are a long-time reader, you’ll know that this is my Bat-Signal; breaking down gated information for anyone to be able to digest is my favorite pastime.

Here’s your study guide to the SEC’s crypto pop quiz..

Section I: Fund-amentals

Valuation

“How would funds develop and implement policies and procedures to value, and in many cases ‘fair value,’ cryptocurrency-related products?”

“How would funds consider the impact of market information and any potential manipulation in the underlying cryptocurrency markets on the determination of the settlement price of cryptocurrency futures?”

The two reference materials you’ll need for this unit are a November 14, 2017 reference article by Business Insider author Oscar Williams-Grut titled, ‘Market Manipulation 101’: ‘Wolf of Wall Street’ – Style ‘Pump and Dump’ Scams Plague Cryptocurrency Markets, and a December 10, 2017 Fortune article by David Z. Morris titled, Could Bitcoin’s ‘Whales’ Manipulate the Market?.

Essentially, the cryptocurrency gold rush has created an elite few who now have a power that, because this is unregulated territory, they can abuse. The SEC wants to know how the creators of ETFs would be able to honestly price their funds when pump-and-dump ICOs are a reality of the crypto landscape.

Liquidity

“What steps would funds investing in cryptocurrencies or cryptocurrency-related products take to assure that they would have sufficiently liquid assets to meet redemptions daily?”

“How would a fund prepare for the possibility that funds investing in cryptocurrency-related futures could grow to represent a substantial portion of the cryptocurrency-related futures markets? How would such a development impact the fund’s portfolio management and liquidity analysis?”

To answer these questions you might want to bone-up on the new fund liquidity rule, rule 22e-4, and the 459-page Final Rule on Investment Company Liquidity Risk Management Programs, Release Nos. 33-10233; IC-32315; File No. S7-16-15.

It’s not as scary as it seems. These are questions that would be asked of any new fund, just with a modern tech twist. As long as these Wall Street trade groups make sure that their liquidity practices fall under this new rule, they’re in the clear.

Custody

“To the extent a fund plans to hold cryptocurrency directly, how would it satisfy the custody requirements of the 1940 Act and relevant rules?”

“To what extent would cybersecurity threats or the potential for hacks on digital wallets impact the safekeeping of fund assets under the 1940 Act?”

There is no hint for this one. The Investment Company Act of 1940 was designed to wrangle the Wild West of mutual funds that were previously unregulated and open for exploitation. In this portion of the quiz, the SEC is doing their due diligence by asking how these new crypto funds will meet the parameters of this Act. Will there be the proper disclosure of conflicts of interest, the necessary oversight?

If the nitty-gritty of how to domesticate untamed crypto tech isn’t nailed down, there will be no fund. Plain and simple.

Section II: Risky Business

Arbitrage (for ETFs)

“In order to promote fair treatment of investors, an ETF is required to have a market price that would not deviate materially from the ETF’s NAV. In light of the fragmentation, volatility and trading volume of the cryptocurrency marketplace, how would ETFs comply with this term of their orders?”

“How would volatility-based trading halts on a cryptocurrency futures market impact this arbitrage mechanism? How would the shutdown of a cryptocurrency exchange affect the market price or arbitrage mechanism?”

The present answer to these questions was addressed on January 12th by Bloomberg Technology author Camila Russo, One of the Biggest Crypto Exchanges Goes Dark and Users Are Getting Nervous.

If you don’t have time to read the whole article, here’s an excerpt:

“The short history of cryptocurrencies has been rife with hackers and stolen bitcoin, so issues with exchanges are quick to unnerve investors. In the most famous case, Mt. Gox filed for bankruptcy in 2014 after losing hundreds of thousands of its clients’ bitcoins. Less dramatically, popular websites such as Coinbase have frequently crashed or slowed down in the past few months as they’ve been unable to handle the increased traffic coming from the growing number of investors trying to cash in on the crypto boom.”

Crypto trading is still in a volatile state. Crashes, hacks, any number of Dark Web sea creatures could rear their head and send the whole system spinning. Without taking all these unknowable factors into consideration, a crypto ETF or mutual fund could quickly fall apart and devastate public investors.

Potential Manipulation and Other Risks

“How would you weigh these concerns in considering whether offering a proposed fund is appropriate for the wide range of investors, including retail investors, who might invest in the fund? Would investors, including retail investors, have sufficient information to consider any cryptocurrency-related funds and to understand the risks?”

“Have you discussed with any broker-dealers who may distribute the funds how they would analyze the suitability of offering the funds to retail investors in light of the risks discussed above? Are there particular challenges investment advisers would face in meeting their fiduciary obligations when investing in cryptocurrency-related funds on behalf of retail investors?”

The SEC already made their thoughts on this known back on December 11th, when they released the Statement on Cryptocurrencies and Initial Coin Offerings by SEC Chairman Jay Clayton. In fact, they included a list of sample questions for investors to ask of any cryptocurrency or ICO investment opportunities that cover a wide array of possibilities that need to be addressed if the investor is taking their money seriously.

The world of crypto right now is globally-impacted, minimally regulated, volatile, and scary new. There is, if you haven’t already realized, an enormous amount of risk you have to take on if you want to get involved.

That’s the whole point of this pop quiz that the SEC lobbed back at the Wall Street hotshots clamoring to be the first to build a crypto fund. Without proof that the risks will be understood and handled appropriately, the conversation is over.

Section III: Key Takeaways

Of course, answers to the questions the SEC is asking aren’t easy.

If they were, they’d have been addressed and answered already by any one of the nine sponsors who’ve tried to get a Bitcoin or cryptocurrency ETF or mutual fund approved. Instead, they’ve failed.

Until those would-be sponsors can adequately address all the SEC’s concerns, we’re all better off without a cryptocurrency ETF or mutual fund.

Without proper investor protections, they’d just be WMFDs. Weapons of Mass Financial Destruction.

Now, I still stand by my words from December on how speculators with capital to risk can play the game. When ETFs come on board, buy into them and use stops. Short them and use stops. You can also play both the rise and fall of Bitcoin by trading options and straddles in particular, when that’s an option.

As in everything, there will be a way to make money from the inevitable funds that spring up around crypto, once they finally make it past the SEC.

But you’ll be wise to keep a close eye on how these funds operate.

Sincerely,

Shah

Leave a Reply

Your email address will not be published. Required fields are marked *