SEC Staff Told Cryptocurrency Fund Sponsors to Hold Off on Registrations

The Securities and Exchange Commission’s Division of Investment Management told fund sponsors on January 18, 2018 that they should not initiate registrations for funds intending to invest substantially in cryptocurrencies or related products until significant investor-protection questions were answered.

The staff letter, signed by division director Dalia Blass and addressed to the Investment Company Institute and the Securities Industry and Financial Markets Association’s Asset Management Group, also said sponsors with registration statements already on file had been asked to withdraw them.

That position mattered because it placed a practical regulatory barrier between cryptocurrency markets and the registered mutual funds and exchange-traded funds commonly available to retail investors. It arrived shortly after regulated bitcoin futures began trading in the United States, when sponsors were attempting to turn those contracts into securities products accessible through ordinary brokerage accounts.

A regulatory gate, not a permanent prohibition

The January 18 document was a staff letter, not a Commission rule, adjudication or blanket finding that every cryptocurrency fund was unlawful. It invited detailed engagement with the fund industry and left open the possibility that sponsors could eventually resolve the identified issues.

Its immediate direction was nevertheless firm. Staff said it did not consider new registrations appropriate while the questions remained unanswered. It also objected to using Securities Act Rule 485(a), under which certain post-effective amendments for new fund series could become effective automatically. The letter warned that staff could recommend a stop order if a sponsor attempted that route for a fund investing substantially in cryptocurrency or related instruments.

A January 9, 2018 EDGAR filing illustrates the process already underway before the public letter. ProShares Trust requested withdrawal of an amendment covering four proposed bitcoin-futures and bitcoin-related ETFs, stating that it was responding to a staff request. ProShares reported that the amendment had not become effective and that no securities had been sold. That filing verifies one withdrawal request but does not establish the complete number of affected sponsors or products.

Five unresolved operating questions

The letter organized its concerns around valuation, liquidity, custody, ETF arbitrage and possible manipulation or other market risks.

Registered mutual funds and ETFs had to calculate net asset value each business day. Staff asked whether fragmented, volatile and generally less-regulated cryptocurrency markets supplied reliable information for valuing holdings, including after blockchain forks or distributions of newly created assets.

Open-end funds also had to meet redemption requests. Staff questioned whether the limited trading history and volume of cryptocurrency futures permitted a meaningful market-depth analysis, and what would happen if a fund became a substantial participant in the futures market.

Custody presented a different problem. The division said it was unaware of a custodian then providing registered-fund custodial services for cryptocurrencies. It asked how a fund could validate the existence and exclusive ownership of private keys, protect wallets against cyberattacks and handle derivatives that might eventually settle through delivery of cryptocurrency.

For ETFs, staff focused on whether market makers and authorized participants could keep share prices close to net asset value through arbitrage when underlying markets were fragmented or when a cryptocurrency exchange or futures venue stopped operating. The division also asked how manipulation concerns in underlying markets could affect derivatives pricing and suitability for retail investors.

Futures had opened the institutional route

Cboe Futures Exchange launched its cash-settled bitcoin futures on December 10, 2017. CME made its own cash-settled contract available on December 17 for the December 18 trade date. Those launches created regulated derivatives through which a registered fund might seek bitcoin exposure without directly holding private keys.

The January 18 letter made clear that cash settlement did not resolve every fund-law issue. A regulated futures venue could reduce direct-custody complications, but valuation, liquidity, market concentration, arbitrage and exposure to activity in underlying cryptocurrency markets remained open questions.

The defensible conclusion on January 18 was therefore narrower than an approval or permanent rejection: SEC investment-management staff had paused the registered-fund pathway and specified the operational evidence sponsors would need to supply before that pathway could advance.