SEC’s crypto hedge fund probe is healthy for the industry

A recent report on planned examinations by the Securities and Exchange Commission of more than 100 cryptocurrency funds is the latest example of regulatory scrutiny of digital currency — an unflinching gaze that continues to be healthy for the industry. 

Cryptocurrency, as a new asset class, presents a myriad of novel considerations for regulators to grapple with, and hedge funds are uniquely positioned in the asset class.

{mosads}A hedge fund is essentially the only viable fund management vehicle for crypto investing, and it will probably be that way for some time, as digital assets are unlikely to fall within the purview of mutual funds or traditional money managers for the near future due to regulatory constraints and market factors.

The SEC’s desire to interview cryptocurrency hedge funds, the only asset managers currently operating in the space, seems a logical next step in the development of the digital asset regulatory framework.

The probe also underscores the fact that the SEC takes the crypto hedge fund space very seriously and will continue to keep a close eye on it moving forward.

Pre-policy setting assessment

Having established a large percentage of the total number of emerging cryptocurrency funds in the U.S. and globally, I’ve dealt with a lot of managers in this space. There is no doubt that the SEC’s move will cause concern across this segment of the asset management industry.  

But for fund managers that have been properly structured and have carefully followed the advice of conservative-minded legal counsel by taking precautions in anticipation of regulatory movement, the SEC exams should not be a cause for major concern.

With only about 220 funds in existence, and the SEC reportedly looking to interview almost half of them, this appears to be a pre-policy setting industry review, especially since the questions the SEC is reportedly asking center on some of the main points of open regulatory issues in the space, rather than probing for questions centered on violations.

Three key areas of uncertainty for crypto funds 

From a hedge fund’s perspective, the key unanswered regulatory questions appear to be: 

1) How will SEC regulation affect so-called initial coin offerings (where digital currency is released to the open market like an unregulated version of a company’s initial stock offering)?

2) How will cryptocurrency exchanges (where coins are bought and sold like a stock exchange) comply with SEC requirements?

3) And, perhaps most important of all, how will the SEC and state law impose custody requirements on cryptocurrencies?

Key unsolved problem for crypto funds — no true custodian  

The issue of custody for crypto funds is important not just because the asset is inherently sensitive to cybersecurity risks, but because there is currently no third-party custodian that is able to completely handle a hedge fund’s custody requirements.

Unlike traditional hedge funds, which have a central prime broker and custodian (such as Goldman Sachs or Interactive Brokers), there is no prime broker available for a cryptocurrency fund. 

Instead, funds must rely on the crypto exchanges for active trading and on digital asset custodians, such as Kingdom Trust (soon to be acquired by BitGo), to house their digital currencies. 

By not having a central custodian, it becomes extremely important to keep clients’ assets safe. Through this probe, the SEC’s main goal will likely be to learn how these hedge funds are safeguarding investors’ digital currency assets.

This initiative will be helpful for the industry. The SEC is working with these funds to address the most important questions and concerns they face, which will help regulators and fund managers alike going forward.

Most importantly, it will ensure investors’ assets are housed securely, and it will increase consumer confidence in this fresh, exciting hedge fund crypto space.

John Lore is the managing partner of Capital Fund Law Group, a boutique investment fund law firm that has helped establish a large volume of cryptocurrency funds in the United States and throughout the world.