Wilson Sonsini Goodrich & Rosati is pleased to present the February 2018 issue of the WSGR Fintech Update. This latest edition features an article discussing a letter recently issued by the SEC’s Division of Investment Management that details the division’s concerns about potential investments by registered funds in virtual currencies.

SEC Investment Management Division Tells Registered Fund Industry "No for Now" on Virtual Currencies

The director of the SEC’s Division of Investment Management (IM), Dalia Blass, recently issued a letter detailing IM’s concerns about potential investments by registered funds (e.g., mutual funds and exchange-traded funds (ETFs)) in virtual currencies. Among other things, the letter raises several questions about the unique features of virtual currencies and the complications virtual currency investments may create for registered funds under the Investment Company Act of 1940—particularly with respect to issues of valuation, liquidity, custody, and anti-fraud—and briefly discusses challenges that such funds could pose to investment advisers and broker-dealers.  

• Valuation. Mutual funds and ETFs must value their assets on a daily basis to accommodate for daily purchases and redemptions of their shares. In light of the volatility, limited trading volume, and nascent state of virtual currency markets, the letter questions whether registered funds would be able to value their assets accurately on a daily basis, thereby posing risks that investors that purchase or redeem shares may not receive the correct net asset value per share.
• Liquidity. To accommodate for daily redemptions of their shares, mutual funds and ETFs must limit the amount of illiquid assets they hold. Under a newly adopted rule that has not yet gone into effect, mutual funds and ETFs must classify their assets into varying liquidity categories based on market and trading data for those assets, among others. The letter questions the extent to which a registered fund could analyze meaningfully the liquidity of virtual currencies and, therefore, manage the liquidity risk of the portfolio, which is one of the chief aims of the newly adopted rule.
• Custody. Registered funds must maintain their assets with certain types of qualifying custodians (e.g., banks or broker-dealers). The letter questions how registered funds could satisfy this requirement when there are apparently no known qualifying custodians that provide custodial services for virtual currencies compliant with the Investment Company Act. As a result, these registered funds will likely hold the currencies directly, exposing those assets to the harms that the custody requirement was designed to prevent—the safeguarding of assets against threats of misappropriation.
• Market Manipulation. The letter expresses concerns that the virtual currency markets afford fewer investor protections than traditional securities markets, thereby providing greater opportunities for manipulation and fraud.¹ The letter suggests that these market risks may exacerbate the ability of registered fund sponsors to manage the valuation and liquidity concerns expressed above.
• Investment Advisers. The letter questions whether investment advisers would face particular challenges in meeting their fiduciary duties when recommending, on behalf of retail clients, an investment in a registered fund that invests primarily in virtual currencies and related products.
• Broker-Dealers. The letter raises questions how broker-dealers would fulfill their suitability obligations when distributing shares of a registered fund that invests primarily in virtual currencies and related products to retail investors and whether such investors would have sufficient information to evaluate the risks of such investments.

Until the concerns above can be addressed, the letter states that registered fund sponsors wishing to introduce registered funds that invest primarily in virtual currencies and related products to the public should not seek to register such funds or their shares. The letter also noted that, for certain types of registered funds that can go effective without an SEC order of effectiveness, IM would consider seeking a stop order to prevent such a fund from offering its shares publicly.

The letter does not directly address IM concerns about investment advisers that provide advice about direct investments in virtual currencies and related products, but as noted above, suggests that such advice may raise fiduciary concerns.

¹The SEC cited similar concerns when it declined to authorize for public trading two exchange-traded products that would track the price of bitcoin. See our discussion of these denials in our April 2017 WSGR Fintech Update.