Our law firm focuses on advising hedge fund managers throughout the world in starting and operating US and offshore hedge funds. During the past several months, we have received more inquiries for starting cryptocurrency hedge funds (including Bitcoin Funds and coin alternative funds) than for all other hedge fund strategies combined.
Hedge Funds Investing in Cryptocurrency: Common questions
This article is directed primarily to managers looking to start a cryptocurrency fund to invest in Bitcoin and alternative coins directly. The most common questions we hear from startup cryptocurrency fund managers involve the regulatory requirements of imposed on cryptocurrency funds by the Commodities Futures Trading Commission (CFTC) and the Securities Exchange Commission (SEC).
- Must a cryptocurrency fund register with the CFTC?
- Must a cryptocurrency fund register with the SEC as an RIA or otherwise comply with state investment advisor regulation?
- Must a cryptocurrency fund satisfy 3(c)(1) or 3(c)(7) Investment Company Act exemptions?
1. Must a Cryptocurrency Fund Register with the CFTC?
The short answer is: no, if the fund manager purchases cryptocurrencies outright, and yes, if the fund manager purchases cryptocurrencies with margin, leverage, or as a futures contract. Our analysis is below.
Cryptocurrencies are Commodities Subject to the CFTC
The CFTC, which regulates commodities, futures, swaps and currencies, has stated that Bitcoin and other cryptocurrency will be treated different than currency under the Commodities Exchange Act of 1934 (Commodities Act), since it does not have legal tender status in any jurisdiction. However, the CFTC has stated that Bitcoin and other block-chain based virtual currencies are “commodities” under Section 1a(9) of the Commodities Act and subject to the CFTC (see In Re-Coinflip, Inc., d/b/a Derivabit, and Francisco Riordan).
Leverage and Futures
Cryptocurrency fund managers that invest in cryptocurrency futures contracts, as opposed to straight cryptocurrencies, are required to register as a CTA and CPO with the CFTC and with the National Futures Association (NFA), or satisfy an exemption. Also, because of additions to the Dodd-Frank Act, cryptocurrency hedge fund managers that use leverage or margin would also need to register with the CFTC and NFA. The Dodd-Frank Act amended the Commodities Act to add new authority over certain leveraged, margined, or financed retail commodity transactions. The CFTC exercised this jurisdiction in an action against BFXNA INC. d/b/a BITFINEX in 2016. Fund managers should either avoid using margin/leverage or plan to register as a CTA and CPO with the CFTC and register with the NFA.
2. Must a Cryptocurrency Fund Register as an RIA with the SEC or Comply with State Investment Advisor Regulation?
For most funds investing in cryptocurrencies, the answer can be 'it depends'. We recommend that startup fund managers take reasonable preemptive precautions to act as if cryptocurrencies were already designated as securities. Note also that the cryptocurrency fund is itself a security, and must satisfy an exemption from registration under the Securities Act of 1933 (usually Regulation D Rule 506). Read more about Regulation D and hedge funds.
Also, any fund, such as a fund of funds investing in cryptocurrency funds or any other funds would need to follow investment advisor regulation.
Are Cryptocurrencies Securities?
The Investment Company Act of 1940 (the Company Act), discussed below, the Investment Advisers Act of 1940 (the Advisers Act), as well as state investment advisor laws, impose regulations on hedge funds that invest in securities. The Securities and Exchange Commission (SEC) is currently determining how to treat cryptocurrencies as an asset class, but for now, it has not given definitive guidance. The SEC has stated that a cryptocurrency could be a security depending on how the digital token was created. The key question for both the Advisers Act and the Company Act is whether Bitcoin and other cryptocurrencies are deemed to be “securities.”
The Howe Test
The seminal Supreme Court case for determining whether an instrument meets the definition of security is SEC v. Howey, 328 U.S. 293 (1946). According to Howey, an investment instrument, namely an investment contract, meets the definition of a security if there is:
(i) an investment of money;
(ii) in a common enterprise;
iii) with an expectation of profits; and
(iv) solely from the efforts of others (e.g., a promoter or third party).
Based on our internal analysis of SEC trends involving initial coin offerings, we believe that the possibility that the SEC designating cryptocurrency funds is high enough that we recommend that emerging cryptocurrency funds act, as much as reasonably possible, as though cryptocurrencies were regulated as securities with the SEC, and as if the fund were already subject to the Advisers Act.
This is not to say that funds should necessarily preemptively register with the SEC or state securities division, but that they should consider taking reasonable precautions, such as offering investments solely to qualified clients in certain states (per the Advisers Act).
For startup fund managers with less than $150 million in assets under management, investment advisor compliance is highly dependent on the state in which the investment advisor is located. For a thorough discussion on how hedge funds are regulated by state and federal investment advisor regulation, read our article: Must a Hedge Fund Register as an Investment Advisor?
3. Must a Cryptocurrency Fund satisfy 3(c)(1) or 3(c)(7) Investment Company Act exemptions?
The Company Act generally requires investment companies to register with the SEC as Mutual Funds unless they meet an exemptions. Cryptocurrency funds, and hedge funds generally, can be structured under one of two exemptions from registration under the Investment Company Act. Section 3(c)(1) allows a fund to have up to 100 investors.
Section 3(c)(7) allows a fund to have an unlimited number of investor (but practically it should be limited to 2,000 to avoid being deemed a publicly traded partnership under the Securities Exchange Act), but requires a significantly higher net worth suitability requirement for each investor (roughly $5 million for individuals, $25 million for entities). As a general rule, most startup funds are structured as 3(c)(1) funds because of the lower investor suitability requirements. Read more about how the Company Act impacts hedge funds in our white paper: Hedge Fund Structural Considerations.
Until the SEC provides guidance designating cryptocurrencies as securities, there is no definitive requirement to comply with the Company Act exemptions. However, as stated above, the likelihood of cryptocurrencies being deemed securities is great enough, that we recommend that startup cryptocurrencies comply now with the Company Act preemptively. For most startup funds, this would mean limiting investors within a given fund to less than 100 beneficial owners.
SEC and CFTC’s Jurisdiction Over Crypto Currency Hedge Fund Managers Involving Fraud
Regardless of whether a startup cryptocurrency fund manager is required to register as a CPO/CTA with the CFTC under the Commodities Act, register or seek exemption from the SEC as an investment advisor (under the Adviser’s Act), or investment company (under the Company Act), every cryptocurrency fund manager will be subject to the fraud provisions of both the CFTC and the SEC. In September, 2017, the CFTC announced its first anti-fraud enforcement action involving Bitcoin. These anti-fraud actions can be taken by the SEC and CFTC regardless of the cryptocurrency fund’s exempt status.
Other Cryptocurrency Regulations
Various US regulatory bodies, self-regulating agencies, and regulatory bodies throughout the world have or are in the process of regulating this new asset class. Most of these regulations (for now) are not likely to have a major impact on the majority of startup fund managers that merely invest in cryptocurrencies, but can directly impact funds that go beyond purchasing cryptocurrency outright and are involved with ICOs, setting up exchanges, and other activities.
These regulations include IRS regulations designating cryptocurrency as property, FinCEN’s view cryptocurrency as a currency, regulating those who run platforms for exchanging cryptocurrencies as a Money Service Business (MSB) under the Bank Secrecy Act, and others.