With the recent boom in cryptocurrencies such as bitcoin, many investors are looking for opportunities to further capitalize on the emerging market. Some successful investors are forming financial vehicles such as hedge funds to optimize the return on their knowledge and skill. Though the regulations concerning cryptocurrencies in the United States are generally scarce and often ambiguous, as many regulatory agencies have yet to officially weigh in on the treatment of the asset, some longstanding regulations may apply to guide hedge fund managers.
Cryptocurrency Funds and the Commodity Futures Trading Commission (CFTC)
The Commodity Futures Trading Commission (CFTC) is an independent agency of the United States federal government that regulates certain trade activities in addition to commodities and currencies. The CFTC has stated bitcoin and other cryptocurrencies fail the traditional understanding of “currency,” as they do not have legal recognition in any jurisdiction. Alternatively, the CFTC identifies bitcoin and other cryptocurrencies as “commodities,” as understood by Section 1a(9) of the Commodities Exchange Act.
Generally, when a fund manager buys cryptocurrency outright, the fund does not need to register with the CFTC. However, should the fund manager make cryptocurrency purchase with margin, leverage, or as a futures contract, then registration is required. Unless an exemption is satisfied, fund managers must register with the CFTC as a Commodity Trading Advisor (CTA) and Commodity Pool Operator (CPO), and register with the National Futures Association (NFA).
Cryptocurrency Funds and the Securities Exchange Commission (SEC)
The Securities Exchange Commission (SEC) is an independent agency of the United States federal government responsible for regulating the security industry. Currently, the SEC is deciding on the classification and treatment of cryptocurrencies as an asset class and has yet to provide official guidance on the matter.
The guiding authority on determining whether an asset meets the understanding of security is 1946 Supreme Court case SEC v. Howey. This case famously delivered what is known as the “Howey Test,” which provides clarity when classifying investment instruments. The Howey Test, composed of four parts, requires securities to be: (1) an investment of money; (2) in a common enterprise; (3) with an expectation of profits; and (4) solely from the efforts of others. Until the SEC renders an official statement concerning cryptocurrencies, case rulings, such as SEC v. Howey, will guide fund managers in determining classification and compliance.
Cryptocurrency Funds and the Investment Company Act of 1940
The Investment Company Act of 1940 (“Act”) is the primary source of regulations for closed-end, hedge, mutual, and private equity funds and holding companies. Generally, the Act requires funds to register with the SEC, unless an exemption is satisfied. Two of the most common exemptions to registration are Sec. 3(c)(1) and Sec. 3(c)(7). First, Sec. 3(c)(1) is available for funds that have no more than 100 investors. Alternatively, Sec. 3(c)(7) allows funds to have an unlimited number of investors, though requires a high net worth for each investor (approximately $5 million for individuals and $25 million for entities). Additionally, funds using the Sec. 3(c)(7) exemption should limit their investors to 2,000 to avoid being recognized as a publicly traded partnership under the Securities Exchange Act.
With great investment opportunity comes great responsibility. Regardless of whether a fund is exempted from registration under the provided exemption, fund managers will still be subject to the fraud provisions of the CFTC and SEC. Cryptocurrency investors looking to establish their own fund should be keenly aware of the regulations and implications concerning the financial well-being of the fund and its investors.
The information contained in this post is for general information and educational purposes only. The application and impact of laws can vary widely based on the specific facts involved. Given the changing nature of laws, rules and regulations, and the inherent hazards of electronic communication, there may be delays, omissions or inaccuracies in information contained in this publication. Accordingly, the information on this post is provided with the understanding that the author and publishers are not herein engaged in rendering legal, accounting, tax, or other professional advice and services. As such, it should not be used as a substitute for consultation with professional accounting, tax, legal or other competent advisers. Before making any decision or taking any action, you should consult a professional.