Why Can’t I Add a Crypto-Fund to my Retirement Portfolio?

The evolution of the U.S. Investment Fund market has prompted fund sponsors to become increasingly innovative in the creation of registered funds (e.g., exchange-traded funds and money market funds). Recently, however, the U.S. Securities and Exchange Commission (S.E.C.) made the decision to – at least temporarily – restrict registered funds from holding cryptocurrencies and cryptocurrency-related products. The S.E.C. has attributed its hesitancy to the investor protection issues that must be addressed before it allows crypto funds to hit the market. Unfortunately, eager investors looking to gain exposure to the crypto market in their retirement portfolios (and, otherwise, traditional portfolios) will have to continue utilizing exchange platforms. Such platforms restrict investors to investing in cryptocurrencies coin-by-coin, as opposed to building a portfolio. However, the S.E.C.’s vetting of the crypto industry may benefit investors in the long run; for instance, crooked companies such as Bitconnect will be weeded out. The S.E.C. has signaled that it will not allow crypto funds to hit the market until the following  questions have been answered. 

Valuation

Net Asset Value (NAV) of traditional funds, such as exchange-traded funds (ETFs) and mutual funds, is calculated on a daily basis. This allows investors to have full transparency in knowing exactly why the fund is worth what it is worth. Transparency is possible because the assets these funds hold are highly regulated by valuation procedures and policies. When it comes to valuation, the chief concern is whether there is sufficient information to calculate an honest NAV if a cryptocurrency were to be included. For example, what if a cryptocurrency were to diverge into different paths (i.e., a “fork”)? Think Ethereum and Ethereum Classic. How would a fund handle an asset diverging into two of essentially the same asset, each with a different price? What policies would have to be implemented to prevent or remedy such an event?

Liquidity

Questions of liquidity highlight one of the biggest concerns in the crypto industry. A key feature of the funds currently available in the market is governed by Rule 22e-4. This rule, the new fund liquidity rule, requires investors to limit their illiquid investments to 15% of the fund’s assets. Open-end funds, such as the ones described throughout the S.E.C.’s statement, offer daily redemption. Not only do some cryptocurrency exchange platforms offer little transparency on what exactly is happening with investor money behind the scenes, most platforms take days or weeks to process a transaction. If funds were to hold crypto assets, how could we ensure sufficient liquidity? Would we have to consider these funds illiquid by default? Would funds investing in crypto futures have a substantial effect on the overall crypto futures market? Most importantly – would you, the investor, feel comfortable investing in a fund that could not promise you liquidity?

Custody

To ensure the safekeeping of investor assets, there are many checks in place guaranteeing that funds maintain custody of their holdings. This immediately begs the question of how a fund would be able to satisfy these custody requirements. Would funds be a target for cybersecurity threats and digital wallet hacks? The crypto futures market will surely expand in the coming years, which poses an additional problem – some futures will be cash settled (paid in net difference) and some will be physically delivered (paid by delivery of entire asset). How would the fund plan to provide custody for two different crypto futures contracts if the fund is not directly holding the assets?

Arbitrage

Simply put, an ETF (or any other open-ended fund, for that matter) must have a market price that does not deviate from the NAV. However, since the markets are not perfect, there are opportunities for arbitrage. The underlying securities in funds currently offered on the financial markets make it very tough for arbiters to take advantage of large price differences, because substantial differences rarely exist. Now with that in mind, does the extreme volatility of the crypto markets mean more opportunities for arbitrage? How might the failure or closure of a crypto exchange platform affect the market price of the NAV?

Potential for Manipulation

There have been growing concerns regarding the potential for manipulation and fraud in crypto markets. The recently exposed operations of Bitconnect provide a cogent example. Surely, as the industry matures, more of these questionable operations will come to light. So far, issues have been more attached to crypto products and services than with the cryptocurrencies themselves. To separate genuine companies from scams and allow them to infiltrate one of the most regulated markets in the world, there remains a lot of vetting to be done by regulatory agencies. Will potential investors obtain sufficient transparency and information to fully comprehend the risks they may be taking?

To Conclude…

The S.E.C. essentially stated that, until the aforementioned questions are answered, fund sponsors would be wasting their time if they attempt to initiate registration of a crypto fund. How will these questions be answered, and how long are we going to have to wait? With how quickly the crypto space moves, answers could come within mere weeks or months. Or, perhaps, cryptocurrencies have no place in the investment fund market at all.  The S.E.C.’s pursuit of answering these questions may very well correlate into a weeding out of dubious crypto-companies and open doors for more self-regulated crypto-companies. If a company wants its coin to be included in the U.S. investment fund market, a good place to start would be to ensure conformity to the various securities and investment acts passed by Congress.