We are witnessing the emergence of Bitcoin as a new (and growing) asset class among institutional investors – a rather rare and unique development in the investment world. So, what lies ahead for investment advisers?
Some Bitcoin Background:
First, what is Bitcoin? In short, Bitcoin is a decentralized digital currency, untethered to any sovereign currency, without a central bank or single administrator, that can be sent from user to user on the peer-to-peer bitcoin network without the need for intermediaries As an asset class, it continues to gain acceptance among investors. Why? With portfolio diversification becoming more challenging, Bitcoin has garnered more attention from institutional investors as an asset class to be seriously considered. Increasing market liquidity, improvements in custodial practices, a more favorable regulatory outlook and, of course, impressive long-term performance have driven institutional acceptance at a time when widespread concerns abound about monetary and fiscal policies driving inflationary expectations. A common theme among Bitcoin Conference attendees is that owning Bitcoin is an alternative to fiat currencies and an insurance policy against the perception that irresponsible government policies will continue to devalue traditional fiat currencies overtime, including the dollar.
Investment Adviser Perspectives:
How should investment advisers react? As a fiduciary, should investment advisers ignore Bitcoin as an overly risky alternative investment, despite the impressive long-term returns? Does Bitcoin fit into portfolios as a small portion of a balanced portfolio? Advisers are now grappling with these and other issues. Solutions? Some investment advisers are offering or planning to offer private funds to high net-worth and institutional investors to gain exposure to this asset class. Others are doing the same for retail clients. Some at the Bitcoin Conference believe that going all in on Bitcoin as an investment is the answer. Others take a very different view and believe that owning Bitcoin as part of a balanced portfolio is the best course to take. All agree that investors must understand the benefits and risks of investing in Bitcoin and have a high risk-tolerance.
Like any other investments, prior to investing, it is critical for investment advisers to do their homework first, and conduct product due diligence on Bitcoin from an operational perspective by examining a host of supervisory and regulatory issues, including, but not limited to valuation, liquidity, trade execution, recordkeeping, custodial functions, and client know your customer onboarding processes and disclosures. Additionally, in the private fund space, having adequate governing fund document disclosures is of paramount importance. Taking a risk assessment view, all these issues must be carefully thought out, managed, documented in written policies and procedures, and supported by adequate oversight and recordkeeping. Of course, Form ADV disclosures regarding cryptocurrencies will also be a critical component of the regulatory disclosure landscape for all investment advisers.
SEC & Office of the Comptroller of the Currency (OCC) Regulatory Views:
As regulators, including the SEC, continue to address various concerns, such as custody, investment advisers and broker-dealers must monitor all forthcoming regulatory guidance, such SEC’s custody rule guidance, issued on December 23, 2020, which spelled out a regulatory framework that will function as a custody rule road map for broker-dealers, pursuant to which “special purpose” brokers may follow certain, specific measures and custody digital asset securities during a five-year program period without the risk of facing an enforcement action. The SEC defined a “special purpose broker-dealer”—one that “limit[s] its business to digital asset securities (to isolate risk) and [that has] policies and procedures to, among other things, assess a given digital asset security’s distributed ledger technology and protect the private keys necessary to transfer the digital asset security.” In the SEC’s December 23, 2020 statement, it also solicited comments on “evolving standards and best practices with respect to custody of digital asset securities.”
On the banking side of the custody equation, in its Interpretive Letter #1170 issued on July 22, 2020, the OCC issued a legal interpretation affirming that federally chartered banks and thrifts (collectively “national banks”) may now provide crypto custodial services for crypto assets.
Furthermore, in its Risk Alert, dated February 26, 2021, the SEC started that, “In the experience of the Division of Examinations (the “Division”), a number of activities related to the offer, sale, and trading of digital assets1 that are securities (“Digital Asset Securities”) present unique risks to investors. Moreover, distributed ledger technology has many distinct features that the Division encourages firms to consider when designing their regulatory compliance program. To address these risks and adapt as distributed ledger technologies change and mature, many market participants involved with Digital Asset Securities have been updating and enhancing their compliance practices.” The SEC’s Risk Alert went on to “provide observations made by Division staff during examinations of investment advisers, broker-dealers, and transfer agents regarding Digital Asset Securities that may assist firms in developing and enhancing their compliance practices. In addition, as more securities industry participants seek to engage in digital asset-related activities, this Risk Alert provides transparency about areas of focus for the Division’s future examinations.”
Finally, in comments made at CoinDesk’s Consensus 2021, (held virtually, May 24-27, 2021) SEC Commissioner Hester Peirce said, “The bottom line message I have is that we have work to do in modernizing our custody rules all across the board, As with many other areas, crypto may force us to do that modernization faster than we otherwise would.”
Stay Plugged In:
There’s no escaping the fact that we are witnessing evolutionary, transformative developments in the crypto-currency marketplace. Key participants in this space, including investment advisers, broker-dealers, mutual funds, regulators, investors and the growing crypto ecosystem of crypto brokers/exchanges/service providers will all have a seat at this table and play a key role in moving these developments forward. Stay tuned for more regulatory developments, as we’ve only just begun.