Hedge fund prism ethereum
Since the story broke, it has clearly had an effect on the price of bitcoins. Take a look at this timeline of events from last week posted by the EFF when compared to a chart of the price of bitcoins on the Mt. Gox market. On Sunday, a time when the market for bitcoins is slow-moving historically, the price dropped during heavy volume trading.
The link between bitcoin price and public opinion has been well discussed. The rash of sell-offs in the past week indicates that some might be concerned about the role of bitcoin, considering how much the United States government knows about what occurs on the internet. While they cannot stop bitcoin, they can monitor it — which after the past weeks' revelations, they most certainly are doing. That may be in contrast to what many bitcoin experts believe makes decentralized currencies important to people.
The just print money for whatever it is that they want to spend it on. If the world were using bitcoin that would no longer be a possibility. One could question whether or not people think that given that programs like PRISM are now out in the open. If people around the world were concerned about U.
The introduction of cryptocurrency debit cards, [] Bitcoin ATMs, [] and payment options at large vendors [] suggests that cryptocurrency can function much like fiat currency. Still, cryptocurrencies are functionally different from any other fiat currency in the world. They are not regulated by a central authority, they rely on a computer network, and they have not yet reached general acceptance. As discussed above, a sophisticated cryptocurrency fund manager handling their own private keys may have a significant operational advantage over a fund bound by the custody rule.
Even if the SEC determines that cryptocurrencies constitute neither client funds nor securities, fund managers without a qualified custodian would still fall afoul of the rule. Funds could avoid this by having investors invest and take redemptions in only cryptocurrency. Such a policy would be impracticable for many investors and would require modification of Form D and many other registration documents that denominate minimum investment and offering amounts in US dollars.
If a token is a security, it can still be exempt from the qualified custodian requirement if it falls under the private placement exemption. This exemption applies to privately offered uncertificated securities. The SAFT is a standard agreement promising to deliver future tokens, modeled after an agreement used by startups entering angel and seed-round investments. This would be attractive to fund managers who invest in a diverse range of pre-ICOs and would otherwise struggle finding custodians able to accommodate these yet-to-be-released tokens.
Introducing an Alternative Mechanism for Compliance with Rule 4 -2 In light of the complications of applying the current custody rule to cryptocurrencies, the SEC has three possible options. First, it could institute a period of no action while the market for specialized qualified custodians develops. Funds would continue operating without fear of immediate censure in the hope that a mature and sophisticated set of qualified custodians would develop. Second, a more aggressive SEC could take enforcement action immediately and fine fund managers that are not complying with the rule.
But in the absence of fraud or tangible harm to investors, wide-reaching fines and cease-and-desist orders may be hard to justify. Solving the fundamental inconsistency between the rule and practice requires a more comprehensive regulatory response. The third option is to issue a no-action letter that specifically sets out new requirements for the custody rule for investment advisers managing cryptocurrency hedge funds.
This is the best choice. This Part explores both the regulatory basis and rationale for changing the rule and what those modifications should entail. Creating a special set of custody rules for digital assets would necessarily discriminate between funds with traditional assets and funds with digital assets. For one, investors in hedge funds are wealthier than the average individual. Even when they do not understand the risk, they likely have the assets to recover from complete loss.
Six months after Tim Draper lost forty thousand Bitcoins he held on the Mt. As a counterpoint, although hedge funds were traditionally the target of wealthy individuals, institutional investors now make up more than 60 percent of hedge fund assets. In addition, even if Bernard Madoff and other pre-Dodd-Frank scandals are in the rearview mirror as far as hedge fund investors are concerned, the securities rules should not adjust to the often-myopic mood of the hour. On the other hand, by not modifying the rule, the SEC would be inhibiting capital formation in a promising industry, contrary to its third goal of facilitating capital formation.
This has happened before. In the past, the SEC has allowed modifications to the custody rule when the circumstances were compelling and protections were adequate. Like the IAA custody rule, Section 17 f of the ICA requires that funds hold securities only with qualified custodians [] —typically banks or members of national securities exchanges.
The challenges in applying the current custody rule present a compelling case for modification. A difficult question is whether the current exchanges can provide adequate protections to satisfy concerns about investor protection.
Modifying the Rule Unlike the funds in previous no-action letters, hedge funds do not have a viable qualified custodian option for their cryptocurrency assets. These would include 1 the fund hiring an independent, third-party administrator; 2 requiring the administrator to receive direct pricing from the exchange; 3 quarterly audits; 4 mandatory policy on custody and security; 5 adequate disclosure of risk; 6 mandatory best interest determination; and 7 encouraging the use of insurance.
Although these procedures cannot eliminate all of the security risks digital currency exchanges present, they provide reasonable safeguards under which the industry can develop. For example, clients could direct their investments in fiat currency directly to a bank account under the control of the administrator. The fund manager would have no ability to withdraw funds from this account.
The administrator would then take responsibility for directing the fiat currency to third parties, such as exchanges or parties to private negotiations. Since fiat currency does not present the same problems as digital assets, there is no reason to extend an exemption to custody for it. If the fund manager involves any brokers or third-party traders in their transactions, the administrator must take responsibility for reconciling the accounts.
Direct Pricing from the Exchange Second, the custody rule requires the fund to deliver account statements to customers to deter general partners from reaching into the cookie jar and taking improper payments. Cryptocurrencies do not have a standard pricing and the price of any coin can differ from exchange to exchange. The third-party administrator should develop a methodology that looks to either the application programming interface API [] of a particular exchange or an averaged blend of data from different APIs.
Navigating APIs requires the administrator to employ technical knowledge. However, unlike storing cryptocurrency, the use of APIs is standardized and widely understood. Quarterly Audit Third, like the surprise examination, a quarterly audit would help make sure that the assets that the adviser is telling its clients are there are actually there.
Rather than extending a fraudulent scheme for years, as in the case of Bernard Madoff, a quarterly audit would detect misallocation or misappropriation of cryptocurrency and flag the issue for gatekeepers and regulators. While the procedures for storing cryptocurrencies are plagued with technological difficulties and malicious actors, accounting firms are fully capable of auditing digital assets. The only barrier to competency is whether accounting firms are willing to commit resources to learning the field.
This differs from anything found in the current custody rule. However, having a custody and security policy in place would help identify failures and warn investors of risks. In the case of a malicious actor, it would provide the SEC and non-malicious fund managers a roadmap for understanding where the failure occurred and how it could be remedied. In addition, policies would provide additional materials for investors to do due diligence.
Especially in the context of cybersecurity, investors would have the opportunity to read the policy and determine whether it provided enough assurances to make them comfortable enough to invest. The exercise of drafting a policy would have benefits regardless. For example, a market for compliance consultants may evolve and create industry standards. Disclosure of Risks Fifth, the fund must provide investors with a special disclosure stating risks stemming from the custody arrangement and trading on exchanges.
This would put potential investors on notice that the fund manager is relying on an SEC no-action letter and that, by investing into this arrangement, the investor is potentially subjecting their digital assets to complete loss. Best Interest Determination Sixth, the general partner of the fund or fund manager must determine that holding client funds or securities on an exchange is in the best interest of the limited partners investors.
Insurance These requirements alone might still be insufficient. If the comparison is to current custodians holding traditional asset classes, then the answer becomes less clear. He is no different from the individual storing cash under a mattress. Even more importantly, holding cryptocurrency on an exchange could subject the funds to a total loss. Although there has never been a case of a cryptocurrency hedge fund absconding with assets, recent history is replete with large-scale theft of digital assets held on cryptocurrency exchanges.
Some of the risk inherent to keeping custody of cryptocurrencies can be mitigated through insurance. And insurance might make the SEC more willing to tolerate a set of rules that allows significantly more risk of misappropriation and loss from theft, depending on what type of assets a given hedge fund manager chooses to invest in.
Although there is not yet a mature market for insuring cryptocurrency, it is foreseeable that one will evolve. In addition, new technologies and innovations may dramatically reduce the risk of fund managers and exchanges maintaining custody of digital assets.
The private company Chainalysis offers investigative tools that can track Bitcoin transactions to wallets. Furthermore, the recent failures of exchanges to prevent attacks may also be remedied by innovation. Conclusion As hedge funds continue to invest in cryptocurrency, the market for custodial services will adapt to the changing landscape.
My proposed alterations of the custody rule will allow hedge funds to continue to invest in cryptocurrency while providing investors a higher degree of security. Still, they are preferable to the two likely alternatives: hedge funds acting as their own bank by holding cryptocurrency themselves, or a rigid application of the rule that stifles the industry. The question will be whether the SEC can stomach the idea of allowing funds to hold assets in a way that is known to contain significant risk of loss.
California Law Review, Inc. CLR is a California nonprofit corporation. CLR and the authors are solely responsible for the content of their publications. See Press Release, U. See Diana B. Times Dec. See K. See Advisers Act Rule 4 -2, 17 C. IA, 68 Fed. See Complaint at 5, SEC v. Madoff, No. See, e. Robert E. See id. Hammer et al. Regulation of Hedge Funds Hammer, supra note 19, at 9. See Advisers Act Rule 4 -2 a , 17 C.
See 17 C. See Hammer, supra note 19, at Hammer, supra note 19, at 1. Private Fund Adviser Exemption, 17 C. However, even when exempt from SEC regulation, they may nonetheless be subject to an analogue under state law. Codes R.
To the extent a Licensee maintains a trust account in accordance with this section, such trust account must be maintained with a Qualified Custodian. See also Hammer, supra note 19, at The Public Company Accounting Oversight Board is a non-profit corporation established by Sarbanes-Oxley Act of to supervise the audits of public companies and broker-dealers. Company Acct. See Pedro Franco, Understanding Bitcoin 9—10 For the purposes of this paper, we will refer to all three as cryptocurrencies, unless the topic requires further specificity.
Sarah J. See Daniel Drescher, Blockchain Basics 63—69 Imran Bashir, Mastering Blockchain ; Franco, supra note 46, at However, like much of the overview here, a more simplistic overview is sufficient for purposes of applying the custody rule. See Drescher, supra note 53, at 29—32, See Franco, supra note 46, at See Id. Caetano, supra note 61, at An exchange traded fund, or ETF, would allow individuals to invest in cryptocurrency without owning the coin directly. Instead, they would own shares in the entity that hold the coins.
See Winklevoss Bitcoin Trust, supra note Winklevoss Bitcoin Trust, supra note 48 emphasis added. Although there are frequent news stories about large custodians developing cryptocurrency products, as of writing, none of the largest hedge fund custodians act as qualified custodians for cryptocurrency assets. Transactions are confirmed by distributed consensus and then immutably recorded on the blockchain. So, ring signatures ensure that transaction outputs are untraceable.
GenericShill, supra note
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