SEC Staff Statement on Registered Funds Investing in the Bitcoin Futures Market

The Securities and Exchange Commission’s Division of Investment Management (IM) staff released a statement this week concerning registered funds, most notably mutual funds, investing in the Bitcoin futures market. The statement addressed both perceived investor risk when investing in a mutual fund with exposure to the Bitcoin futures market, as well as IM staff’s intended coordination with the Division of Examinations (EXAMS) and the Division of Economic and Risk Analysis (DERA).

Throughout the statement, IM staff makes the distinction of investing in Bitcoin futures between mutual funds, exchange-traded funds (ETFs), and closed-end funds. To explain why, a brief recap of the IM staff’s 2018 letter on Engaging on Fund Innovation and Cryptocurrency Related Holdings is needed. In the 2018 letter, IM staff identified five substantive areas of questions pertaining to potential investing in digital assets (including cryptocurrency or cryptocurrency-related investments). The five areas were: (i) valuation, (ii) liquidity, (iii) custody, (iv) arbitrage mechanisms for ETFs, and (v) potential manipulation and other risks associated with cryptocurrency-related markets. At that time, IM staff raised questions pertaining to each noted area, and with regard to the first four, the interaction with requirements under the Investment Company Act of 1940 (IC Act).

While many of the staff’s questions may still hold true three years later, funds also need to recognize that in the interceding three-year period several things have changed, namely:

• New Rule 2a-5 under the IC Act was adopted introducing new rules on determining fair valuation of fund holdings including a new definition of “readily available market quotations,”
   
• Rule 22e-4 under the IC Act came into full force for mutual funds and ETFs placing a limitation on holding illiquid assets and requiring the classification of all fund holdings into four buckets of liquidity,
   
• ​​While IM staff were not aware of any custodian providing fund custodial services for cryptocurrencies in 2018, several such custodians have emerged since and operate today,
   
• New Rule 18f-4 under the IC Act was adopted introducing new rules on funds’ abilities to invest in derivatives, including limitations on leverage risk and the requirement to develop a derivatives risk management program, and
   
• ​​​​​While not changing the questions around ETF arbitrage mechanisms, new Rule 6c-11 under the IC Act was adopted and came into force outlining how certain ETFs (those able to rely on the rule versus still requiring exemptive relief) operate and come to market.

As a result, funds looking to come to market with strategies involving investment in cryptocurrency or futures on cryptocurrencies need to be prepared to have an open discussion and answers to IM staff’s 2018 questions, the 2021 staff statement, recent rule changes, and how appropriate investor protection would be provided. IM staff encourages funds to consult with the staff prior to making a registration filing.

Risk disclosure

IM staff believes investors in mutual funds that have investment exposure to the Bitcoin futures market should “carefully consider the risk disclosure of the fund, the investor’s own risk tolerance, and the possibility, as with all investing, of investor loss.” Mutual funds that do provide exposure to the Bitcoin futures market should ensure their prospectuses and statements of additional information risk disclosure and description of Bitcoin futures fully represents the nature and risk of such investment. When drafting such a disclosure, a mutual fund should consider IM staff’s previous statements about principal risks disclosure, and, in particular, how to order prospectus risk descriptions (i.e., importance versus alphabetical).

Division coordination

IM staff along with their colleagues in EXAMS and DERA intend to “monitor the impact of mutual funds’ investments in Bitcoin futures on investor protection, capital formation, and the fairness and efficiency of markets.” In doing so, the staff expects to, among other things:

• Analyze mutual funds’ ability to liquidate Bitcoin futures positions as necessary to meet daily redemption demands, as well as the efficacy of mutual funds’ derivatives risk management and the extent of any leverage obtained through derivatives,
   
• Monitor funds’ valuations of holdings in the Bitcoin futures market and consider the impact of mutual fund participation in the Bitcoin futures market on valuations in that market, as well as the impact on valuation of any disruptions in the underlying Bitcoin markets,
   
• ​​​​​​As part of funds’ compliance with the open-end fund liquidity rule, consider mutual funds’ liquidity classification of any position in the Bitcoin futures market and the basis for such classification and also consider the overall construction of a fund’s liquidity risk management program, and
   
• Consider whether, in light of the experience of mutual funds investing in the Bitcoin futures market, the Bitcoin futures market could accommodate ETFs, which, unlike mutual funds, cannot prevent additional investor assets from coming into the ETF if the ETF becomes too large or dominant in the market, or if the liquidity in the market starts to wane.

How we help

ACA offers compliance consulting services to registered funds along with:

• mock SEC examinations
• compliance program reviews
• liquidity risk management program assessments, and
• assistance with the creation of new valuation policies and derivatives risk management programs

ACA also offers consulting services to crypto-focused firms.

To learn more about how ACA can help enhance or strengthen your compliance program, please contact your ACA consultant or contact us here.

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