A forthcoming paper in the Stanford Journal of Law, Business, and Finance looks at the cryptocurrency markets (bitcoin and its kin), the hedge funds that look to make money from them and the operational issues involved.
Two independent scholars collaborated on writing the paper: Edmund Mokhtarian and Alexander Lindgren.
Although Mokhtarian and Lindgren wrote this paper in October, it seems to have become more, not less, topical with the passage of time. After all, as November ended bitcoin reached stratospheric heights, briefly trading above $11,000, then fell precipitously to $9000. Depending on who it is to whom one listens, this was either an unremarkable matter of successful traders taking their profits, or it was the bursting of a bubble, the beginning of the end. A Nobel Prize winner, Joseph Stiglitz, declared amidst the excitement that bitcoin has no valuable social role and ought to be banned by law.
In this context, it is pertinent to look at the broader picture Mokhtarian and Lindgren paint. They define a cryptocurrency in the standard way as a digital or virtual currency that uses cryptography for security. It has no physical form, paper or metallic. Further, in contrast to a fiat currency, it isn’t validated by the simple fact that someone has tendered it. It is validated in accord with algorithms.
The underlying technology is the blockchain, a distributed public ledger system that records all the transactions in the currency’s history.
Typically, individual holders provide computational power to the blockchain sufficient to solve a puzzle in exchange for a small reward in the currency – that is, they “mine” bitcoins. The mine involves digging into logical possibility rather than digging into the bowels of the earth.
The Regulatory Reaction
The authors point out that a “functional” regulatory scheme has developed in the United States, according to which a cryptocurrency can be classified either as a commodity or as a security depending on its uses. Furthermore, the best established of the cryptocurrencies are treated as commodities, which means in the opinion of these authors that they “present a far greater risk of fraud or investor losses than a traditional hedge fund, as cryptocurrency markets lack the liquidity, stability, and regulatory certainty of traditional securities markets.”
The Regulatory System
Four of the most important areas in which hedge funds are at present regulated (leaving aside those that might deal exclusively in cryptocurrencies for the moment) are as follows: anti-fraud and non-solicitation provisions of the Securities Act and the Exchange Act; regulation of investment activity under the Investment Advisors Act and the Investment Company Act; taxation (specifically, in order to avoid corporate taxation at the entity level a hedge fund must avoid classification as a publicly traded partnership); and oversight by the CFTC.
With regard to the fourth of those areas, Mokhtarian and Lindgren remind us that investment managers and pooled investment vehicles trading on designated self-regulatory exchanges must register with the CFTC, which puts them under a set of requirements similar to those of the Advisers and Investment Company Acts.
The Dodd-Frank Act expanded the scope of CFTC jurisdiction to include all commodity swaps and derivatives contracts of any type. The only escapees from this regulatory net were to be forward delivery contracts involving cash settlement and physical delivery.
So: do cryptocurrency investment funds fit into this framework? Mokhtarian and Lindgren make the case that the activity of a crypto fund could indeed fall within that lonely exception to the scope of the expansion of the CFTC’s authority: Crypto tokens could be regarded as the subject of forward delivery contracts with physical delivery and cash settlement. Thus, “the unique challenges of crypto funds will require new and different solutions than the best practices embodied in current regulation.”
Custodians and Taxation
With regard to custodianship, the article observes that block chains obviate the need for a third party custodian “as might be desirable for other investments,” and that indeed they go further than this, making “first-party custodianship the only responsible form of safeguarding client assets.” The usual functions of a third party custodian are “automatically performed by the public-key encryption underlying the corresponding blockchains.”
Public key encryption “validates, secures, and creates trust in cryptocurrency transactions” with valid digital signatures that cannot be forged by an intruder.
As to regulation via taxation, the report for the most part sets that subject aside, saying only that “the full tax implications of cryptocurrency transactions are complex and uncertain” and offering in a footnote four fact patterns that demonstrate as much.