Monday, April 02, 2018

CBOE responds to SEC on fund innovation and cryptocurrency holdings

By Brad Rosen, J.D.

Cboe Global Markets, Inc. President and COO Jack Concannon provided a comprehensive response to an SEC staff letter issued by the Division of Investment Management earlier in the year which raised numerous concerns relating to cryptocurrencies and related products. In its letter dated March 23, 2018, Cboe focused on the specific areas noted by the SEC where significant outstanding questions exist in connection with how funds holding substantial amounts of cryptocurrencies and related products would satisfy the requirements of the Investment Company Act and SEC rules. These topics included valuation, liquidity, custody, arbitrage for ETFs, manipulation and suitability.

Cboe, including affiliates, was the first national securities exchange to submit a proposal to list and trade an ETP that would hold bitcoin and has since submitted three additional proposals to list and trade ETPs that would hold bitcoin futures. Additionally, the affiliated Cboe Futures Exchange was the first U.S. futures exchange to offer a Bitcoin futures product for trading. In March, 2018, trading volume exceeded 10,000 contracts per day for Bitcoin futures.

A common thread running through Cboe’s letter was that cryptocurrency-related holdings should be treated like other assets for regulatory purposes, although it conceded these holdings do raise a number of unique issues. Cboe’s letter was in response to a letter dated January 18, 2018 from Dahlia Blass, the director of the SEC’s Division of Investment Management, to the Investment Company Institute and the Securities Industry and Financial Markets Association. Some of the key points from Cboe’s submission follow.

Valuation. One area of concern noted in the SEC’s letter was how funds would value cryptocurrencies given their volatility, the fragmented markets, the general lack of regulation, and the current state of the cryptocurrency futures markets. SEC staff noted that mutual funds and ETFs must value their assets each business day to determine a net asset value. A central question raised was: how would funds develop and implement policies and procedures to value, and in many cases “fair value,” cryptocurrency-related products?

Cboe agreed that valuation was of critical importance for cryptocurrency ETPs, but it asserted that most valuation issues are either very similar or identical to those encountered in valuing other assets. Cboe noted that for Bitcoin, there are numerous robust indices that Cboe and other market participants have been tracking for years. Additionally, there is a significant amount of reliable price information available from the bitcoin futures market on Cboe Futures Exchange and CME. Finally, there is real-time trade data available 24 hours a day from a number of different trading platforms around the world, with a collective volume in the billions of dollars daily. Cboe concluded there is more than sufficient information for cryptocurrency ETPs to create reliable and robust valuation methodologies for bitcoin and potentially for other cryptocurrencies.

Liquidity. Another area of concern for the SEC is liquidity. The SEC queried what steps funds would take to assure that they have sufficient liquid assets to meet daily redemptions and how they would classify the liquidity of cryptocurrency and related products for purposes of Rule 22e-4, the new fund liquidity rule. A central question raised was: what steps would funds investing in cryptocurrencies or cryptocurrency-related products take to assure that they would have sufficiently liquid assets to meet redemptions daily?

Cboe noted that while there are certain aspects that differentiate cryptocurrency-related assets from more traditional assets, almost all of the issues related to liquidity are substantively identical to those of other commodities, including the spot, over-the-counter, and commodity futures markets. It pointed to the billions of dollars of bitcoin traded on cryptocurrency exchanges on a daily basis. Cboe asserted that as the volumes continue to grow, especially on regulated U.S. markets, the overall spot bitcoin market looks more and more like a traditional commodity market and believes the spot market is sufficiently liquid to support a bitcoin ETP.

Custody. To the extent that a fund plans to hold cryptocurrency directly, the SEC staff asked how it would satisfy the custody requirements and related rules.

Cboe noted that to the extent that a cryptocurrency ETP plans to hold cryptocurrency directly, whether as fund holdings or for physical settlement of a futures contract, firms like Gemini Trust Company, LLC and a number of others are establishing themselves as regulated custodians offering custodial services.

Arbitrage. SEC staff questioned how ETFs would comply with Commission orders that they have a market price that would not deviate materially from their net asset value given the fragmentation, volatility, and trading volume of the cryptocurrency marketplace.

In its response, Cboe encouraged the Commission to treat cryptocurrency-related assets in the same manner that they have treated existing ETPs that hold commodities or the associated futures contracts. It noted that based upon a number of factors, including conversations with market makers and authorized participants, Cboe believed that the spot and over-the-counter bitcoin market could easily support the arbitrage mechanism for an ETP.

Suitability. SEC staff noted that the cryptocurrency markets that are currently in operation offer less investor protection than traditional markets and provide a greater opportunity for fraud and manipulation. Staff questioned whether investors have sufficient information to consider the risks and whether broker-dealers have analyzed the suitability of offering these funds to retail investors. Investment advisers may face challenges in meeting their fiduciary obligations when investing in these products on behalf of retail investors.

In its submission, CBOE noted that cryptocurrency funds would NOT be appropriate for all investors. It added that comprehensive risk disclosure in the applicable regulatory documentation backstopped by rigorous broker-dealer evaluation of the suitability of a particular product for a client would provide a sufficient framework for investor protection. Cboe indicated that it does not believe that cryptocurrency-related funds are so much different as to warrant disparate treatment from other commodity-related funds.

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