Sunday, October 21, 2018

Investment Funds Primer - Crypto Funds Overview

I was motivated to write this series of blog posts after attending the NYU Stern FinTech Conference, where I led lunchtime discussion about crypto funds and investing.  In this blog post, I aim to summarize what I see as the state of development of this recently new but quickly growing investment class.   In the next blog post, I will try to explain the regulatory vacuum that allows (and explains) some of this proliferation.

First, let's talk about the statistics so we can understand the magnitude of what is happening.  It is estimated that currently there are 621 crypto funds around the world (a half of them being in the United States), 198 of which were launched in 2017 and a projected 220 in 2018.  Roughly half of the crypto funds (303 out of 621) are small: they have less than $10 million AUM and less than 5 employees.  188 crypto funds have AUM between $10 million and $50 million, and only 37 funds have AUM of over $100 million (such as Pantera Capital, Galaxy Digital Assets, Alphabit Fund, and Polychain Capital).  So, to summarize, 621 crypto funds manage over $7.1 billion, and it is all done by less than 5,000 people globally (most of whom are located in the U.S.).

Now, let's talk about the crypto fund strategies.  Crypto funds are private investment vehicles that raise money to invest into various types of crypto or digital assets.  The main categories are crypto hedge funds and crypto venture capital funds.  Crypto hedge funds act more like typical hedge funds: some actively trade cryptocurrencies on various exchanges, others adopt a buy and hold approach, some are passive index funds that invest in indices of top performing cryptocurrencies, yet others invest into crypto funds of funds, some are AI-driven quant funds that use machine learning to execute statistical arbitrage strategies, and some are token basket funds that invest into baskets of crypto assets.   Crypto venture capital funds invest into ICOs, tokens, and equity of blockchain-related startups.

At this point I would like to briefly summarize the U.S. laws that apply to investment funds generally.  There are no specific regulations yet that apply only to crypto funds. 

The Securities Act of 1933 regulates the process of how the funds can raise investment capital.  Onshore fund offerings are typically conducted in reliance on Regulation D under the Securities Act.  Funds are also subject to the anti-fraud and insider trading regulations under the Securities Act and the Securities and Exchange Act of 1934.  Their disclosures to investors may not contain false or incomplete information.

The Investment Company Act of 1940 (the "Company Act") regulates trading activities of entities that "engage primarily, in the business of investing, reinvesting, or trading in securities" and are "investment companies."  Most traditional hedge funds rely on exemption from the definition of "investment company" found either in Section 3(c)(1) or 3(c)(7) of the Act.  This means that funds either cannot have more than 100 investors or all of investors have to be "qualified purchasers" - a much higher standard of wealth than what is required to be an accredited investor.

The Investment Advisers Act of 1940 (the "Advisers Act") regulates the fund managers that are in the "business of advising others . . . as to the value of securities or as to the advisability of investing, purchasing, or selling securities" and after the Dodd-Frank Act, generally requires them to register with either state agencies or with the SEC.

The Commodities Exchange Act (the "CEA") regulates commodity swaps and other commodity derivatives and investment advisers that advise commodity pools.

As I will explain in the next blog post, some crypto funds escape from most of the current regulations because they do not invest into, or advise on, securities.  The question of what is a "security" becomes paramount.  Investing in  commodities can place the crypto funds outside of regulation of the Company Act, the Advisers Act, and the CEA, thus significantly lowering barriers to crypto fund formation and management.  This helps explain the growth phenomenon of the crypto funds.

This article is not legal advice, and was written for general informational purposes only.  If you have questions or comments about the article or are interested in learning more about this topic, feel free to contact its author Arina Shulga.  Ms. Shulga is the co-founder of Ross & Shulga PLLC, a New York-based boutique law firm specializing in advising individual and corporate clients on aspects of corporate and securities law.

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