Rise of The Crypto Hedge Fund

CRYPTO PROOF_AD[61869] (3) (DO NOT DELETE) 2/19/2018 1:48 PM
Rise of the Crypto Hedge Fund:

Operational Issues and Best Practices for
an Emergent Investment Industry
Edmund Mokhtarian* and Alexander Lindgren
Abstract
In the last several years, a discreet $800+ billion financial system has emerged in the form of
cryptocurrency markets. The extraordinary returns generated by cryptocurrencies such as
Bitcoin have led to a frenzy of investment activity and interest from traditional investors. This
interest has, in turn, spawned dozens of cryptocurrency-focused hedge funds to service this
growing demand. Moreover, although this trading activity is highly speculative, it is subject to
almost no regulatory oversight. Regulators at the IRS, CFTC, and most notably the SEC have
only recently established a regulatory framework to govern cryptocurrency activity. Notably,
that framework is a functional one, classifying each cryptocurrency either as a security or
commodity based on its particular uses. However, most of the established and highly-traded
cryptocurrencies, such as Bitcoin and Ether, qualify as commodities rather than securities, and
thus they are not subject to securities laws. Hedge funds that trade in these cryptocurrency
commodities, or “crypto funds,” fall almost entirely outside the extensive securities regulations
that would apply to traditional hedge funds.
This article argues that these crypto funds constitute a new type of financial institution that is
not, and cannot be, governed by traditional hedge fund regulation because doing so would
disregard the unique operational and technological features of cryptocurrencies. Existing rules
and best practices for hedge funds in key areas—such as investor asset custodianship, capital
formation, and distribution of returns—are frequently nonsensical or even counterproductive
in the context of crypto funds. Without regulatory guidance, crypto funds will need—and have
the opportunity—to develop a set of best practices tailored to cryptocurrency trading. In doing
so, crypto funds also present a significant opportunity for much-needed financial innovation
and problem-solving in the cryptocurrency markets. However, crypto funds also 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.
This article concludes with concrete recommendations regarding several of the most salient,
cryptocurrency-specific concerns currently facing crypto funds, including (i) the types of
cryptocurrencies that should be traded, (ii) the types of potential investors who can provide
* Technology Advisor; J.D., Harvard Law School.

 Partner at Lindgren, Lindgren, Oehm, & You LLP; J.D., University of Minnesota Law School.
112
Winter 2018 Rise of the Crypto Hedge Fund 113
funding, (iii) internal procedures for safeguarding client assets, (iv) optimization of the tax
treatment for the fund and its investors, and (v) cryptocurrency-related disclosures to investors.
By encouraging the development of uniform best practices across the crypto fund industry, this
article provides a starting point for regulators to adopt policies that can address investor
protection concerns without strangling the innovation of the emerging cryptocurrency markets.
114 Stanford Journal of Law, Business & Finance Vol 23:1
Introduction ......................................................................................................................... 115
I. The Evolving State of Cryptocurrency Regulation ..................................................... 118

A. Terminology ...................................................................................... 118
B. What is a Cryptocurrency? ............................................................... 119
1. Decentralized Payments ........................................................... 121
2. Smart Contracts ......................................................................... 122
3. Decentralized Applications ..................................................... 122
4. Fundraising ................................................................................. 123
C. SEC Regulation of Security Tokens ................................................ 124
1. Background ................................................................................. 125
2. Application of the Howey Test to the DAO Tokens ............. 126
D. Non-Regulation of Virtual Currencies .......................................... 127
II. The Current State of Hedge Fund Regulation ............................................................ 130

A. Anti-Fraud and Non-Solicitation Provisions under the Securities
Act and Exchange Act ........................................................................... 130
B. Regulation of Investment Activity under the Investment Advisers
Act and Investment Company Act ...................................................... 132
1. Investment Advisers Act ........................................................... 132
2. Investment Company Act ......................................................... 134
C. Hedge Fund Taxation ....................................................................... 135
D. Commodities Futures Trading Commission Oversight .............. 137
E. Non-Applicability of Investment Activity Regulation to
Crypto Funds ......................................................................................... 138
III. The Crypto Fund: Administrative and Operational Issues ..................................... 139
A. Solicitation of Investors .................................................................... 139
B. Custodianship of Assets ................................................................... 141
C. Tax Treatment: Foreign Investor Exemptions and
Redemptions In-Kind ............................................................................ 144
1. 864(b)(2) Exemption ................................................................... 146
D. Disclosure of Cryptocurrency Risks, Investment Strategy,
and Regulatory Uncertainty to Limited Partners .............................. 147
IV. Best Practices for Crypto Funds .................................................................................. 152

A. Comply with the Simpler Non-Solicitation Rules of Reg D ........ 152
B. Trade Established, Pure Currencies ................................................ 152
C. Safeguard Private Keys and Limit Trading Authorization ......... 154
D. Mitigate and Devolve Tax Risk ....................................................... 155
E. Mitigate Regulatory Risks ................................................................ 155
V. Conclusion ...................................................................................................................... 156
Introduction
Over the last several years, few financial assets have generated returns
comparable to those of cryptocurrencies.1 For example, Bitcoin, the largest
cryptocurrency by market capitalization, has risen over 500,000,000% in value between
its creation in January 2009 and January 2018,2 and 4,328% between December 2014
and December 2017.3 Ether, the third largest cryptocurrency by market capitalization,
has risen 34,876% in value since its inception in 2015.4
The intense interest and extraordinary returns in such cryptocurrencies have led
to the rapid and exponential creation of new cryptocurrencies, with over 1,300
currently in existence.5 Bitcoin, the first cryptocurrency, was conceived simply as a
1. To compare, some of the best NASDAQ performers between mid-2014 and mid-2017
increased in value by about 530% to 730%. Keith Speights, These 3 Stocks Are Up Over 500%
in the Last 3 Years, MOTLEY FOOL (June 25, 2017),
https://www.fool.com/investing/2017/06/25/these-3-stocks-are-up-over-500-in-the-last-3-
years.aspx. The best-performing stocks of established, “traditional” companies showed
returns in the 300% range, though one must note their relative stability. Frank Byrt, 10
Best-Performing Stocks in Three-Year Bull Market (Update2), STREET (Mar. 12, 2002),
https://www.thestreet.com/story/11450815/1/10-best-performing-stocks-in-three-year-
bull-market.html; Top-Performing Mutual Funds by Category, KIPLINGER (Dec. 31, 2017),
http://www.kiplinger.com/tool/investing/T041-S001-top-performing-mutual-
funds/index.php; Commodities Broad Basket, U.S. NEWS: MONEY,
https://money.usnews.com/funds/mutual-funds/rankings/commodities-broad-basket.
2. Some of the first Bitcoin exchanges took place on BitcoinMarket.com in early 2010, where
user Theymos sold 15,000 Bitcoins for just $0.003 each. About a month later, on May 22,
2010, Laszlo Hanyecz successfully traded 10,000 Bitcoins for two pizzas, giving those
Coins the estimated value of $0.01. Eight years later, the closing value of one Bitcoin on
Jan. 5, 2018 was $17,014.17. See Fun fact “I Sold 15,000 BTC on Bitcoin Market for ~0.003 USD:
The All-Time Low on Any Market, AFAIK.”, REDDIT (Mar. 2017),
https://www.reddit.com/r/Bitcoin/comments/5w4kpp/fun_fact_i_sold_15000_btc_on_bit
coin_market_for/. See also If Bits Go from $0.003 to $0.006 It Doesn’t Seem Like a Big Move.
But if BTC Goes from $3000 to $6000 It Seems Like a Massive Unsustainable Bubble, REDDIT
(July 2017),
https://www.reddit.com/r/Bitcoin/comments/6gjnvy/if_bits_go_from_0003_to_0006_it_d
oesnt_seem_like/.
3. Calculated using closing prices at end of month. Bitcoin was valued at $13,955.2300 on
Dec. 31, 2017 and $315.1900 on Dec. 31, 2014.
4. Calculated using closing prices on first trading day and at end of month, respectively.
Ether was valued at $968.8357 on Jan. 5, 2018, and $2.77 on close of its first day of trading.
5. See Catherine Bosley, Global Central Banks Can’t Ignore the Bitcoin Boom, BIS Says,
BLOOMBERG (Sept. 18, 2017, 3:01 AM), https://www.bloomberg.com/news/articles/2017-
09-17/world-s-central-banks-can-t-ignore-the-bitcoin-boom-bis-says. See also Joe
Liebkind, How to Find Your Next Cryptocurrency Investment, INVESTOPEDIA (Sept. 7, 2017,
3:43 AM), http://www.investopedia.com/news/how-find-your-next-cryptocurrency-
investment/; Rachel Rose O’Leary, WSJ, Bloomberg Latest to Claim Bitcoin Exchange
Crackdown in China, COINDESK (Sept. 11, 2017, 1:00 PM), https://www.coindesk.com/wsj-
latest-to-claim-bitcoin-exchange-crackdown-in-china/; Andrew Tarantola, How to Trade
decentralized currency, operating via peer-to-peer transactions.6 While the technology

underlying and validating such transactions was novel, Bitcoin was meant to function
similarly to existing currencies like the dollar. Thus, the term “cryptocurrency” was an
accurate reflection of its function.
Newer cryptocurrencies, however, go far beyond the functionality of a traditional
currency. Some facilitate the automatic execution of contracts using computerized
protocols, also known as “smart contracting”7; others support decentralized
applications, like voting8; still others are used primarily as a means of company
fundraising —often by companies or individuals that intend to bypass a more
complicated private or public securities offering.9
The latter use—fundraising in lieu of an offering—has caught the attention of the
Securities and Exchange Commission (SEC), which has recently issued guidance that
classifies cryptocurrencies issued in such offerings as “securities” and thus subject to
federal securities laws.10 In contrast, cryptocurrencies like Bitcoin have instead been
classified as “virtual currencies” excluded from the application of federal securities
Bitcoin (And If You Should), GIZMODO (Jan. 4, 2014, 11:00 AM), http://gizmodo.com/how-
to-trade-bitcoin-and-if-you-should-1484488823; Catherine Bosley, Predicting the Future of
Money, ECONOMIST (July 1, 2017), https://www.economist.com/news/books-and-
arts/21724374-new-book-argues-mobiles-are-future-predicting-future-money.
6. In 1998, Wei Dai and Nick Szabo individually published descriptions of a decentralized
electronic cash system, respectively named “b-money” and “bit gold.” In 2004, Hal Finney
built on Dai and Szabo’s works and created the first reusable proof-of-work system. Dai,
Szabo, and Finney all became early adopters and supporters of Bitcoin at its inception.
Morgan Peck, Bitcoin: The Cryptoanarchists’ Answer to Cash, IEEE SPECTRUM (May 30, 2012,
4:33 PM), https://spectrum.ieee.org/computing/software/bitcoin-the-cryptoanarchists-
answer-to-cash/0. See also Wei Dai, Description of b-money (Untitled),
http://www.weidai.com/bmoney.txt; Benjamin Wallace, The Rise and Fall of Bitcoin, WIRED
(Nov. 23, 2011, 2:52 PM), https://www.wired.com/2011/11/mf_bitcoin/; Joshua Davis, The
Crypto-Currency, NEW YORKER (Oct. 10, 2011),
https://www.newyorker.com/magazine/2011/10/10/the-crypto-currency.
7. See Smart Contracts: The Blockchain Technology That Will Replace Lawyers, BLOCKGEEKS
(2017), https://blockgeeks.com/guides/smart-contracts/.
8. What is a Decentralized Application?, COINDESK,
https://www.coindesk.com/information/what-is-a-decentralized-application-dapp/. See
also id. (“Insiders vouch that it is extremely hard for our voting system to be rigged, but
nonetheless, smart contracts would allay all concerns by providing an infinitely more
secure system. Ledger-protected votes would need to be decoded and require excessive
computing power to access. No one has that much computing power, so it would need
God to hack the system! Secondly, smart contracts could hike low voter turnout. Much of
the inertia comes from a fumbling system that includes lining up, showing your identity,
and completing forms. With smart contracts, volunteers can transfer voting online and
millennials will turn out en masse to vote for their Potus[OTUS].”)
9. What is An Initial Coin Offering? Raising Millions In Seconds, BLOCKGEEKS (Mar. 2017),
https://blockgeeks.com/guides/initial-coin-offering/.
10. The Dao, Exchange Act Release NO. 81207, 117 SEC Docket 5 (July 25, 2017),
https://www.sec.gov/litigation/investreport/34-81207.pdf) [hereinafter “The DAO
Report”] (distinguishing between cryptocurrencies that qualify as securities and those
that qualify as virtual currencies).
laws, thus receiving the presumptive blessing of the SEC. 11 Subsequent actions and
statements by the SEC have provided further instruction on the line between security
and commodity tokens, discussed at greater length below. Nevertheless, the SEC’s
guidance leaves considerable ambiguity between cryptocurrencies that qualify as
securities and those that do not.12
The distinction between security and non-security cryptocurrencies is of special
interest to financial institutions seeking to profit from the cryptocurrency rush.
Extraordinary returns have led to a frenzy of investment activity including the
formation of new hedge funds focused partially or exclusively on trading
cryptocurrencies.13 Funds that trade exclusively in non-security tokens, or “crypto
funds,” bypass most of the regulations imposed on traditional hedge funds.
These “crypto funds” present unique benefits and issues, however, because of the
operational efficiencies and risks inherent in cryptocurrencies as well as the almost
complete lack of regulation of their cryptocurrency trading activity. On the operational
end, the technology underlying cryptocurrencies automates security measures, such
that safeguarding client property is more secure and efficient for a crypto fund. 14
However, since cryptocurrency markets lack the liquidity, stability, and regulatory
certainty of traditional securities markets, crypto funds generally have a far greater
burden of disclosure to investors than a traditional hedge fund. On the regulatory end,
crypto funds face significantly less regulation because, unlike traditional hedge funds,
they trade exclusively in cryptocurrencies that do not qualify as securities.15 As a result,
they are permitted to solicit investment from a far broader swath of investors and have
more flexibility in setting their fees, thus granting them a significant competitive
advantage against other hedge funds. Conversely, crypto funds face more complicated
tax concerns that may encourage them, for example, to distribute returns in-kind
rather than in cash.16
These differences are even more interesting considering the volatility of
cryptocurrencies. Cryptocurrencies are more speculative than many of the
instruments, such as stocks and bonds, that do constitute securities – yet institutional
trading of cryptocurrencies offers less barriers to market entry, including less
11. Id.
12. See id.
13. See Joe Liebkind, The Rise of the Crypto Hedge Fund, INVESTOPEDIA (Aug. 18, 2017, 11:16
AM), http://www.investopedia.com/news/rise-crypto-hedge-fund/. See also Frank
Chaparro, Hedge Funds Are Cashing in on Bitcoin Mania – There Are Now More Than 50
Dedicated to Cryptocurrencies, BUSINESS INSIDER (Aug. 30 2017, 3:33 PM),
http://www.businessinsider.com/bitcoin-price-surge-leads-to-growth-in-hedge-funds-
2017-8.
14. See, e.g., LIN WILLIAM CONG AND ZHIGUO HE, BLOCKCHAIN DISRUPTION AND SMART
CONTRACTS 10-13 (2018); Blockchain Automates Compliance Processes that Overhead Banks,
PAYPERS (Dec. 8, 2016), https://www.thepaypers.com/interviews/blockchain-automates-
compliance-processes-that-overhead-banks/767255-38.
15. See infra Part 3.
16. See infra Part 3(C).
regulation, lower start-up costs, and easier fundraising.17 The crypto fund thus
represents a new class of financial institution with significantly more risk, higher
upside, and fewer barriers to entry than a traditional modern hedge fund.18
This article analyzes the rise of the crypto fund, compares it to the traditional
hedge fund, and discusses unique operational issues and recommendations for
managing a crypto fund. This article proceeds in four parts. Part I discusses the
evolving state of cryptocurrency regulation considering recent guidance released by
the SEC. In this Part, we first define the term “cryptocurrency” and then address the
SEC’s current functional test to distinguish cryptocurrencies that qualify as securities
from those that do not. Part II briefly discusses current regulation of hedge funds
under US securities law, including registration, filing, and disclosure obligations,
trading activities, solicitation of investors, compensation arrangements, and tax
treatment. Part III then discusses the unique benefits and operational issues that crypto
funds face in four key areas: solicitation of investors, custodianship of client assets, tax
treatment and distributions, and required disclosures to investors. Part IV concludes
with recommendations and best practices for the crypto fund.
I. The Evolving State of Cryptocurrency Regulation
To understand the nature of crypto funds, their trading activities must first be
understood. The key question is, “What is a cryptocurrency, and how is it regulated?”
The difficulty in regulating cryptocurrencies lies in understanding what they do.
Contrary to their name, they can do far more than a typical currency, such as
automating transactions or complex decision-making.19 In turn, the SEC has taken a
functional approach to regulation, ignoring the underlying form or technical aspects
of each currency and instead classifying the cryptocurrency based on its purpose and
uses.20 However, the SEC’s guidance leaves substantial ambiguity, given the
abundance of cryptocurrencies with substantially different functionalities.
This Part first provides an overview of cryptocurrencies and their uses and then
defines the current line that separates cryptocurrencies that qualify as securities from
those that do not under current SEC guidance.
A. Terminology
As a preliminary matter, a consistent terminology must be established for crypto

funds and their trading activities, as cryptocurrencies and cryptocurrency-trading
17. See infra Part 3(A).

18. See, e.g., Angela Walch, Islands No More: Crypto Hedge Funds Bring Cryptocurrency Risk Into
Mainstream Financial System, FORBES (Oct. 11, 2017),
https://www.forbes.com/sites/angelawalch/2017/10/11/islands-no-more-crypto-hedge-
funds-bring-cryptocurrency-risk-into-mainstream-financial-system/#552de6225281.
19. Smart Contracts, supra note 7.
20. See infra Part I(C).
funds can take many forms. With respect to cryptocurrencies, this article draws two
distinctions: a functional one between networks and tokens, and a legal one between
commodities and securities. In this article, we consider a cryptocurrency “token” to be
a unit of the cryptocurrency that can be bought or sold, and a cryptocurrency
“network” to refer to the blockchain underlying the cryptocurrency. 21 For example, a
Bitcoin token is a tradeable unit that can be exchanged for services or other currencies,
whereas the Bitcoin network is the Bitcoin blockchain, which records every transaction
in the community.22 Cryptocurrency tokens may be treated either as securities or
commodities depending on their functionality, as discussed below. This article refers
to these as “security tokens” and “commodity tokens,” respectively.
With respect to cryptocurrency-trading funds, this article defines and
distinguishes between “crypto funds” and “ICO funds.” The former deals exclusively
in commodity tokens and, as a result, is subject to significantly different regulation
than traditional hedge funds, which trade in securities. 23 The latter deals partially or
wholly in security tokens and, as a result, is substantially similar to other hedge
funds.24 The crypto fund is the sole focus of this article because, unlike the ICO fund,
it represents a new type of financial institution that faces substantial regulatory
uncertainty.
B. What is a Cryptocurrency?
At the most basic level of understanding, a cryptocurrency is a “digital or virtual

currency that uses cryptography for security.”25 This definition simply treats a
cryptocurrency as a substitute for any currently existing fiat currency, like the US
dollar or British pound. The sole difference lies in the form that the currency takes: a
cryptocurrency does not take a tangible form of paper or coins in circulation, but rather
is an encrypted, digital representation of value. A fiat currency is validated by the
simple act of possession: if one tenders a physical dollar it is presumed to be the
21. See Preethi Kasireddy, Bitcoin, Ethereum, Blockchain, Tokens, ICOs: Why Should
Anyone Care?, HACKERNOON (July 5, 2017), https://hackernoon.com/bitcoin-ethereum-
blockchain-tokens-icos-why-should-anyone-care-890b868cec06 (distinguishing among
tokens, blockchains, and the many layers of a blockchain). For a discussion of the technical
distinction between cryptocurrency blockchains and networks, see infra note 27.
22. See id.
23. See infra Part III.
24. ICO Funds trade in the types of initial coin offerings that, under the SEC’s analysis in The
DAO Report, would be deemed securities. See infra Part I(C) for a discussion of the
attributes that would cause such initial coin offerings to be deemed offerings of securities.
See infra Part II for a brief overview of regulations that apply to all hedge funds trading
in securities, which would include ICO funds.
25. Cryptocurrency, INVESTOPEDIA, http://www.investopedia.com/terms/c/cryptocurrency.asp
(last visited Jan. 28, 2018).
property of the person who tenders. In contrast, a cryptocurrency is validated in

accordance with computerized security protocols.26
Understanding cryptocurrencies, however, requires an understanding of their
underlying technology, particularly the blockchain. A blockchain is a distributed
public ledger system that records all transactions in a particular cryptocurrency.27 Each
cryptocurrency has its own blockchain, each with its own cryptographic security
measures, including public-key encryption.28 A ‘typical’ blockchain is decentralized,
such that all transactions on the blockchain must be validated and recorded by holders
of the cryptocurrency. This typically occurs through a process known as mining,
whereby individual holders provide computational power to the blockchain sufficient
to solve an encryption algorithm29, thus verifying that a transaction is valid and
26. Kasireddy, supra note 21 (“A blockchain is collectively maintained by ‘miners’, who are
members within the network that compete to validate Bitcoin transactions in each block
by solving the complex algorithmic problem associated with the block.”)
27. It is important to understand that the term “blockchain” is a complete, and potentially
dangerous, misnomer for many cryptocurrency networks. We adopt it in this article only
because it is widely used, and generally adopted by U.S. regulatory opinions, to refer to
the distributed networks underlying each cryptocurrency. However, the actual
“blockchain” technology, using proof-of-work systems and a completely distributed
ledger, is only one of many solutions to the fundamental problem of trust in transactional
networks amongst strangers. The actual solutions embodied in each cryptocurrency
network vary widely but generally share some key characteristics. They almost
universally attempt to use a combination of cryptography, distributed rewards, and
extensive game theory to secure and stabilize their transactional networks without the
need for a trusted and centralized third party. Bitcoin uses one particular solution - the
blockchain - to solve several fundamental problems faced by human society: faith in the
stability of the monetary supply, harmonization of ledger records, accuracy of
recordation of ownership of money, and so forth. Normally, these recordation,
inflationary control, monetary supply, and verification functions are solved through a
combination of unique “tokens” with government identifiers (coins, dollar bills) and
centralized ledger-keepers (banks) that are overseen by the master issuer and controller
of the monetary supply (the government). By contract, the Bitcoin network and its
attendant tokens distribute these essential functions by removing the physical aspect of
the dollar bill and just keeping its unique identifying number, tying it directly to a
distributed ledger accessible by all, and rewarding the stakeholders in the network for
performing the recordation and verification function of banks via rewards that
themselves are designed to ensure a deterministic monetary supply. Other
cryptocurrencies solve other basic problems; Ethereum, for example, effectively does the
same for contract and dispute-resolution systems. See, e.g. The Dao Report, supra note 10.
28. See infra Part III(B) for a discussion of public-key cryptography.
29. The choice of algorithm varies extensively among cryptocurrencies, but there are two
primary categories of algorithms: proof-of-work and proof-of-stake. In a proof-of-work
system, holders of the cryptocurrency compete to solve the cryptographic algorithm first;
only the person who solves the algorithm—and thus adds a block to the blockchain—is
given a reward of newly generated units of the cryptocurrency for such effort. In contrast,
a proof-of-stake system assigns holders to solve the algorithm deterministically – with the
probability of being chosen proportional to their amount of currency – and rewards
transaction fees (rather than generating new units) for properly adding a new block to the
blockchain. Proof-of-work algorithms are more computationally intensive, which some
recording the transaction onto the blockchain, in exchange for a small commission
paid in the cryptocurrency being validated.
This role of the blockchain points to a more accurate, more technical, and simpler
definition of a cryptocurrency—and of any currency more generally—as “limited
entries in a database no one can change without fulfilling specific conditions.”30 A fiat
currency, for example, is akin to “limited entries in a public physical database that can
only be changed if you match the condition tha[t] you physically own the coins and
notes[.]”31 That is, possession is the mechanism or condition for validating transactions
in physical currencies, and the change of possession is similar to recording each
transaction on a hypothetical public ledger that tracks how much currency each living
human being owns.
Cryptocurrencies, however, are far more complex because the “conditions” that
must be satisfied to transfer ownership on the blockchain include, but go beyond,
simple validation of ownership.32 On the one hand, cryptocurrencies implement
computerized security protocols to validate each transaction and record it on the
blockchain, in lieu of physical tender and receipt of a tangible currency. On the other
hand, cryptocurrencies have functions that exceed those of a typical currency: they can
be used as a means of payment (like a fiat currency) 33, but also as tools to facilitate
contracting34, internet-based applications35, and fundraising.36
A brief overview of such functions follows.
1. Decentralized Payments
Several cryptocurrencies, including Bitcoin and Litecoin, focus primarily on

payments for goods and services, akin to fiat currencies. For example, a merchant may
have criticized as causing cartel-like centralization of mining power and wasting

significant amounts of energy. See Proof of Stake FAQ, GITHUB,
https://github.com/ethereum/wiki/wiki/Proof-of-Stake-FAQ (last updated Jan. 14, 2018).
30. What is Cryptocurrency: Everything You Need to Know [Ultimate Guide], BLOCKGEEKS (2017),
https://blockgeeks.com/guides/what-is-cryptocurrency/.
31. Id. Note, however, that this definition of a cryptocurrency is more accurate for
cryptocurrencies that employ a proof-of-work system rather than a proof-of-stake system
or other verification system. See The DAO Report, supra note 10.
32. A cryptocurrency’s cryptographic security measures set the conditions that must be
accomplished to transfer ownership. See infra Part III(B) for a discussion of public-key
cryptography.
33. Kasireddy, supra note 21.
34. Smart Contracts: The Blockchain Technology That Will Replace Lawyers, supra note 7.
35. What is a Decentralized Application?, supra note 8. For a specific, technical example of a
cryptocurrency that supports smart contracting and decentralized applications, see White
Paper, GITHUB (Sept. 31, 2017), https://github.com/ethereum/wiki/wiki/White-
Paper#applications.
36. What is An Initial Coin Offering? Raising Millions in Seconds, supra note 9.
accept payment in Bitcoin in lieu of dollars. 37 Such cryptocurrencies enable that

exchange in a decentralized manner, such that one individual can transfer payment
directly to another without processing by a central bank, unlike fiat currencies.38
2. Smart Contracts
Several cryptocurrencies, including Ether and NEO, facilitate smart contracting,

or the automatic execution of contracts through computer code. 39 More particularly, a
smart contract is:
a computerized transaction protocol that executes terms of a contract.

The general objectives of smart contract design are to satisfy common
contractual conditions (such as payment terms, liens, confidentiality,
and even enforcement), minimize exceptions both malicious and
accidental, and minimize the need for trusted intermediaries. Related
economic goals include lowering fraud loss, arbitrations and
enforcement costs, and other transaction costs.40
Thus, the purpose is to facilitate peer-to-peer transactions, but with added

automation to exclude middlemen and transaction fees and risks associated
with middlemen, as well as standardize contractual language.
3. Decentralized Applications
Other cryptocurrencies support decentralized applications built on top of such

cryptocurrency’s blockchain. For instance, the Ethereum blockchain is open source,
meaning the underlying code is freely available and licensed to the public for use in
37. For a list of many merchants that already accept Bitcoin as payment, see Jonas Chokun,
Who Accepts Bitcoins as Payment? List of Companies, Stores, Shops, 99 BITCOINS,
https://99bitcoins.com/who-accepts-bitcoins-payment-companies-stores-take-bitcoins/
(last updated Jan. 14, 2018).
38. Kasireddy, supra note 21.
39. Smart Contracts: The Blockchain Technology That Will Replace Lawyers, supra note 7. Note
that, technically, smart contracting is a feature built into the blockchain, rather than the
cryptocurrency. However, each such blockchain issues cryptocurrencies which are then
used to satisfy the objectives of the blockchain. For example, the Ethereum blockchain
supports smart contracting and the cryptocurrency it issues, Ether, is the currency by
which payment for such contracts is provided.
40. See Nick Szabo, Smart Contracts, NICK SZABO’S ESSAYS, PAPERS, AND CONCISE TUTORIALS
(1994),
http://www.fon.hum.uva.nl/rob/Courses/InformationInSpeech/CDROM/Literature/LOT
winterschool2006/szabo.best.vwh.net/smart.contracts.html. This definition appears to be
the SEC’s preferred definition. See also The DAO Report, supra note 10.
applications created by the public.41 It thus supports a variety of applications,

including prediction markets (Augur42, Gnosis43), banking services (Humaniq44),
investment or venture capital (DAO Tokens45), and web browsing (Mist46). Ether, the
primary cryptocurrency token issued on the Ethereum blockchain, can either be used
either directly within such applications or indirectly as payment for other
cryptocurrencies built on the Ethereum blockchain that can be used in such
applications.
4. Fundraising
Many cryptocurrencies are also issued primarily as a means of fundraising for

private entities or individuals, similar to a private or public offering of stocks or other
securities.47 Such fundraising frequently occurs in the form of an “initial coin offering”
(“ICO”), whereby a promoter makes an initial issuance of a newly-created
cryptocurrency. The largest ICOs to date have been those of Filecoin ($257 million in
September 2017)48 and Tezos ($232 million in July 2017)49. Other notable examples
41. The Ethereum source code is available on Github, a website that hosts software projects
and code. ethereum, GITHUB, https://github.com/ethereum/ (last visited Dec. 5, 2017)
(containing 137 repositories of code related to various implementations of Ethereum and
related tools and software). The most popular, official implementation of Ethereum (in
the Go software language) is licensed under the GNU Lesser General Public License v.
3.0, though other tools and software may have different licenses. go-ethereum/COPYING,
GITHUB, https://github.com/ethereum/go-ethereum/blob/master/COPYING (last visited
Dec. 5, 2017).
42. See AUGUR, https://augur.net/ (last visited Nov. 8, 2017). (“Augur combines the magic of
prediction markets with the power of a decentralized network to create a stunningly
accurate forecasting tool”).
43. See GNOSIS, https://gnosis.pm/ (last visited Nov. 8, 2017) (“Speculate on anything with an
easy-to-use prediction market”).
44. See HUMANIQ, https://humaniq.com/ (last visited Nov. 8, 2017) (“Humaniq is a simple and
secure mobile app, delivering financial inclusion solutions to the 2.5 billion unbanked / 1
billion underbanked globally.”).
45. See infra Part I(C).
46. See Mist, DAO WIKI (May 29, 2016),
https://daowiki.atlassian.net/wiki/spaces/DAO/pages/1212461/Mist.
47. Julie Verhage et al., What’s an ICO? Like an IPO but with Digital Coins, BLOOMBERG
BUSINESSWEEK (Sept. 17, 2017, 9:00 PM), https://www.bloomberg.com/news/articles/2017-
09-18/what-s-an-ico-like-an-ipo-but-with-digital-coins-quicktake-q-a.
48. Stan Higgins, $257 Million: Filecoin Breaks All-Time Record for ICO Funding, COINDESK (Sept.
7, 2017, 8:45 PM), https://www.coindesk.com/257-million-filecoin-breaks-time-record-
ico-funding/.
49. Omri Barzilay, Tezos’ $232 Million ICO May Just Be the Beginning, FORBES (July 15, 2017,
8:39 AM), https://www.forbes.com/sites/omribarzilay/2017/07/15/tezos-232-million-ico-
may-just-be-the-beginning/#77b018ae4c52.
include Bancor ($153 million in June 2017)50, Brave ($35 million raised in May 2017)51,
and Gnosis ($12.5 million raised in April 2017)52. Notably, Kik, a company that has
raised over $120 million in traditional venture capital, also conducted an ICO to raise
roughly $100 million in September 201753 in lieu of an initial public offering54
As a result of these various cryptocurrency functions, regulating the entire
cryptocurrency space and adopting a one-size-fits-all solution would ignore the
realities underlying the use of these cryptocurrencies, particularly that many are not
acting primarily as currencies. Unsurprisingly, the SEC has never defined the term
“cryptocurrency,” instead opting to define each cryptocurrency according to its
function.55 The result is an evolving framework that classifies some cryptocurrencies
as securities and some as commodities, and leaves substantial ambiguity on the line
between the two.56
C. SEC Regulation of Security Tokens
Prior to mid-2017, the SEC had been largely silent with respect to directly
regulating the purchase or sale of cryptocurrencies. Most of its regulation in this area
had, instead, solely attempted to protect the public from issuers or exchanges which
operate cryptocurrency-related businesses and offer conventional securities. The SEC
regulated online exchanges that use cryptocurrencies to trade in securities57,
redemptions of shares in a trust that held cryptocurrencies as its sole assets 58, issuers
selling shares in themselves in exchange for cryptocurrencies 59, and issuers holding
cryptocurrency assets or operating cryptocurrency-related businesses that did not
50. Stan Higgins et al., $150 Million: Tim Draper-Backed Bancor Completes Largest-Ever ICO,
COINDESK (June 12, 2017, 6:45 PM), https://www.coindesk.com/150-million-tim-draper-
backed-bancor-completes-largest-ever-ico/.
51. Jonathan Keane, $35 Million in 30 Seconds: Token Sale for Internet Browser Brave Sells Out,
COINDESK (May 31, 2017, 5:40 PM), https://www.coindesk.com/35-million-30-seconds-
token-sale-internet-browser-brave-sells/.
52. Roger Aitken, Gnosis’ Prediction Market Scores $12.5M in ‘Record-Breaking’ Crypto Auction,
FORBES (April 24, 2017, 9:23 PM),
https://www.forbes.com/sites/rogeraitken/2017/04/24/gnosis-prediction-market-scores-
12-5m-in-record-breaking-crypto-auction/#66e62c69e87d.
53. Jon Russell, Kik Raises Nearly $100M in Highest Profile ICO to Date, TECHCRUNCH (Sept. 26,
2017), https://techcrunch.com/2017/09/26/kik-ico-100-million/.
54. Eric Jackson, Why a Messaging Start-up is Making its Own Digital Currency Instead of Going
Public, CNBC (July 11, 2017, 2:08 PM), https://www.cnbc.com/2017/07/11/kik-looks-to-
cryptocurrency-instead-of-an-ipo-commentary.html.
55. See, e.g., The DAO Report, supra note 10 (the DAO Report never uses the term
“cryptocurrency.”)
56. See infra Part I(D).
57. BTC Trading, Corp., Exchange Act Release No. 73783, 110 SEC Docket 8 (Dec. 8, 2014).
58. Bitcoin Investment Trust, Exchange Act Release No. 34-78282, 114 SEC Docket 11 (July 11,
2016).
59. In re Erik T. Voorhees, Securities Act Release No. 9592, 109 SEC Docket 1 (June 3, 2014).
disclose sufficient information about such assets 60 or made fraudulent representations

(including operation of Ponzi schemes). 61
However, this changed with an investigation report released on July 25, 2017 (the
“DAO Report”), where the SEC found for the first time, that cryptocurrencies issued
for the purpose of raising funds are securities and thus subject to securities laws. 62
Notably, the SEC refused to create a one-size-fits-all solution and instead chose to
regulate cryptocurrencies based on the particular functionality of each
cryptocurrencies stating that “securities law may apply to various activities, including
distributed ledger technology, depending on the particular facts and circumstances,
without regard to the form of the organization or technology used to effectuate a
particular offer or sale.”63 Thus, the standard for determining whether a financial
instrument, including a cryptocurrency, constitutes a security remains a functional
one. The SEC disregards the underlying technology, including the blockchain, on
which the cryptocurrency is based.
The SEC then applied the Howey test to specifically determine that the DAO
Token it was investigating was an “investment contract,” a type of security, and, as a
result, the DAO Token’s ICO violated federal securities laws.64 To understand this
determination, the nature of the DAO Token must be analyzed in more depth.
1. Background
The DAO Tokens closely resembled a conventional security in both function and
structure. Functionally, the underlying purpose of the DAO Token was raising “funds
to grow [a] company in the crypto space.”65 This would be accomplished by submitting
project proposals to the holders of the DAO Tokens, who would be entitled to vote on
such proposals.66 Accepted proposals would be funded, with returns from those
proceeds being distributed to the token holders.67 The creators of the DAO Token were
the co-founders of an unincorporated organization, Slock.it UG, which planned to
submit the first funding proposal in order to raise funds for use in Slock.it.68
60. In re Sunshine Capital, Inc., Exchange Act Release No. 80435, 116 SEC Docket 10 (Apr.
11, 2017).
61. SEC v. Homero Joshua Garza, Civil Action No. 3:15-CV-01760 (D. Conn. filed Dec. 1,
2015); SEC v. Trendon T. Shavers, Civil Action No. 4:13- CV-416 (E.D. Tex. filed July 23,
2013).
62. The DAO Report, supra note 10.
63. Id. at 10.
64. Id. at 11.
65. Christoph Jentzsch, The History of the DAO and Lessons Learned, SLOCK.IT BLOG (Aug. 24,
2016), https://blog.slock.it/the-history-of-the-dao-and-lessons-learned-
d06740f8cfa5#.5o62zo8uv.
66. The DAO Report, supra note 10, at 4.
67. Id.
68. Id. at 12.
Moreover, the DAO Token went significantly beyond fundraising, essentially

functioning as a proxy for stock ownership in a corporation. Conceptually, the DAO
Token was meant to serve as the initial implementation of a Decentralized
Autonomous Organization, or “DAO entity.” A DAO entity is one which replaces a
“traditional corporate form” by using smart contracts to automate corporate
governance functions.69 More specifically, buying DAO Tokens, would act similarly to
“buying shares in a company and getting . . . dividends”,70 because token holders
would have the right to vote on, and share in the proceeds of, project proposals. Those
proposals would be filtered and submitted to the token holders by a group of
curators.71 Thus, like a board of directors in a typical corporation, the curators would
submit significant matters to the token holders. Like stockholders, the token holders
would then both vote on proposals significant to the community of holders and share
in the proceeds.72
2. Application of the Howey Test to the DAO Tokens
The DAO Tokens were determined to be “investment contracts,” a form of

security, under the Howie standard. 73 Under this standard, an investment contract is
an (1) “investment of money in a common enterprise,” (2) “with a reasonable
expectation of profits,” (3) “to be derived from the entrepreneurial or managerial
efforts of others.”74
The first two prongs received relatively little scrutiny from the SEC.75 DAO token
holders invested Ether, another cryptocurrency, for their tokens, satisfying the first
prong.76 token holders were also entitled to returns on funded project proposals,
satisfying the second.77
The third prong received the bulk of the SEC’s analysis. Of key concern was
whether the token-holding relationship bore a greater resemblance to a stockholder in
a corporation or a partner in a partnership, with the former implicating an investment
contract.78 Here, the SEC found that token holders resembled stockholders based on
69. See Christoph Jentzsch, Decentralized Autonomous Organization to Automate

Governance Final Draft – Under Review (unpublished manuscript),
https://download.slock.it/public/DAO/WhitePaper.pdf (last visited Jan. 28, 2018).
70. See Slockit, Slock.it DAO demo at Devcon1: IoT + Blockchain, YOUTUBE (Nov. 13, 2015),
https://www.youtube.com/watch?v=49wHQoJxYPo.
71. The DAO Report, supra note 10, at 7-8.
72. Id. at 3.
73. Id. at 10.
74. See SEC v. Edwards, 540 U.S. 389, 393 (2004); SEC v. W.J. Howey Co., 328 U.S. 293, 301 (1946).
75. The entire analysis for both prongs spans approximately half a page, whereas the analysis
for the third spans almost four pages. See The DAO Report, supra note 10, at 11-15.
76. The DAO Report, supra note 10, at 11.
77. Id. at 11-12.
78. Id. at 14-15.
two key factors. First, the centralization of control in, and efforts exerted by, Slock.it,
the Slock.it co-founders and the curators, including their solicitation of token holders,
constituted significant managerial efforts by non-token holders.79 Second, the
decentralization and lack of “meaningful control” of the DAO token holders made
such token holders dependent on Slock.it, the Slock.it co-founders, and the curators.80
Perhaps most notably, the SEC may have carved for itself a broad catch-all
exception by which to find nearly any token as satisfying the requirements of the
Howey standard. As stated above, the first two prongs were satisfied with little
scrutiny. As for the third, the SEC particularly emphasized that the token holders were
numerous, dispersed, and pseudonymous (token holders did not know each other’s
identities), so that their control was significantly diminished. 81 However, nearly all
cryptocurrencies will have such diffuse, pseudonymous ownership, as discussed in
the following Subpart.
Subsequent statements by the SEC and its staff, alongside commensurate
enforcement actions by the new Cyber Crimes Unit within the SEC 82, have maintained
this fact-based Howey approach and provided greater insight into the line between
security and commodity tokens. In a public statement on ICOs, SEC Chairman Jay
Clayton highlighted a number of security-like aspects of many ICOs.83 Promoters of
ICOs whose marketing efforts which emphasize the secondary market trading of the
tokens were called out as particularly troubling.84 Other public statements have
expressed concern over celebrity promotion of ICOs85, issued investor alerts on the
dangers of ICOs86 and alerted investors to the risk of market manipulation with
regards to public companies making ICO-related claims.87
79. Id. at 12-13.

80. Id. at 13-15.
81. Id. at 14 (“The voting rights afforded DAO Token holders did not provide them with
meaningful control over the enterprise, because (1) DAO Token holders’ ability to vote
for contracts was a largely perfunctory one; and (2) DAO Token holders were widely
dispersed and limited in their ability to communicate with one another.”).
82. See infra Part III(D) for a discussion of recent SEC enforcement actions in the
cryptocurrency sector.
83. Press Release, SEC Chairman Jay Clayton, Statement on Cryptocurrencies and Initial Coin
Offerings, (Dec. 11, 2017), https://www.sec.gov/news/public-statement/statement-
clayton-2017-12-11.
84. Id. at 3.
85. Press Release, SEC Division of Enforcement and SEC Office of Compliance Inspections
and Examinations, Statement on Potentially Unlawful Promotion of Initial Coin Offerings
and Other Investments by Celebrities and Others (Nov. 1, 2017),
https:/www.sec.gov/news/public-statement/statement-potentially-unlawful-promotion-
icos.
86. Press Release, SEC, Investor Bulletin: Initial Coin Offerings (July 25, 2017),
http://www.sec.gov/oiea/investor-alerts-and-bulletins/ib_coinofferings.
87. Press Release, SEC, Investor Alert: Public Companies Making ICO-Related Claims (Aug.
28, 2017), https://www.sec.gov/oiea/investor-alters-and-bulletins/ia_icorelatedclaims.
D. Non-Regulation of Virtual Currencies
In the DAO Report, the SEC also distinguishes cryptocurrencies that qualify as
securities from those that qualify as “virtual currencies.”88 A “virtual currency” is:
a digital representation of value that can be digitally traded and

functions as: (1) a medium of exchange; and/or (2) a unit of account;
and/or (3) a store of value, but does not have legal tender status (i.e.,
when tendered to a creditor, is a valid and legal offer of payment) in
any jurisdiction. It is not issued or guaranteed by any jurisdiction, and
fulfils the above functions only by agreement within the community
of users of the virtual currency.” Virtual currency is distinguished
from fiat currency (a.k.a. “real currency,” “real money,” or “national
currency”), which is the coin and paper money of a country that is
designated as its legal tender; circulates; and is customarily used and
accepted as a medium of exchange in the issuing country. 89
Note that a virtual currency is, for tax purposes, treated as a commodity but not a
currency.90 However, for purposes of securities laws, the SEC’s analysis suggests that
the distinction between virtual and fiat currency is formal, with fiat currency being in
tangible form and having the official backing of a governmental entity. Thus, the
determining factor regarding whether an instrument constitutes a currency—virtual
or not—is functional: is the instrument a medium of exchange, a unit of account,
and/or a store of value? If so, it is a currency.
Currencies are, in turn, not securities. The term “security” is defined in section
2(a)(1) of the Securities Act of 1933 (the “Securities Act”) and section 3(a)(10) of the
Securities Exchange Act of 1934 (the “Exchange Act”), neither of which includes
currencies.91 The DAO Report implicitly validates the exclusion of virtual currencies
88. Compare id. at 2-3 (noting that Ether is a virtual currency) and id. at 11 (noting that the
DAO tokens are securities). At no point is Ether referred to as a security, nor the DAO
token as a virtual currency. Id.
89. FIN. ACTION TASK FORCE, VIRTUAL CURRENCIES, KEY DEFINITIONS AND POTENTIAL AML/CFT
RISKS (June 2014), http://www.fatf-gafi.org/media/fatf/documents/reports/Virtual-
currency-key-definitions-and-potential-aml-cft-risks.pdf.
90. IRS Notice 2014-21 addresses the tax treatment of at least some cryptocurrencies. The
guidance applied only to “convertible virtual currency” (“CVC”): those that have “an
equivalent value in real currency, or that act[] as a substitute for real currency.” The
guidance explicitly cited Bitcoin as an example. The Notice made clear that CVC is treated
as property for tax purposes. This means its character is determined based upon whether
the CVC is a capital asset or not. Thus, gains and losses from CVCs purchased, held, or
exchanged for investment purposes are treated as capital gains and losses. The Notice
explicitly declined to address the status of CVC trading under the 864 commodities
exemption. I.R.S. Notice 2014-21 (April 14, 2014)..
91. The definition in each statute is substantially similar but not identical. Under § 3(a)(10) of
the Exchange Act, currency is expressly excepted from the definition of “security,”
from securities laws by mentioning, in passing, that both Bitcoin and Ether qualify as
virtual currencies, but never referring to the DAO Tokens as virtual currencies. 92
Unsurprisingly, the SEC failed to acknowledge the DAO Token’s capacity as, or
similarity to, a virtual currency because doing so could omit the DAO Token from the
purview of securities laws. In the SEC’s analysis, a virtual currency seems to be
something altogether different from the DAO Tokens and other security tokens whose
primary purpose is raising capital.
This is particularly notable because security tokens and virtual currencies have
more commonalities than dissimilarities. Nearly all security tokens could conceivably
meet the SEC’s functional test for determining whether an instrument qualifies as a
virtual currency because a cryptocurrency, by definition, operates as a store of value
that is generally freely transferable (and thus a medium of exchange) and supported
by a blockchain that records each transaction (such that it is also a unit of account). For
example, the DAO Tokens were freely transferable and ran on the Ethereum
blockchain.
Similarly, virtual currencies tend to have at least some of the attributes of
securities because of their reliance on blockchain technology. Each blockchain is
typically developed by a small and close group of developers. The holders, conversely,
tend to be diffuse and numerous, limited ability to act in concert. For instance, Bitcoin
had reached over 10 million wallets, each corresponding to a separate Bitcoin holding,
whereas § 2(a)(1) of the Securities Act simply omits currencies. The Exchange Act defines
a security as:”any note, stock, treasury stock, security future, security-based swap, bond,
debenture, certificate of interest or participation in any profit-sharing agreement or in any
oil, gas, or other mineral royalty or lease, any collateral-trust certificate, preorganization
certificate or subscription, transferable share, investment contract, voting-trust certificate,
certificate of deposit for a security, any put, call, straddle, option, or privilege on any
security, certificate of deposit, or group or index of securities (including any interest
therein or based on the value thereof), or any put, call, straddle, option, or privilege
entered into on a national securities exchange relating to foreign currency, or in general,
any instrument commonly known as a “security”; or any certificate of interest or
participation in, temporary or interim certificate for, receipt for, or warrant or right to
subscribe to or purchase, any of the foregoing; but shall not include currency or any note,
draft, bill of exchange, or banker’s acceptance which has a maturity at the time of issuance
of not exceeding nine months, exclusive of days of grace, or any renewal thereof the
maturity of which is likewise limited.” Securities Act of 1933, 15 U.S.C. § 77 (2012);
Securities Exchange Act of 1934, 15 U.S.C. § 78c(a)(10) (2012).
92. Additional insight as to the distinction between those cryptocurrency tokens which
qualify as securities, and those which are merely virtual currencies and do not qualify as
securities, can be gleaned from the recent FinCEN BTC-E decision. There, FinCEN
imposed monetary penalties on an overseas cryptocurrency exchange and its operator for
violations of the Bank Secrecy Act. The exchange in question, BTC-e, was described as an
“exchanger of convertible virtual currencies, offering the purchase and sale of U. S.
dollars, Russian Rubles, Euros, Bitcoin, Litecoin, Namecoin, Novacoin, Peercoin,
Ethereum, and Dash.” Id. at 2. The consistency of terminology, and near-simultaneous
release of the FinCEN decision alongside the SEC’s DAO guidance, suggest that these
listed cryptocurrencies may also qualify as virtual currencies, not securities. U.S. Dept. of
Treas., Fin. Crim. Enforc. Network., BTC-E a/k/a/ Canton Bus. Corp. and Alexander
Vinnik., FinCEN, 2017-03 (July 26, 2017).
by the end of 2015.93 In addition to the problem of numerosity, the pseudonymous

nature of blockchain transactions further inhibits organized action by token holders.
For example, Bitcoin holdings are identified by a custom address rather than the name
or other personal information of the holder.94 Thus, like the DAO Tokens, virtual
currencies tend to exhibit at least some hallmarks of stock ownership which the SEC
weighed so heavily against the DAO Token.
However, the Securities Act and Exchange Act (having been largely written over
80 years ago) do not contemplate such a nuanced treatment, and so the SEC has no
choice but to ignore some of the currency-like functionality of security tokens and
classify them purely as investment contracts so that they are subject to securities
regulation. In contrast, virtual currencies face no such regulation.
II. The Current State of Hedge Fund Regulation
Having addressed the treatment of the financial instruments that crypto funds
trade, this Part now proceeds to discuss and compare the regulations that traditional
hedge funds and crypto funds face.
This Part specifically focuses on four of the most significant areas in which
traditional hedge funds are regulated: anti-fraud and non-solicitation provisions
under the Securities Act and Exchange Act; investment activity regulation under the
Investment Advisers Act of 1940 (the “Advisers Act”) and the Investment Company
Act of 1940 (the “Investment Company Act”); taxation under various statutes; and
regulation by the Commodities Futures Trading Commission (CFTC).
In contrast to the extensive regulations governing traditional hedge funds, many
of these regulations do not apply to crypto funds. While crypto funds face similar
regulation under the Securities Act, Exchange Act, and certain taxation statutes, they
need not comply with any of the same investment activity regulations or CFTC
regulation.
A. Anti-Fraud and Non-Solicitation Provisions under the Securities Act and Exchange Act
The general provisions of the Securities Act and the Exchange Act generally
prohibit public solicitation and fraud in connection with a public offering of
securities.95 Interests in a hedge fund, such as limited partnership interests, are treated
as “equity securities” under both the Securities Act and the Exchange Act.96 Offerings
93. Michael Jackson, Bitcoin’s Big Challenge in 2016: Reaching 100 Million Users, COINDESK (Jan.
1, 2016, 4:34 PM), https://www.coindesk.com/2016-bitcoin-challenge-100-million-users/.
94. See infra Part III(B) for a public-key cryptography, by which holders can engage in secure
transactions without the need to provide or verify identifying information.
95. 15 U.S.C. § 77e (2012) (unlawful to make offer for sale or sell securities through mails or
interstate commerce, barring lawful registration).
96. See 17 C.F.R. § 230.405; 15 U.S.C. § 77(3)(a)(11-1) (“equity security is hereby defined to
include [. . .] limited partnership interests. . .”).
on interests in a hedge fund must therefore either comply with the registration
requirements of the Securities Act or seek an exemption from registration. Most hedge
fund managers therefore choose to avoid the costs of registration by conducting their
offerings pursuant to one or more of the available exemptions. 97
Onshore offerings of hedge fund interests are frequently conducted pursuant to
Regulation D under the Securities Act.98 Regulation D codifies several safe harbors
which ensure exemption from section 4(a)(2) of the Securities Act so long as the
securities are “restricted”99, the offering is conducted in accordance with the
requirements of the particular exemption sought, and the offeror files Form D with the
SEC.100 Generally, hedge funds choose to either forego general solicitation or
advertising in marketing the securities in which case they may sell to an unlimited
number of accredited investors101 and up to 35 other purchasers.102 Those funds
wishing to make an unlimited offering and make use of general solicitation or
advertising must restrict their sales to accredited investors.103
Hedge funds are similarly subject to the anti-fraud, insider trading protections,
and related disclosure requirements common to all security offerings. Hedge funds
have been previously prosecuted on this basis for a variety of offenses, including
misrepresentation of investment manager experience, prior success, and/or
disciplinary history;104 misappropriation of investor funds;105 Ponzi schemes;106 and
excessive or unfair management and performance fees,107 among many others.108 A
97. 17 C.F.R. §§ 230.504-.506 (2017).

98. 17 C.F.R. § 230.506 (2017).
99. 17 C.F.R. §§ 230.501-.508 (2017).
100. Form D is a limited notice including basic information on directors and the offering entity.
101. Rule 501 of Regulation D defines an accredited investor, and includes natural persons
whose individual net worth (with their spouse) exceeds $1,000,000, or who had an
individual income in excess of $200,000 in each of the two most recent years or joint
income with that person’s spouse in excess of $300,000 in each of those years and has a
reasonable expectation of reaching the same income level in the current year. 17 C.F.R. §
230.501 (2017).
102. Rule 504 permits any type of person to be included among the 35 unaccredited
purchasers, but limits the offering to $5,000,000. 17 CFR §230.504. Rule 506(b) allows an
unlimited amount of funds to be raised in the offering, but requires that the unaccredited
purchasers be “sophisticated”, with sufficient knowledge and experience in relevant
matters to make them capable of evaluating the merits and risks of the prospective
investment. 17 C.F.R. § 230.506(b) (2017).
103. 17 C.F.R. § 230.506(c) (2017).
104. See SEC v. GEI Financial Services, No. 12-7927 (N.D. Ill. filed October 3, 2012).
105. See SEC v. Lion Capital Management, No. CV 12-05116-EJD (N.D. Cal. filed October 3,
2012).
106. See SEC v. Yusaf Jawed, No. 12-1696 (D. Or. filed September 20, 2012); SEC v. Angelo A.
Alleca, No. 1:12-cv-03261-WSD (N.D. Ga.).
107. See GEI Financial Services, No. 12-7927, supra note 104.
108. E.g., SEC v. Mark Megalli, No. 1:13-CV-03783-AT (N.D. Ga., Nov. 11, 2013) (hedge fund
trader prosecuted for insider trading); SEC v. Sigma Capital Management, No. 13-civ-
non-exhaustive list of typical disclosures to investors includes each fund’s investment

strategies and permissible investments; details on the fund’s sponsors and other key
personnel; essential terms regarding price, liquidity, manager compensation, and
redemption; and risks inherent to the particular strategies or markets in which the
fund will engage.109
B. Regulation of Investment Activity under the Investment Advisers Act and Investment
Company Act
1. Investment Advisers Act
Under the Advisers Act, investment advisors are generally required to register
with the SEC.110 Prior to the passage of the Dodd-Frank Act of 2012, investment
advisers with fewer than fifteen clients were not subject to registration or compliance
under the Advisers Act.111 Because a hedge fund was treated as a single client, almost
all hedge fund managers were entirely exempt from regulation under the Advisers
Act.112
The passage of the Dodd-Frank Act eliminated this private adviser exemption.
Title IV of Dodd-Frank brought hedge fund investment advisers into the purview of
the Advisers Act.113 Consequently, hedge fund now investment advisers must
generally register with the SEC. “Small advisers” are not permitted to register with the
SEC, but they must register with the relevant state agencies, if any. 114 In addition to
registration, the Advisers Act subjects hedge fund managers to a variety of
requirements regarding their compensation, custodianship of client assets, investor
reporting, and other key issues.
1740 (S.D.N.Y. filed Mar. 19, 2013) (hedge fund advisory firm prosecuted for insider
trading); SEC v. Tiger Asia Management, No. 12-cv-7601 (D.N.J. filed Dec. 13, 2012)
(hedge fund managers prosecuted for illegal and deceptive offshore trading activities).
109. For a practical discussion of recommended disclosure topics, see ASSET MANAGERS’
COMMITTEE TO THE PRESIDENT’S WORKING GROUP ON FINANCIAL MARKETS, BEST PRACTICES
FOR THE HEDGE FUND INDUSTRY (2009),
http://www.cftc.gov/idc/groups/public/@swaps/documents/file/bestpractices.pdf.
110. Investment Advisors Act, 15 U.S.C. § 80b-3 (2012).
111. The Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank Act”),
repealed section 203(b) of the Investment Advisers Act, as in effect in 2011. This
eliminated the “15 client private fund adviser” exemption from registration previously
relied upon by most private investment fund managers. Dodd-Frank Wall Street Reform
and Consumer Protection Act., 12 U.S.C. § 53 (2012).
112. Id.
113. Id.
114. Section 203A of the Investment Advisers Act of generally prohibits an investment adviser
from registering with the Commission unless that adviser has more than $25 million of
assets under management or is an adviser to a registered investment company. For
example, California law provides that an investment adviser is required to register with
the state and adhere to certain requirements, and generally tracks the language of the IAA
and ICA.
Section 205 of the Advisers Act was amended by the 1970 Act to provide
protection against performance fee agreements.115 Prior to its passage, many
performance fee agreements failed to provide for any kind of penalty or disincentive
for the investment adviser in the event of a loss.116 These performance agreements were
viewed as inherently unfair to investment companies because they disproportionately
incentivized high-risk behavior on the part of the investment adviser. To combat this
risk, section 205 prohibits all performance fees unless the investors in question are
“qualified clients,” who must have a net worth of $2.1M excluding primary residence,
or have at least $1M under the management of the investment adviser. 117
In addition, compensation under performance fee arrangements must increase
and decrease proportionately with the investment performance of the company over
a specified period in relation to the investment record of an appropriate index of
securities prices.118 This type of performance fee is commonly referred to as a
“fulcrum” fee or an “incentive” fee. Consideration of the fairness of a performance fee
arrangement must start with the midpoint or “fulcrum fee” (the fee paid when the
investment company’s performance equals that of the index).119 The maximum and
minimum incentive fee rates and all performance increments are measured from the
fulcrum fee.120
Although section 205 does not require a particular length of time over which to
measure performance, investment advisers are nevertheless obligated to use an
interval sufficiently long to provide a reasonable basis for indicating the adviser’s
performance.121 The SEC has indicated approval for the use of intervals that specifically
minimize the possibility that payments will be based upon random or short-term
fluctuations.122
115. The Investment Company Amendments Act, 15 U.S.C. § 80 (1970).

116. See, e.g., H.R. Rep. no. 2639, 76th cong., 2d Sess. 29 (1940); S. Rep. No. 1775, 76th Cong., 3d
Sess. 22 (1940) (characterizing performance fees based on capital gains or appreciation as
nothing more than “heads I win and tails you lose” arrangements).
117. 17 C.F.R. § 275.205-3 (2017).
118. 15 U.S.C. § 80b-5(b)(2)(B) (2012).
119. Inv. Co. Act Rel. No. 7113, Pg. 2 (Apr. 6, 1972).
120. Id. at 2.
121. Id.
122. Factors to be Considered in Connection with Investment Company Advisory Contracts
Containing Incentive Free Arrangements, Investment Company Act Release No. 7113,
Investment Advisors Act Release No. 315 (1972),
http://www.brightlinesolutions.com/files/Plaze/Release%20IA-
0315%20Incentive%20Fees.pdf (finding that 103 of 999 investment companies surveyed
measured their performance over a period of at least one year).
The Advisers Act also requires investment advisers with custody123 of client funds
and securities to use the services of a third-party “qualified custodian”124 to maintain
control of those funds and assets. As most hedge fund managers are subject to the
Advisers Act following the passage of Dodd-Frank, hedge funds generally fall under
this rule. ‘An investment adviser for a pooled investment fund (such as limited
partnerships or limited liability companies) meeting the requirements under Rule
206(4)-2(b)(4) must obtain the services of a “qualified custodian” to maintain client
funds and securities125 but is exempt from the other gatekeeping requirements in Rule
123. “Custody” means “holding, directly or indirectly, client funds or securities, or having any
authority to obtain possession of them.” An investment adviser has custody if a related
person holds, directly or indirectly, client funds or securities, or has any authority to
obtain possession of them, in connection with advisory services [the investment adviser]
provide[s] to clients. Custody includes: (i) Possession of client funds or securities . . .
unless . . . receive[d] . . . inadvertently and . . . returne[d] . . . to the sender promptly but
in any case within three business days of receiving them; (ii) Any arrangement (including
a general power of attorney) under which [the investment adviser is] authorized or
permitted to withdraw client funds or securities maintained with a custodian upon [the
investment adviser’s] instruction to the custodian; (iii) Any capacity (such as general
partner of a limited partnership, managing member of a limited liability company or a
comparable position for another type of pooled investment vehicle, or trustee of a trust)
that gives [the investment adviser or the investment adviser’s representative] legal
ownership of or access to client funds or securities 17 U.S.C. § 206(4)-2(d)(2) (2012).
124. “Qualified custodians” include bank or savings associations that have deposits insured
by the Federal Deposit Insurance Corporation under the Federal Deposit Insurance Act;
broker-dealers registered with the Commissioner and with the Securities and Exchange
Commission holding the client assets in customer accounts insured by the Securities
Investor Protection Corporation (SIPC); registered futures commission merchants
registered under § 4f(a) of the Commodity Exchange Act (7 U.S.C. 6f(a)), holding the client
assets in customer accounts, but only with respect to clients’ funds and security futures,
or other securities incidental to transactions in contracts for the purchase or sale of a
commodity for future delivery and options thereon; and foreign financial institutions that
customarily hold financial assets for their customers, provided that the foreign financial
institution keeps the advisory client’s assets in customer accounts segregated from its
proprietary assets. .17 U.S.C. § 206(4)-2(d)(6) (2012).
125. There is a “privately offered securities” exemption, whereby restricted securities
purchased in a private offering or private chain of transactions can be held by the
investment manager without the involvement of a qualified custodian. See 17 U.S.C. §
206(4)-2(b) (2012). While profoundly helpful to venture capital and other private equity
funds, this exemption is of limited use to hedge funds primarily trading public securities.
206.126 For those hedge funds too small to register federally most states have statutes
that track the federal custody requirements for investment advisers. 127
2. Investment Company Act
The Investment Company Act (as modified by Dodd-Frank Act of 2010) places
significant limitations on the behavior of entities falling within its definition of
“investment company.”128 This includes limitations on shorting, use of leverage, and
other trading activities. These limitations are highly prohibitive to the investment
strategies employed by hedge funds. Thus, almost by definition, hedge funds are
investment companies which seek exemption from treatment or classification as such
under the Investment Company Act. Most hedge funds rely on either of section 3(c)(1)
or 3section (c)(7) of the 1940 Act to avoid classification as an investment company.
Section 3(c)(1) exempts entities whose outstanding securities are beneficially
owned by not more than 100 persons and that are not making and do not presently
propose to make a public offering of those securities. 129 Section 3(c)(7) similarly
exempts entities whose outstanding securities are owned exclusively by persons who,
at the time of acquisition, are qualified purchasers and do not presently propose to
make a public offering of those securities.130 “Qualified purchasers” include any
individual who owns more than $5 million in investments; any closely held
corporation holding the same; certain types of trusts; and any person who, on their
own account or the accounts of other qualified purchasers, in the aggregate invests on
a discretionary basis at least $25 million in investments. 131
126. Advisers need not comply with the reporting requirements of § 260.237(a) with respect to
pooled investment vehicles, if the pooled investment vehicle is audited at least annually
and distributes its audited financial statements, prepared in accordance with GAAP, to
all limited partners (or members or other beneficial owners) within 120 days of the end of
its fiscal year. Nonetheless, the adviser must submit Form ADV notifying the
Commissioner that the adviser has or may have custody of client assets and intends to
provide audited financial statements to the limited partners.
127. For example, the language and structure of California’s investment advisor custody rules
are almost identical to the federal rules. Compare C.F.R. § 275.206(4)-2 (2017) with CAL.
CODE ANN. tit. 10, § 260.237 (2016).
128. An “investment company” means “any issuer which is or holds itself out as being
engaged primarily, or proposes to engage primarily, in the business of investing,
reinvesting, or trading in securities; (B) is engaged or proposes to engage in the business
of issuing face-amount certificates of the installment type, or has been engaged in such
business and has any such certificate outstanding; or (C) is engaged or proposes to engage
in the business of investing, reinvesting, owning, holding, or trading in securities, and
owns or proposes to acquire investment securities having a value exceeding 40 per
centum of the value of such issuer’s total assets (exclusive of Government securities and
cash items) on an unconsolidated basis.” 15 U.S.C. § 80a–3 (2012).
129. 15 U.S.C. § 80a-3 (2012).
130. Id.
131. 15 U.S.C. § 80a-2(a)(51)(A) (2012).
C. Hedge Fund Taxation
In order to avoid entity-level corporate taxation, a hedge fund must avoid being
classified as a publicly traded partnership. A publicly traded partnership is one whose
interests are traded on an established securities market or are readily tradable on a
secondary market or its substantial equivalent. Absent an applicable safe harbor, this
is a fact-specific determination considering all circumstances. 132 There are several safe
harbors available, a number of which are commonly utilized by hedge funds. The “100
partner private placement safe harbor” requires that the interests in a partnership of
100 or fewer partners be exempt from registration under the Securities Act. 133 Other
relatively common safe harbors include those setting limits upon partnership interest
liquidity and redemptions,134 and the “qualifying income” safe harbor for buying and
selling commodities derivatives. 135
Protecting foreign investors from effectively-connected business income taxation
is another major regulatory problem for many hedge funds. Generally, dividends
received from a foreign corporation are treated as taxable income in the United States
unless “less than 25 percent of the gross income from all sources of such foreign
corporation for the 3-year period ending with the close of its taxable year preceding
the declaration of such dividends (or for such part of such period as the corporation
has been in existence) was effectively connected (or treated as effectively connected
other than income described in § 884(d)(2)) with the conduct of a trade or business
within the United States.”136
The Foreign Investor Tax Act of 1966 creates a safe harbor from US taxation for
foreign corporations. Specifically, it provides that in the case of a non-resident alien,
“trade or business within the United States” . . . does not include . . .
[t]rading in stocks or securities for the taxpayer’s own account,
whether by the taxpayer or his employees or through a resident
broker, commission agent, custodian, or other agent, and whether or
not any such employee or agent has discretionary authority to make
decisions in effecting the transactions. This clause shall not apply in
the case of a dealer137 in stocks or securities.138
132. I.R.C. 1.7704 (a) et seq. provides the requirements and exemptions discussed in this Part.
133. 6 C.F.R. § 1.7704-1(h)(1)(ii) (2017).
134. 6 C.F.R. § 1.7704-1(e)(1)(vii) (2017).
135. 6 C.F.R. § 1.7704-1(k)(1)(ii)(B) (2017).
136. 26 U.S.C. § 861(a)(2)(B) (2012).
137. A “dealer” in securities or commodities (the language is identical) is one who: “regularly
purchases securities from or sells securities to customers in the ordinary course of a trade
or business or regularly offers to enter into, assume, offset, assign, or otherwise terminate
positions in securities with customers in the ordinary course of a trade or business.”
Foreign Investor Tax Act of 1966, 26 U.S.C. § 475(c) (2012).
138. 26 U.S.C. § 864(b)(2)(A)(ii) (2012).
A similar exemption in the same section provides an equivalent safe harbor for
commodities interests trading. However, the commodities exemption has the
additional limitation that the exemption “shall apply only if the commodities are of a
kind customarily dealt in on an organized commodity exchange and if the transaction
is of a kind customarily consummated at such place.”139
In addition to the usual idea of commodities (e.g., gold, grains, etc.), the IRS has
ruled that spot and forward contracts in precious metals and foreign currencies are
commodities for purposes of the safe harbor provision under § 864(b)(2)(B) of the
Code.140 The commodities transactions in question need not actually occur on an
organized commodity exchange. 141 Rather, the transactions need only be similar to
transactions carried out on an organized exchange. 142
D. Commodities Futures Trading Commission Oversight
The CFTC, under the Commodities Exchange Act (the “CEA”), has jurisdiction143
over all commodity swaps and other derivative contracts, as well as the investment
advisers and pooled investment funds dealing in such commodity interests.144 Trading
of such products must occur on designated self-regulated exchanges, authorized and
supervised by the CFTC. Investment managers and pooled investment vehicles
trading on such exchanges must also register with the CFTC and abide by a set of
requirements comparable to those funds operating under the Advisers Act and
Investment Company Act.145
139. 26 U.S.C. § 864(b)(2)(B)(iii) (2012); S. REP. NO. 89-1707, at 17 (1966) (“It is not intended that
as a result of [§ 864(b)(2)], a foreign investment company . . . is to be permitted to locate
its general business activities in the United States and avoid taxation at the regular
corporate rates on its income and gains effectively connected with its business in this
country. However, a foreign investment company conducting its general business
activities in a foreign country (i.e., having its principal office there) can conduct trading
activities in the United States through an agent with discretionary authority, without this
giving rise to its being considered as conducting a trade or business in the United
States.”).
140. I.R.S. Priv. Ltr. Rul. 8527041 (Apr. 8, 1985).
141. Id.
142. Id.
143. Futures Trading Practices Act of 1992, 7 U.S.C. §§ 6(a), 6(c)–(d) (2012) (authorizing CFTC
to exempt swaps and OTC energy derivatives from regulation under the CEA)
[hereinafter “FPTA”]; Commodity Futures Modernization Act of 2000, 7 U.S.C. 6g (2012)
(exempting all OTC derivative instruments from regulation by the CFTC and SEC)
[hereinafter “CFMA”].
144. 7 U.S.C. § 2 (2012).
145. Private funds investing in commodity derivatives must register with the National Futures
Association (“NFA”) as a commodity pool operator (“CPO”) or seek an exemption, which
Although many swaps and other derivative contracts were previously excluded
from CFTC jurisdiction, the Dodd-Frank Act expanded its ambit to include commodity
swaps and derivative contracts of any type.146 Only so-called forward delivery
contracts, involving cash settlement and physical delivery of the commodity, escape
regulation under the CEA.147
Little opportunity for arbitrage or other returns exists in pure commodity
markets, such that derivatives, swaps, and leveraged products are essential to
generating returns for a pooled investment fund trading in commodity interests. Thus,
the expansion of CFTC authority under Dodd-Frank to include trading previously
excluded swaps and other derivative contracts, combined with the end of the fifteen-
client private adviser exemption, effectively brought all traditional hedge funds under
regulation. 148
E. Non-Applicability of Investment Activity Regulation to Crypto Funds
Like all hedge funds, crypto funds must comply with the Securities Act and
Exchange Act with respect to the sale of their limited partnership interests. However,
the interplay between the Investment Company Act, Advisers Act, and CEA with
recent regulatory decisions has placed at least some cryptocurrency investment funds
outside the regulatory framework which normally governs hedge funds. 149
The SEC has distinguished between cryptocurrency tokens qualifying as
securities, such as the DAO Token, and those which are virtual currencies.150 The latter
are for regulatory purposes treated as general commodities, and are not subject to the
special rules regarding foreign national currencies.151 Because of the high volatility and
are significantly more limited than those available under the Investment Company Act.
Similarly, commodity trading advisers (“CTAs”) must also register or seek an exemption.
146. Dodd-Frank Wall Street Reform and Consumer Protection Act, supra note 111 (repealing
the exemptions made under the FTPA and CFMA).
147. Section 2(c)(2)(D) of the Commodity Exchange Act (CEA) provides the CFTC with direct
oversight authority over “retail commodity transactions” – defined as agreements,
contracts or transactions in any commodity that are entered into with, or offered to retail
market participants on a leveraged or margined basis, or financed by the offeror, the
counterparty or a person acting in concert with the offeror or counterparty on a similar
basis. Such a transaction is subject to the CEA “as if” it were a commodity future. This
statute contains an exception for contracts of sale that result in “actual delivery” within
28 days from the date of the transaction. See infra note 155.
148. In 2002, the SEC first proposed an elimination of the ‘private client exemption’, which
was adopted despite a split vote and met vociferous opposition from market participants.
See Advisers Act Release No. 2333 (Dec. 2, 2004), 69 Fed. Reg. 72,054 (Dec. 10, 2004)
(includes the dissent of the 2 Commissioners who opposed the new rules). These efforts
were stymied in part by Goldstein v. SEC, 451 F.3d 873 (D.C. Cir. 2006), which held that
the 2004 Rule eliminating the private client exemption exceeded the statutory authority
of the SEC. Full regulation of hedge funds did not come until the passage of the Dodd-
Frank Act.
149. See supra Parts I(C)-(D) and II(D).
150. See supra Parts I(C)-(D).
151. See id.
other unusual traits of these “commodity tokens,” trading or investing in these pure
commodities—in contrast to derivative contracts thereon—can be highly lucrative, far
more so than investing or trading in traditional commodities such as gold. As a result,
“pure” commodity investment and trading is a viable strategy for hedge funds in the
cryptocurrency sector.
By only trading in commodities, such funds do not “engage primarily, in the
business of investing, reinvesting, or trading in securities.”152 Their investment
advisers are also not engaged in the “business of advising others . . . as to the value of
securities or as to the advisability of investing, purchasing, or selling securities.”153
They do not engage with securities markets at all. Because the Advisers Act and the
Investment Company Act apply only to those investing or advising on investing in
securities, funds investing or trading in commodity tokens do not qualify as
investment companies. Advisers for such funds similarly do not qualify as investment
advisers at all.
Nor do these crypto funds fall under the purview of the CFTC. Following the
passage of Dodd-Frank, nearly all commodity swap or derivative transactions are
regulated under the CEA.154 Most, if not all, of the primary market trading in
commodity tokens involves forward delivery contracts specifying physical delivery
and cash settlement, removing the transactions—and the funds engaging in them—
from the requirements of the CEA and its implementing regulations.155 These funds
are largely creations of common law concepts (such as fiduciary duties), rather than
152. 15 U.S.C. § 3(a)(1)(A).

153. 15 U.S.C. § 202(a)(11).
154. Commodity Exchange Act, 7 U.S.C. § 1a(47) (2016).
155. The CFTC exempts a commodity option transaction from certain swap requirements if
the following conditions are satisfied: (i) the offeror of the option is either an “eligible
contract participant” as defined in section 1a(18) of the Commodity Exchange Act
(“CEA”) or a commercial participant (a producer, processor, commercial user of, or
merchant handling, the underlying physical commodity and entering into the option
solely related to its business as such); (ii) the offeree of the option is a commercial
participant; and (iii) the parties intend to physically settle the option so that, if exercised,
the option would result in the sale of a nonfinancial commodity for immediate (i.e., spot)
or deferred (i.e., forward) shipment or delivery. Commodity Options, 77 Fed. Reg. 25,320
(Apr. 27, 2012). However, the CFTC recently issued further guidance and a request for
comment on the matter of the physical delivery settlement treatment of digital
commodities. Retail Commodity Transactions Involving Virtual Currency, 82 Fed. Reg.
60335 (proposed Dec. 20, 2017). The CFTC noted that the “one-size-fits-all 28 day delivery
period in CEA . . . may not properly account for . . . virtual currency transactions that
would presumably take much less than 28 days to deliver to a purchaser in a typical spot
transaction.” Id. The CEA restricts the authority of the CFTC to shorten the 28-day
delivery period. 7 U.S.C. § 2(c)(2)(D)(ii)(III)(aa). Nevertheless, the CFTC specifically
inquired in the request for comment as to whether it would be appropriate to lobby
Congress for authority to shorten the statutory delivery period. Retail Commodity
Transactions Involving Virtual Currency, 82 Fed. Reg. 60335 (proposed Dec. 20, 2017).
Such a change could have a significant impact on the nature of cryptocurrency markets
and impinge upon the trading strategies available to crypto funds.
proscriptive regulation (or the need to claim exemptions from such regulation). The
net result is a hedge fund structure that is much more lightly regulated and flexible
than that of a ‘traditional’ hedge fund. This was an essential and perhaps prophetic
move by regulators, and gives much-needed room for innovation in the sector. The
unique challenges of crypto funds will require new and different solutions than the
best practices embodied in current regulation.
III. The Crypto Fund: Administrative and Operational Issues
The potential rate of return and volatility of cryptocurrencies far exceed the rate
of return and volatility of other commodities. As a result, a new wave of hedge funds
that trade significantly or exclusively in these currencies is emerging. Examples
include MetaStable Capital (~$70 million in assets under management as of June 2017
and over 500% in returns between September 2014 and March 2017)156 and Polychain
Capital (~$200 million in assets under management as of July 2017).
In addition to such potential returns, crypto funds possess a significant
competitive advantage over traditional hedge funds, but also carry additional
operational and regulatory risks. This Part discusses such advantages and risks in four
key areas: (i) regulations governing the solicitation of investors, (ii) custodianship of
client assets, (iii) tax treatment of cryptocurrency transactions, including foreign
investor qualifications and in-kind redemptions, and (iv) disclosure obligations to
investors.
A. Solicitation of Investors
Limiting the types of investors who can invest in a hedge fund limits the hedge
fund’s access to capital. The Investment Company Act draws a distinction among four
types of investors, in order of the amount of assets held and/or income generated by
those investors: qualified purchasers (very large investors), qualified clients (wealthy
investors), accredited investors (mid-sized investors), and non-accredited investors
(small investors).157 Hedge funds typically attain an exemption to the Investment
Company Act under section 3(c)(1) or section 3(c)(7), which impose higher non-
solicitation requirements than required for other entities pursuant to Regulation D. 158
Those exemptions require limiting fundraising to either (i) 100 accredited investors or
(ii) 2,000 qualified purchasers—and hedge funds typically opt to either comply with
the latter to maximize their funding, and their ability to take performance fees, or
156. Jen Wieczner, Sequoia and Andreessen Horowitz Are Secretly Backing This Cryptocurrency
Hedge Fund, FORTUNE (July 26, 2017), http://fortune.com/2017/07/26/Bitcoin-
cryptocurrency-hedge-fund-sequoia-andreessen-horowitz-metastable/.
157. For a discussion of the requirements for qualifying as a qualified purchaser or accredited
investor, see supra Part II(B) (qualified purchasers) and Part II(A) (accredited investors).
158. See supra Part II(B).
restrict their fundraising under the former to qualified clients. 159 Thus, the current
regulatory regime applicable to security-trading hedge funds favors limiting capital to
the largest investors. The intent is for the risk of speculative activity to be borne only
by high-worth persons who can most easily shoulder the burden.
However, crypto funds do not need to obtain an exemption to the Investment
Company Act.160 By trading in non-securities, they are not subject to the Investment
Company Act.161 As a result, they do not need to comply with the Investment
Company Act’s amplified non-solicitation provisions.
Crypto funds thus have far broader discretion in choosing and marketing to
smaller investors, and in turn a significant competitive advantage to other hedge
funds. Most notably, Rules 504 and 506 of Regulation D provides safe harbors where
fundraising is limited to either (i) accredited investors or (ii) accredited investors and
up to thirty-five sophisticated non-accredited investors so long as general solicitation
or advertising is not used. 162 That provides crypto funds vis-à-vis other hedge funds
exclusive access to smaller funding sources in non-accredited, sophisticated investors
and easier access to mid-sized accredited investors. For example, a crypto fund could
target itself solely to mid-sized or small investors. Fund managers who have difficulty
raising large amounts of funds due to lack of contacts, expertise, or otherwise could
also create “micro crypto funds” comprised primarily of funds from non-accredited,
sophisticated investors. In addition, because such funds are not subject to the Advisers
Act limitations on performance fees,163 these fledgling managers can take advantage of
the traditional profits allocation—the 20% normally only available for investment
advisers with much wealthier investors who are qualified clients. As a result of such
flexibility, crypto funds have significantly fewer legal barriers to entering the market
and earning profits than other hedge funds.
B. Custodianship of Assets
By automating transactional validation and security, blockchains not only obviate

the need for a third-party custodian as might be desirable for most other investments,
but make first-party custodianship the only responsible form of safeguarding client
assets. To understand how blockchain changes the ideal form of custodianship, the
benefits and operational issues of traditional custodianship must be compared with
those of blockchain.164
159. Id.
160. See supra Part II(E) for a more extensive discussion of this exemption.
161. Id.
162. See supra Part II(A) for a more extensive discussion of Regulation D.
163. See supra Part II(E).
164. Paul Schott Stevens & Timothy W. Cameron, SEC Interpretive Letter, (January 18, 2018),
https://www.sec.gov/divisions/investment/noaction/2018/cryptocurrency-011818.htm.
Investment advisers registered under the Advisers Act are required to use third-
party “qualified custodians,” such as banks, to hold client assets.165 The underlying
assumption is that a specialized, independent third-party will keep client assets more
secure than the investment adviser and/or investment company. 166 Because most
hedge fund advisers are not exempt from the requirements of the Advisers Act, most
hedge funds must turn to such traditional third parties to manage client assets, in order
to mitigate risk of theft, misappropriation, or accounting inconsistencies.
In the context of most transactions, third-party custodians, at a minimum, perform
three valuable functions: validation, security, and trust. 167 First, they validate
transactions by controlling and transferring the funds in the account and releasing
only on the authorization of the holder of the funds or his agent. 168 Those transfers also
create a clear record of transactions that can be easily audited to ensure accuracy and
correct anomalies.169 Second, third-party custodians implement security measures to
protect against both internal and external attacks, such as hacks or identity theft.170
Banks, for example, are subject to extensive regulation with respect to consumer
privacy, consumer protection, and unfair or deceptive practices. 171 Applying such
regulations to investment companies would significantly increase their burden,
resulting in legal costs and significant compliance programs, nor would they have the
extensive experience of regulated financial institutions such as banks. Third, by
performing such validation and security functions, third-party custodians generate
public trust and confidence in transactions effected by the custodian, which in turn
facilitates efficient market activity.172
With respect to cryptocurrencies, however, all three of those functions are
automatically performed by the public key encryption underlying the corresponding
blockchains, obviating the need for a third-party custodian. In public key encryption,
a user generates two keys using a cipher, or encryption algorithm: a public key that is
165. See supra Part II(B).

166. Id.
167. See, e.g., 2009 CCOutreach Regional Seminars: Safeguarding Clients’ Assets Under Management
through Asset Verification and Reconciliation,” SEC (April 2009),
https://www.sec.gov/info/iaiccco/iaiccco-custody.pdf (providing recommendations to
investment advisers for safeguarding client assets).
168. See THE CLEARING HOUSE, THE CUSTODY SERVICES OF BANKS 4 (2016),
https://www.davispolk.com/files/20160728_tch_white_paper_the_custody_services_of_
banks.pdf (“In providing custody services, custodians act solely on instructions from
their clients and do not exercise any discretion over the use or reuse of client assets under
custody, or use them for proprietary purposes. In this regard, the role of a custodian is
different from that of an asset manager, which typically has discretion over investments
made with, and the use and reuse of, client assets under its management.”).
169. See id.
170. See id. at 24-26.
171. See Major Consumer Protection Laws, THE FEDERAL RESERVE BOARD (last updated May 17,
2007), https://www.federalreserve.gov/pubs/Complaints/laws.htm.
172. See THE CLEARING HOUSE, supra note 168, at 3-5
visible to those who have access to the blockchain (usually, the entire public) and a
private key that is held only by the owner of the cryptocurrency. 173 The public key is
used for encryption, while the private key is used for decryption. 174 When the user
purchases or sells a cryptocurrency, the user must create a “digital signature” by
processing his private key with the cipher.175 Holders of the public key can then check
whether the digital signature is valid using the public key. 176 If any data have been
changed—for example, if an intruder attempts to change the address of the user so
that purchases are sent to another address—the digital signature will be automatically
invalidated, and the transaction cannot be added to the blockchain. 177
In turn, public-key encryption validates, secures, and creates trust in
cryptocurrency transactions. Since valid digital signatures cannot be forged by an
intruder, and only valid signatures result in blocks on the blockchain, a block on the
blockchain will always be valid insofar as it is authorized by the appropriate owner. 178
All members of the public also have a copy of the blockchain that they can themselves
audit to verify the integrity of transactions.179 Moreover, transactions are secure insofar
as it is unfeasible for any transaction to be entered onto the blockchain without the
authorization of the owner.180 Only the owner can generate a valid digital signature,
and any change in that signature’s data by an intruder (for example, changing the
owner’s address) will immediately invalidate the signature. 181 Those validation and
security features, especially the fact that all members of the public can themselves copy
and examine the blockchain, create trust in the efficient and accurate operation of the
cryptocurrency markets.182
173. Chris Pacia, Bitcoin Explained Like You’re Five: Part 3 – Cryptography, ESCAPE VELOCITY
(Sept. 7, 2013), https://chrispacia.wordpress.com/2013/09/07/Bitcoin-cryptography-
digital-signatures-explained/.
174. Id.
175. Id.
176. Id.
177. Id.
178. Of course, this ignores instances in which a hacker has gained access to the holder’s
private key. However, this situation is no different than any other theft of account
credentials or identity, and is equally a risk with electronic third-party custodianship. For
example, if a hacker gains access to one’s bank account username and password, the
hacker can wire money out of such person’s account.
179. Sacha Huber, Blockchain and the Auditing Revolution – Real Time Audit within the Capabilities
of Blockchain, FINTECH NEWS SWITZERLAND (June 24, 2016),
http://fintechnews.ch/blockchain_bitcoin/blockchain-auditing-revolution-real-time-
audit-within-the-capabilities-of-blockchain/3864/.
180. See Pacia, supra note 173 (“Digital signatures are the key ingredient in Bitcoin that allows
only the owner of a particular Bitcoin address, and no one else, to publish a transactions
to the block chain transferring bitcoins from that address to another.”).
181. Id.
182. This is otherwise known as “trustless consensus” because participants need not trust one
another to validate and accept transactions. See Alexsandr Bulkin, Explaining Blockchain—
How Proof of Work Enables Trustless Consensus, KEEPING STOCK (May 3, 2016),
More importantly, the primary security risk in cryptocurrency transactions is the

private key.183 Transactions are solely effected by use of a user’s private key, without
need for any identifying information.184 Thus, whoever holds the private key is
effectively treated as the owner of the currency. 185 The risk is solely on the user to
safeguard that key, lest he lose his ownership rights.186
Moreover, if the key is intercepted and cryptocurrencies stolen, there is in most
instances no effective remedy due to two factors: immutability and pseudonymity.
Blockchains are immutable, such that transactions are irreversible.187188 Thus, once a
cryptocurrency is stolen, it cannot be retrieved. 189 Ownership in most cryptocurrency
blockchains is also pseudonymous, with the only piece of identifying information
being the person’s address for receiving the cryptocurrency.190 Thus, the identities of
both the rightful owner and of any offending intruder will not be generally known, so
that an owner whose cryptocurrency has been stolen through hacking generally will
not be able to recover his holdings from the wrongdoer.191
The safeguarding of private keys, then, is the utmost security concern for fund
managers, and any dissemination of those keys—including to third-party
custodians—will only serve to increase the risk of theft. The more people have access
to keys, and the more computers or servers on which those keys can be found, the
more likely that those keys can be hacked or misappropriated. Unlike with traditional
securities or funds, storage risk for cryptocurrencies lies solely on the fund managers
and cannot be effectively delegated to others. The tradeoff for blockchains’ automated
https://keepingstock.net/explaining-blockchain-how-proof-of-work-enables-trustless-
consensus-2abed27f0845.
183. See Chad Arroyo, Holding Cryptocurrency—The Real Risks, HACKERNOON (Oct. 7, 2017),
https://hackernoon.com/holding-cryptocurrency-the-real-risks-3c54ca8d73b6 (“The
biggest determinant of your cryptocurrency’s security is completely dependent on how
you choose to hold it.”)
184. See Jen Wieczner, Hacking Coinbase: The Great Bitcoin Bank Robbery, Fortune (Aug. 22, 2017),
http://fortune.com/2017/08/22/bitcoin-coinbase-hack/.
185. Id.
186. Arroyo, supra note 183.
187. Immutability means that a block in the chain can never be overridden or rewritten. To
undo a transaction, one would have to affect a second transaction on the blockchain with
the opposite effect. For example, if a holder sells 100 Bitcoin, that transaction can never
be canceled; however, the holder can then repurchase 100 Bitcoin, which would place the
holder in the same position, barring fluctuations in price or transaction costs.
188. In limited instances, a community can “fork” a blockchain to reverse a transaction (i.e.,
create an identical blockchain without the offending transaction). However, that is an
extreme remedy that is rare in practice. An example includes Ethereum’s fork in July 2016
to reverse a $50 million hack of the DAO Token.
189. See Arroyo, supra note 173.
190. Eric Boughman, The Myth of Using Cryptocurrencies for Asset Protection, FORBES (Apr. 4,
2017, 9:00 AM), https://www.forbes.com/sites/forbeslegalcouncil/2017/04/04/the-myth-
of-using-cryptocurrencies-for-asset-protection/#d2c7705526d7.
191. See Wieczner, supra note 184.
validation and security procedures, which largely lower transaction costs and human-
related security risks, is greater storage risk.
Crypto fund managers must take care to implement robust security measures
with respect to storage of private keys. That includes maintaining those keys
internally, minimizing the number of people who have access to those keys, and
minimizing the number of computers on which those keys are stored. These and
related recommendations are discussed in Part IV.
C. Tax Treatment: Foreign Investor Exemptions and Redemptions In-Kind
A complete discussion of the tax treatment of cryptocurrencies is beyond the

scope of this article. However, a brief summary is helpful in understanding the unique
issues faced by crypto funds. “Convertible Virtual Currencies” (CVCs), including
Bitcoin and at least some other cryptocurrencies, are treated as property under U.S. tax
rules.192 Thus, the tax treatment and timing of any taxable event regarding a CVC
transaction is related to whether they are received as income or held for investment
purposes. Following this guidance, cryptocurrencies such as Bitcoin received in
payment for goods or services are taxable as such at the personal income tax rate.
Conversely, the change in value of cryptocurrencies held for investment is treated as
short- or long-term capital gains. The basis value of the asset—in this case each “token”
or “coin”—is determined at the time of purchase. Tokens held for long periods will
generally receive beneficial tax treatment, but be subject to substantial tax payments
upon recognition of any gain. Generally, such gains may not be recognized until the
investment asset—say, a Bitcoin—is exchanged into fiat currency or otherwise
exchanged for a good or service.193
192. I.R.S. Notice 2014-21 (April 14, 2014).

193. Although the analysis presented here seems the most likely interpretation, the full tax
implications of cryptocurrency transactions are complex and uncertain, as the following
examples should demonstrate.
Ex. 1: Suppose an investor, Jane, purchases a Bitcoin in year one for investment purposes. Jane’s
Bitcoin is purchased for a basis value of $1, and held for ten years, at which point the
market value of the Bitcoin is $100. If Jane sells her Bitcoin for USD in year ten, she will
owe (probably long-term) capital gains tax on the $99 gain from the basis value.
Ex. 2: Now, suppose instead that in year ten, Jane exchanges her Bitcoin for a 1974 vintage Ford
Mustang. Although she has secured a great deal on a car, she now has a liquidity problem.
The purchase of the car may have been an excellent deal, but she has now (probably)
recognized the gain in value of her Bitcoin. Assuming for simplicity that the gain is
determined by reference to Bitcoin spot prices, rather than the value of the car, Jane once
again owes taxes on her $99 capital gain—but does not have the liquidity to pay those
taxes unless she has additional available fiat currency, or liquidates more Bitcoins
(incurring even more tax liability).
Ex. 3: It turns out Jane is quite a savvy cryptocurrency investor, and in year ten spots an
opportunity in the Ether market during a temporary correction. Jane buys ten Ether with
her Bitcoin, then worth $100. She has now probably recognized the gain in value in her
Bitcoin, and owes taxes. This seems the likely result because both Ether and Bitcoins are
treated as virtual currencies, and are fully convertible to USD or other fiat currency.
This tax treatment has a number of effects upon crypto funds. Because the act of
exchanging a cryptocurrency token for a readily valued asset, good, or service is likely
a recognition of any gains, it encourages a last-in, first-out accounting methodology to
minimize tax payments.194 Such accounting ensures that long-held coins with a low
relative tax basis are not taxed unless necessary. Perhaps more significantly, the
possibility of avoiding a recognition event encourages the use of in-kind distributions
and redemptions by the fund. Many hedge fund investment adviser agreements
provide the investment managers with wide latitude to make distributions and
redeem interests in kind as well as cash. Often, in-kind redemption options are
intended as ‘emergency’ provisions, allowing the fund to protect the ready cash of the
fund in the event of a large investor redemption and preserve redemption rights when
the fund is invested in highly illiquid positions. Historically, such in-kind redemption
Ex. 4: As in Ex. 3, but instead of purchasing ten Ether for her Bitcoin, Jane purchases a single
AltCoin, a new cryptocurrency. AltCoin is subject to transfer restrictions, may be a
security, and is not readily exchangeable to fiat currencies. AltCoin doubles in value
during the one-year restriction period, at the end of which Jane exchanges her AltCoin in
an over-the-counter transaction for two Bitcoins, each still worth $100. Now, we have a
problem.
Normally, the equivalent transaction would involve selling a commodity (say, gold)
for USD, triggering a recognition, and then exchanging those USD for an equity interest.
Returning to gold from that equity interest naturally requires selling the interest for USD,
and then purchasing gold with those funds. In Jane’s case, her commodity to equity to
commodity exchanges occur without ever returning to fiat currency. Because the return to
fiat is the normal ‘trigger point’ for recognition or gains, it’s not clear when or whether
Jane recognized her gains, or potentially even what the basis value of the various assets
in question is. One possibility is that gains on both the Bitcoin and the AltCoin were
recognized at the time of each purchase/sale event. Another possibility is that the gains
could remain unrecognized until the (now two) Bitcoins are finally exchanged for fiat
currency. In that case, Jane may well have a different basis value for each of the two
Bitcoins, with one ‘retaining’ the basis value of her original Bitcoin ($1) and the other
having a new, higher basis value based on the AltCoin transaction ($100). That would
mean that, even if exchanged at the same time, the gain recognized and taxes owed on
each Bitcoin would be substantially different. Suffice to say, it will be some time before
the precise tax treatment of cryptocurrencies is resolved.
Although its exact consequences are still being worked out, the tax reform bill passed
at the beginning of 2018 may have clarified this issue. Specifically, it clarified that
exchanging one cryptocurrency for another does not qualify for like-kind exchange
treatment, meaning that in the above examples, exchanging a Bitcoin for an Altcoin would
likely result in a taxable realization of gains. Nevertheless, last-in, first-out (LIFO)
treatment, whereby the investor can choose to transact using its highest basis-value
tokens, was preserved in the final version of the bill. This is of particular importance in
crypto hedge funds, where investors making in-kind investments may have a very low
tax basis for their tokens and wish to avoid transacting in them directly as much as
possible.
194. At the time of this writing, there was a proposed bill in the U.S. House of Representatives
to exempt payments for goods and services worth less than $600 from reporting and tax
requirements. While this would resolve the tax-at-transaction issue for small payments,
it would likely be of little help to hedge funds in this sector. See H.R. 3708, 115th Cong.
(2017).
strategies were viewed as negative to investors. 195 In crypto funds, the inverse
becomes true. In-kind distributions may minimize taxes, and generally allow
individual investors to handle recognition according to their own needs and
jurisdiction’s tax rules.
1. 864(b)(2) Exemption
As discussed infra, the IRS specifically declined to address the section 864
exemptions in Notice 2014-21.196 As a result, the IRS has left substantial uncertainty as
to the applicability of the section 864(b) exemption to cryptocurrency and other virtual
currency investment and trading activities. However, prior precedent and subsequent
rulings by other regulatory bodies suggest that the section 864(b)(2)(B) commodities
exemption is applicable to cryptocurrency investments.
IRS Letter Ruling 8850041 (September 19, 1988) ruled that “commodities of a kind
customarily dealt in on an organized commodity exchange” include both exchange-
traded and non-exchange-traded currencies.197 In that ruling, a taxpayer whose
activities consisted solely of trading futures contracts, forward contracts, index futures
contracts, option contracts, and spot contracts for its own account entered into
transactions with respect to two categories of foreign currency. 198 The first category
consisted of foreign currencies traded on U.S. and foreign commodity exchanges
(“regulated currencies”). The second consisted of foreign currencies that were not
traded on an organized commodity exchange, but rather were traded on the interbank
market (“unregulated currencies”).199 The Ruling concluded that both regulated and
unregulated currencies were “of a kind customarily dealt in on an organized
exchange”, and qualified for the safe harbor.200
It is uncertain whether commodity tokens are a “commodity of a kind customarily
dealt in on an organized commodity exchange and is the transaction of a kind
customarily consummated at such place.”201 However, helpful indicia on the matter
has emerged not from the IRS, but another agency altogether.
On July 6, 2017, the CFTC issued a registration order to LedgerX LLC, granting it
status with the CFTC as a Swap Execution Facility (SEF). 202 SEFs are platforms that
195. E.g., Susan Antilla, Wall Street In the Face of a Fund Panic, N.Y. TIMES (June 27, 2003),
http://www.nytimes.com/1993/06/27/business/wall-street-in-the-face-of-a-fund-
panic.html (“in-kind redemptions are rarely made”).
196. I.R.S. Notice 2014-21 (Apr. 14, 2014).
197. Nick D. Hansen, Charles J. Bay & David N. Bowen, Foreign Activities of U.S. Taxpayers, 44
TAX LAW. 1287, 1288-300 (1991).
198. Id.
199. Id.
200. I.R.S. Priv. Ltr. Rul. 8850041 (Sept. 19, 1988).
201. 26 U.S.C. § 864(b)(2)(B)(iii).
202. Press Release, CFTC, CFTC Grants SEF Registration to Ledger X LLC (July 6, 2017),
http://www.cftc.gov/PressRoom/PressReleases/pr7584-17.
operate under the CFTC’s regulatory oversight for trading of swaps. LedgerX is an
institutional trading and clearing platform, which trades and clears options in Bitcoin.
It is the first federally regulated Bitcoin options exchange and clearing house which
will list and clear fully collateralized, physically-settled Bitcoin options for
institutional markets. In other words, the CFTC has formally endorsed virtual
currency cryptocurrencies as commodities and authorized the creation of “regulated
exchanges” for commodity token transactions.
IRS Notice 2014-21 was issued before the CFTC or SEC had issued much guidance
on any major aspects of cryptocurrency markets.203 It is possible that the IRS wished to
wait and defer to its sister agencies as to their regulatory classification of this new asset
class. Based on this recent treatment by the CFTC and the IRS private letter rulings
regarding section 864(b)(2)(B)(iii), it is also possible that the IRS may include
cryptocurrency investments under the safe harbor provision of section 864(b)(2)(B) as
“a transaction of a kind customarily consummated” in an organized exchange.
D. Disclosure of Cryptocurrency Risks, Investment Strategy, and Regulatory Uncertainty to

Limited Partners
Hedge funds have disclosure obligations under securities laws, as well as a duty
of disclosure under state partnership statutes. 204 Both disclosure obligations are
extensive and generally require disclosure of information that is relevant to
investors.205 Given the intense regulatory uncertainty and market risks associated with
cryptocurrencies, these disclosure obligations require that crypto funds make greater
disclosures vis-à-vis other hedge funds, including by disclosing regulatory risks,
investment and operational risks associated with cryptocurrencies in general, and
investment and operational risks associated with the specific cryptocurrencies that the
fund intends to trade.
Hedge fund managers face two disclosure obligations. First, as discussed in Part
I(A), the anti-fraud provisions of the Securities Act and Exchange Act require
disclosure of material information with respect to the initial sale of limited partnership
interests to potential investors.206 In this context, “material information” includes all
information for which there is a “substantial likelihood that a reasonable investor
would attach importance in determining whether to purchase the security
registered.”207 Second, partners in a partnership have a duty of disclosure under state
statutes.208 Hedge funds are typically structured as limited partnerships, with the fund
managers acting as the general partners and investors acting as limited partners, and
203. For example, the earliest SEC action relating to cryptocurrencies at all was in July 2013.
See SEC v. Shavers, No. 4:13-CV-416, 2013 WL 4028182 (E.D. Tex. Aug. 6, 2013).
204. See discussion infra Part III(D).
205. See id.
206. See Supra Part II(A).
207. 17 C.F.R. § 230.405.
208. See UNIF. P’SHIP ACT §§ 19, 403 (NAT’L CONFERENCE OF COMM’RS ON UNIF. STATE LAW 1997).
thus they are subject to state partnership statutes. 209 Notably, there are only two
primary partnership statutes in effect in the United States: the Uniform Partnership
Act of 1914 (the “UPA”), and the Revised Uniform Partnership Act (1997) (the
“RUPA”). The RUPA has been adopted, in whole or in part, in thirty-nine states,
Washington, D.C., and the U.S. Virgin Islands,210 while the UPA is in effect in another
ten states.211 Both model rules impose a duty of disclosure212 on partners. The RUPA
requires that limited partners (i) receive access to partnership books and records and
(ii) be provided all information related to partnership business or the partner that is
either requested by the limited partner or required for such partner’s duties.213 The
209. Hedge funds may also be structured as LLCs. There is less uniformity in state LLC
statutes; however, to the extent that state LLC statutes provide explicitly for disclosure
obligations, or provide for fiduciary duties of care and loyalty under which a duty of
disclosure could be implied, the analysis in this Part will equally apply.
210. The states which have adopted the RUPA include Alabama, Alaska, Arizona, Arkansas,
California, Colorado, Connecticut, Delaware, District of Columbia, Florida, Hawaii,
Idaho, Illinois, Iowa, Kansas, Kentucky, Maine, Maryland, Minnesota, Mississippi,
Montana, Nebraska, Nevada, New Jersey, New Mexico, North Dakota, Ohio, Oklahoma,
Oregon, Pennsylvania, South Dakota, Tennessee, Texas, U.S. Virgin Islands, Utah,
Vermont, Virginia, Washington, West Virginia, Wisconsin, and Wyoming. Partnership Act
(1997) (Last Amended 2013), UNIFORM LAW COMMISSION,
http://uniformlaws.org/Act.aspx?title=Partnership%20Act%20%281997%29%20%28Last
%20Amended%202013%29 (last visisted Jan 28, 2018).
211. Only Louisiana has adopted neither statute, although many provisions of the Louisiana
partnership statute echo provisions of the UPA and RUPA. Id.
212. This duty should not be confused with the fiduciary duties of care and loyalty. The duty
of disclosure is a statutory, not fiduciary, duty.
213. UNIF. P’SHIP ACT § 403 (NAT’L CONFERENCE OF COMM’RS ON UNIF. STATE LAW 1997) (“(a) A
partnership shall keep its books and records, if any, at its chief executive office. (b) A
partnership shall provide partners and their agents and attorneys access to its books and
records. It shall provide former partners and their agents and attorneys access to books
and records pertaining to the period during which they were partners. The right of access
provides the opportunity to inspect and copy books and records during ordinary business
hours. A partnership may impose a reasonable charge, covering the costs of labor and
material, for copies of documents furnished. (c) Each partner and the partnership shall
furnish to a partner, and to the legal representative of a deceased partner or partner under
legal disability: (1) without demand, any information concerning the partnership’s
business and affairs reasonably required for the proper exercise of the partner’s rights
and duties under the partnership agreement or this [Act]; and 64 (2) on demand, any other
information concerning the partnership’s business and affairs, except to the extent the
demand or the information demanded is unreasonable or otherwise improper under the
circumstances.”).
UPA provides a similar, but narrower, right to information that includes access to
books and all requested information related to partnership business. 214 215
Both securities and partnership disclosure obligations are broad, limited primarily
to all relevant information. Just as disclosures under securities laws limit disclosure to
information relevant to the investor’s role as an investor216, disclosures under the UPA
and RUPA are limited to information relevant to the partnership or to the partner’s
role as a partner.217 Moreover, because limited partners in hedge funds take on a
passive role, with almost no managerial rights, their role as a partner is largely
synonymous with their role as an investor. Thus, both obligations significantly
overlap.
The breadth of these disclosure obligations, together with the amount or risk and
novelty in the cryptocurrency field, likely requires crypto fund managers to make
significantly greater disclosures to potential investors than would be required with
respect to a hedge fund trading in traditional securities. There are three primary areas
where such risks are greater than typical: (1) regulatory uncertainty concerning all
cryptocurrencies, (2) operational, technical, and market risks common to all
cryptocurrencies, and (3) specific risks associated with individual cryptocurrencies.
First, the regulatory landscape with cryptocurrencies is significantly changing,
both domestically and internationally, and crypto fund managers should make
significant disclosures with respect to the likelihood of such changes. The SEC’s first
decision regulating an ICO was made on July 20, 2017. Since then, it has shown an
inclination to prosecute more ICOs and has gone so far as to establish a new Cyber
Unit specifically to tackle “misconduct involving distributed ledger technology and
initial coin offerings,” among other cyber-related crimes.218 This division has since
214. Id. § 19 (“The partnership books shall be kept, subject to any agreement between the
partners, at the principal place of business of the partnership, and every partner shall at
all times have access to and may inspect and copy any of them.” UPA § 20 provides,
“Partners shall render on demand true and full information of all things affecting the
partnership to any partner or the legal representative of any deceased partner or partner
under legal disability.”).
215. Note that a similar obligation to disclose could be inferred from the fiduciary duties of
care and loyalty. For example, in the corporate context, Delaware has held that the “duty
of disclosure is not an independent duty, but derives from the duties of care and loyalty.”
Pfeffer v. Redstone, 965 A.2d 676, 684 (Del. 2009) (internal quotation marks omitted).
216. See 17 C.F.R. § 230.405 (2017); supra Part II(A).
217. See UNIF. P’SHIP ACT (1997), supra note 208.
218. Press Release, SEC, SEC Emergency Action Halts ICO Scam (Dec. 4, 2017),
https://www.sec.gov/news/press-release/2017-219 (“The [Cyber Unit] was created in
September to focus the Enforcement Division’s cyber-related expertise on misconduct
involving distributed ledger technology and initial coin offerings, the spread of false
information through electronic and social media, hacking and threats to trading
platforms.”). On December 4, 2017, the Cyber Unit filed its first charges, putting a halt to
the PlexCoin ICO for its creator’s fraudulent representations that investors would receive
“a 13-fold profit in less than a month.” Id. In September 2017, the SEC also prosecuted the
creator and companies behind two ICOs for selling fraudulent tokens that did not exist.
Press Release, SEC, SEC Exposes Two Initial Coin Offerings Purportedly Backed by Real
opened prosecutions against recidivist securities fraudsters operating “fraudulent and

unregistered offer and sale of securities called ‘PlexCoin’”219, suspended trading of a
publicly-listed stock with blockchain connections220, and ordered a cease-and-desist of
an ongoing ICO,221 amongst other activities.
The foreign regulatory landscape also remains in dramatic flux. On September 4,
2017, China banned ICOs as an unlawful fundraising tool and began investigations
into sixty ICO platforms.222 South Korea followed suit and banned ICOs on September
28, 2017.223 Regulation will likely increase significantly over the next few months and
years. While crypto funds are currently largely unregulated, their trading activity may
be regulated significantly in the future. Moreover, individual partners must be made
aware of the risk of tax complications and investment risks, such as potential loss of
investment, if the treatment of some or all cryptocurrencies is changed. Such investors
should be notified of their need for their own individual counsels and accountants,
particularly if they are residents of foreign jurisdictions or do business in multiple
jurisdictions.
Second, cryptocurrencies as a category of assets pose investment and operational
risks that should be disclosed. Few, if any, assets fluctuate as wildly as
cryptocurrencies do. For instance, on June 21, 2017, the price of Ether momentarily
crashed from approximately $319 to 10 cents as a result of a multimillion dollar sell
order on the GDAX exchange, which in turn triggered 800 stop orders and margin calls
as the price of Ether plummeted. 224 Millions in wealth would have been lost to
investors had GDAX not agreed to credit affected customers out of its own cash
reserves.225 Potential investors in crypto funds should be made aware of such instances
of intense volatility and the risks of transacting with young, inexperienced exchanges.
Moreover, cryptocurrency assets operate on unregulated markets with little to no
consumer protection. For example, the DAO Tokens that the SEC investigated were
hacked during their ICO, leading to a potential loss of $50 million, or one third of the
Estate and Diamonds (Sept. 29, 2017), https://www.sec.gov/news/press-release/2017-185-

0.
219. SEC v. PlexCorps, No. 1:17-cv-07007-DLI-RML (E.D.N.Y. filed Dec. 1, 2017).
220. The Crypto Company, Exchange Act Release No. 34-82347 (Dec. 18, 2017).
221. In the Matter of Munchee Inc., Exchange Act Release No. 10445 (Dec. 11, 2017).
222. See Sahely Roy Choudhury, China bans companies from raising money through ICOs, asks local
regulators to inspect 60 major platforms, CNBC (Sept. 5, 2017),
https://www.cnbc.com/2017/09/04/chinese-icos-china-bans-fundraising-through-initial-
coin-offerings-report-says.html.
223. Cynthia Kim, South Korea bans raising money through initial coin offerings, REUTERS (Sept. 28,
2017) https://www.reuters.com/article/us-southkorea-bitcoin/south-korea-bans-raising-
money-through-initial-coin-offerings-idUSKCN1C408N.
224. Adam White, ETH-USD Trading Update, GDAX (June 21, 2017), https://blog.gdax.com/eth-
usd-trading-update-5d8142b5bdc1.
225. Adam White, ETH-USD Trading Update #2, GDAX (June 23, 2017),
https://blog.gdax.com/eth-usd-trading-update-2-216a3b946ef6.
ICO amount.226 To resolve that hack, the core developers of Ethereum, the blockchain
underlying the DAO Tokens, agreed to effect a “fork,” creating an identical blockchain
that omitted the offending transaction.227 Forking, however, is a rare, extreme, and
controversial remedy228 that is not likely to be implemented to resolve most
cybersecurity issues, nor could investors have forced the developers to perform such
change. It was a unilateral decision not subject to the oversight of law enforcement or
regulators. Such lack of effective consumer protections and judicial or legislative
remedies, as well as the risk of hacking or other cybersecurity issues, can significantly
impact an investor’s return and so should be clearly disclosed to potential investors.
Third, each cryptocurrency poses its own regulatory, market, and operational
risks, such that crypto funds should disclose their trading strategy, all traded
cryptocurrencies that will be traded, and those cryptocurrencies’ unique risks.
Cryptocurrencies have multiple functions, including decentralized payments, smart
contracts, decentralized applications, and fundraising 229—and each may be regulated
differently. Since certain cryptocurrencies are securities, the trading of which would
require crypto funds to comply with securities obligations like more stringent non-
solicitation provisions under the Investment Company Act, each cryptocurrency
should be separately assessed to determine whether it is a security, and investors
should be warned to make their own assessments.
Moreover, each cryptocurrency employs different technology. For example, the
coin Monero is used for decentralized payments, but, unlike Bitcoin, it is
untraceable.230 While the Monero blockchain is publicly viewable, all transaction
amounts, sending addresses, and receiving addresses are encrypted. 231 Thus, there is
no way to link any transaction on the blockchain to a particular person. Not
surprisingly, it is very popular for money laundering.232 Cryptocurrencies like Monero,
which employ unique technology and/or technology that can be used for illicit
226. Nathaniel Popper, A Hacking of More Than $50 Million Dashes Hopes in the World of Virtual
Currency, THE NEW YORK TIMES (June 17, 2016),
https://www.nytimes.com/2016/06/18/business/dealbook/hacker-may-have-removed-
more-than-50-million-from-experimental-cybercurrency-project.html.
227. See Joon Ian Wong & Ian Kar, Everything You Need to Know About the Ethereum ‘Hard Fork,’
QUARTZ (July 18, 2016), https://qz.com/730004/everything-you-need-to-know-about-the-
ethereum-hard-fork/.
228. The decision was highly controversial because it undermined the notion of immutability,
since the community forcibly reversed a transaction on the blockchain. As a result, many
holders of Ethereum stayed on the original blockchain, which is now known as Ethereum
Classic. See David Z. Morris, The Bizarre Fallout of Ethereum’s Epic Fail, FORTUNE (Sept. 4,
2016), http://fortune.com/2016/09/04/ethereum-fall-out/.
229. See supra Part I(A).
230. Monero, MONERO, https://getmonero.org/ (last visited Jan. 28, 2018).
231. What is Monero (XMR)?, MONERO, https://getmonero.org/get-started/what-is-monero/
(last visited Jan. 28, 2018) (“Every Monero transaction, by default, obfuscates sending and
receiving addresses as well as transacted amounts.”).
232. Andy Greenberg, Monero, the Drug Dealer’s Cryptocurrency of Choice, is on Fire, WIRED (Jan.
25, 2017), https://www.wired.com/2017/01/monero-drug-dealers-cryptocurrency-choice-
fire/.
purposes, may be more susceptible to regulation. At a minimum, then, crypto fund

managers should make disclosures explaining such unique technologies and the risks
associated with them.
IV. Best Practices for Crypto Funds
As discussed throughout this article, crypto funds face significant risks, including
regulatory uncertainty. This Part brings together the regulatory and technological
discussions throughout this article to distill best practices for crypto funds. The goal is
to briefly address the most salient, pressing problems and opportunities that crypto
funds will confront.
Note that the recommendations in this Part are not exhaustive, nor are they a
substitute for the qualified assistance of legal and accounting advisers with expertise
in this area of the law. The formation and operation of crypto funds poses other
significant issues that are beyond the scope of this article. However, this Part provides
several practices of which every crypto fund should take notice.
A. Comply with the Simpler Non-Solicitation Rules of Regulation D
When raising a crypto fund, the promoters must comply with securities laws with
respect to their sale of limited partnership interests to potential investors. That
includes the non-solicitation rules of Regulation, which in most instances will require
limiting fundraising to accredited investors and/or up to thirty-five unaccredited
investors (and no more than 2,000 total investors). 233 However, that is a significantly
lower bar than faced by security-trading hedge funds, which (1) cannot raise from
unaccredited investors, (2) are limited to 100 accredited investors, and (3) otherwise
can only raise from qualified purchasers.
Thus, crypto funds have significantly more, but not unlimited, discretion in
choosing their investors. If they desire, they can take advantage of such rules to tailor
their solicitations to smaller investors than in a traditional hedge fund.
B. Trade Established, Pure Currencies
The SEC has drawn a bright line: Each cryptocurrency is either a virtual currency
or a security.234 It cannot be both, and only the latter is regulated under federal
securities laws.235 However, the line between the two is far murkier than the SEC’s
guidance would suggest, as all cryptocurrencies, to some extent, have features of
currencies as well as securities. The SEC’s application of the Howie test is also worded
233. See supra Parts II(A) and III(A) for a more extensive discussion of this requirement.
234. See supra Parts I(C)-(D).
235. See id.
so broadly that the SEC could, if it were so inclined, treat any cryptocurrency as a
security.236
Thus, crypto funds can protect themselves against such a risk by solely focusing
their trading activities on those cryptocurrencies which have received the direct
blessing of the SEC or which closely resemble such currencies. Currently, the SEC has
referenced the following cryptocurrencies as virtual currencies: Bitcoin and Ether.237
By extension, cryptocurrencies which resemble Bitcoin or Ether will likely also qualify
as virtual currencies. For example, of the top 12 cryptocurrencies by market
capitalization,238 at least four—Litecoin, Dash, Monero, and Bitcoin Cash—act
primarily as a peer-to-peer unit of exchange akin to Bitcoin.239
Unsurprisingly, the cryptocurrencies currently approved as virtual currencies
also happen to be the two currencies with the largest market capitalization240 and
trading volume.241 While not directly relevant to the Howie test, the DAO Report
emphasizes the security risks in the DAO Tokens, including an attack by hackers that
nearly stole roughly one third of the tokens.242 Thus, security concerns, particularly the
risk of defrauding investors, may be relevant to the SEC’s enforcement policy.
The safest option, then, is for funds to concentrate their trading activity on
currencies with high liquidity, a history of continuous trading activity, and an
established record for security.
Moreover, where a crypto fund does wish to trade in unconventional or less
established cryptocurrencies, it may be preferable to create separate funds for their
securities and non-securities activities.
236. See id. Nevertheless, the CFTC has explicitly taken the position that “[t]here is no
inconsistency between the SEC’s analysis and the CFTC’s determination that virtual
currencies are commodities and that virtual tokens may be commodities or derivatives
contracts depending on the particular facts and circumstances.” A Virtual Primer on Virtual
Currencies, CFTC (Oct. 17, 2017),
http://www.cftc.gov/idc/groups/public/documents/file/labcftc_primercurrencies100417.
pdf.
237. See The DAO Report, supra note 10, at 2–3, 11.
238. As of January 6, 2018, the top twelve cryptocurrencies by market capitalization (in
descending order) were Bitcoin, Ripple, Ether/Ethereum, Bitcoin Cash, Cardano, Litecoin,
NEM, Stellar, TRON, IOTA, Dash, and Monero. Cryptocurrency Market Capitalizations,
COINMARKETCAP.COM, https://coinmarketcap.com/ (last visited Jan. 6, 2018).
239. See The Cryptocurrency for Payments, LITECOIN, https://litecoin.org/ (last visited Jan. 28,
2018); Dash Is Digital Cash, DASH, https://www.dash.org/ (last visited Jan. 28, 2018); What
is Monero (XMR)?, supra note 231; BitcoinCash: Peer-to-Peer Electronic Cash, BITCOINCASH,
https://www.bitcoincash.org/ (last visited Jan. 28, 2018.
240. As of January 6, 2018, Bitcoin’s market capitalization was $293,094,614,674, and
Ethereum’s was $102,301,022,625. Cryptocurrency Market Capitalizations, supra note 238.
241. As of January 7, 2018, Bitcoin’s 24-hour trading volume amounted to over $17 billion of
traded units, while Ethereum’s amounted to almost $5 billion. Historical Snapshot - January
07, 2018, COINMARKETCAP.COM, https://coinmarketcap.com/historical/20180107/ (last
visited Jan. 7, 2018).
242. See The DAO Report, supra note 10, at 9–10.
Finally, given the prevalence of cryptocurrencies and interest in cryptocurrency

trading, the SEC will likely issue further guidance within the next several months,
either through enforcement actions or no-action relief. Cryptocurrency funds should,
in turn, continually re-evaluate the virtual currencies they can trade.
C. Safeguard Private Keys and Limit Trading Authorization
Cryptocurrency blockchains use cryptography to handle the validation and

security functions that would normally be performed by third party-auditors and/or
custodians.243 However, the tradeoff for such cryptography is use of private keys that
places the onus of safeguarding the property on the holder of the key. 244 Any
transmission or disclosure of that key—whether internally or to a third-party
custodian—significantly increases the risk of theft.245
The following best practices should thus be implemented to limit exposure of
private keys:
1. Never transmit keys electronically (by email, text messaging, or

file upload): Almost all commercially available methods of
electronic transmission, including emails on secure and/or private
servers, can be hacked. Moreover, administrative, IT, and other
employees may have access to email accounts or other electronic
systems. In turn, there is significant risk of employees stealing
such information, particularly because thefts of cryptocurrencies
are generally irreversible and untraceable. To the extent possible,
keys should be left on the computer that effected the
corresponding transaction.
2. Limit trading authorization: Trading authorization—and with it,
access to private keys or electronic wallets—should be limited
only to those who need it. For example, traders should not
authorize junior-level or administrative employees to enter trades
on their behalf.
3. Manage keys with a secure electronic wallet: It may be difficult to
securely store hundreds or thousands of private keys, as some
crypto funds will have. An electronic wallet allows those keys to
be imported into one location for easy access. 246 However, extreme
care should be taken in choosing a secure wallet. Most notably,
wallets should provide for “sweeping.” In such a wallet, the
243. Supra Part III(B).

244. See id.
245. See id.
246. See Cryptocurrency Wallet Guide: A Step-By-Step Tutorial, BLOCKGEEKS,
https://blockgeeks.com/guides/cryptocurrency-wallet-guide/ (last visited Jan. 28, 2018).
importing of private keys “sweeps,” or generates a new

transaction on the applicable blockchains and, in turn, creates new
private keys that are then available only inside of that wallet.247 In
contrast, wallets that import without sweeping can be hacked if
they import an insecure private key. 248
D. Mitigate and Devolve Tax Risk
The tax treatment of cryptocurrency transactions is complex, uncertain, and fast-

changing. Unlike in a traditional hedge fund, where conversion to fiat currency is
generally the best practice in handling distributions and redemptions, crypto funds
are best served by preferring in-kind distributions and redemptions. This potentially
avoids unwanted tax recognition events and permits investors to exit their investments
in the way best suited to their local jurisdiction and personal requirements. At the same
time, it protects the remaining investors by preventing the kind of liquidity crunch that
can occur when a large investor withdraws. Finally, in-kind redemptions reduce the
need for a large fiat currency cushion to handle the above exigencies and therefore
serves investors better by maximizing the share of investor capital deployed for profit
generation.
Crypto funds should also be sure to work with their accountants to maintain LIFO
treatment and minimize tax burden to their investors. This is of particular concern in
crypto funds as compared to other hedge funds, because of the unusually low tax basis
many of the digital assets their investor may contribute for subscriptions compared to
traditional instruments.
E. Mitigate Regulatory Risks
Currently, there are over 1,300 cryptocurrencies,249 and the number is rising
exponentially. The SEC has only taken preliminary steps in regulation, but has yet to
issue any opinion on the vast majority of cryptocurrencies and likely would lack the
resources necessary to analyze and issue an opinion with respect to each new
cryptocurrency. This combination of exponential growth and regulatory delay creates
substantial regulatory uncertainty and risk, particularly for funds that opt to trade
unconventional or novel tokens.
In order to mitigate that risk, crypto funds and their attorneys can take several
steps, including (among others) the following:
1. Disclosing a clear trading strategy to LPs, including the

cryptocurrencies that the fund will trade: Funds that can change
247. Private Keys: Import vs. Sweep, 99 BITCOINS, https://99bitcoins.com/know-more-private-

key-import-vs-sweep-difference/ (last visited Jan. 28, 2018).
248. See id.
249. Cryptocurrency Market Capitalizations, supra note 190.
their investment strategy or arbitrarily choose the

cryptocurrencies in which they invest may face stricter scrutiny,
both from unhappy LPs and regulatory agencies. Since each such
cryptocurrency carries its own unique risks, funds should disclose
risks associated with each traded cryptocurrency.
2. Disclosing the risk of regulatory changes to LPs and include a
“catch-all” exception for regulatory changes: Funds should
disclose risks associated with the ambiguity in current regulation
of cryptocurrencies and the likelihood of extraordinary regulatory
changes over the next few years. Just as importantly, funds can
include a “catch-all” or “back-door” exception that would permit
all necessary actions by the fund to comply with current and
future regulations or regulatory guidance.
3. Proactively seeking no-action relief: When in doubt, the safest
path is to request no-action relief for the activities of the fund,
particularly with respect to the trading of unconventional or novel
cryptocurrencies on which the SEC has provided no opinion.
4. Knowing your customers: Work closely with other service
providers on due diligence and compliance. Although this article
has not gone into the issue at length, money laundering and
similar issues are rife in the cryptocurrency world, and most
administrators, banks, and other service providers are new to the
issues involved in cryptocurrencies. Funds and their providers
should take advantage of the immutable nature of blockchain
records to conduct additional diligence and verification on their
investors. Particularly where the fund is taking investments and
making distributions in Bitcoin or other virtual currencies,
attorneys should work closely with service providers to
incorporate cryptocurrency-specific diligence alongside (but not
in place of) more traditional methods.
5. Establishing internal procedures and controls to protect the
crypto fund’s unregulated status: Internal procedures should be
established to ensure that cryptocurrency trades satisfy the 28-day
physical delivery exemption from CFTC jurisdiction. Moreover,
the fund should conduct internal reviews and use counsel to
assess the security or commodity status of a new cryptocurrency
prior to investment.
Note that these steps are not an exhaustive list and any such disclosures should
be made in consultation with experienced counsel.
V. Conclusion
This article has provided a brief overview of a new financial institution, the crypto
fund. By trading exclusively in commodity tokens, the crypto fund evades most hedge
fund-focused regulation. They thus have a significant competitive advantage vis-à-vis
other hedge funds, insofar as they can more freely solicit funding from small to mid-
sized investors, set compensation more flexibly, and receive preferential tax treatment
for conversions of cryptocurrencies. However, crypto funds also face additional
regulatory and technological risks, which require them to make additional disclosures
and safeguard client property internally.
The crypto fund represents a small niche in which funds can innovate, free of
excessive regulation. On first glance, the crypto fund may seem an accidental oversight
by regulators, who did not expect a commodity to be created that is as speculative as
cryptocurrencies. However, the timing and consistency of regulatory decisions from
the SEC, CFTC, and IRS suggest that these agencies are potentially communicating
with one another and attempting to build a coherent framework for cryptocurrencies,
slowly but incrementally. The crypto fund, then, may be less a historical accident, and
more an experiment to let the market operate, judge the results, and reevaluate
regulation.
Nevertheless, the current public fascination and increasing regulatory scrutiny of
cryptocurrencies nearly guarantees that further regulations will not be long to follow.
Future regulation may treat the crypto fund like any other hedge fund, or even
increase regulation beyond that. As this article has shown, however, cryptocurrencies
are not one-size-fits-all, and neither should cryptocurrency trading be typecast.
Regulators should take account of the unique technology underlying various types of
cryptocurrencies and make a regulatory regime that acknowledges and regulates those
differences according to the risks they pose.

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CRYPTO PROOF_AD[61869] (3) (DO NOT DELETE) 2/19/2018 1:48 PM

Rise of the Crypto Hedge Fund:

* Technology Advisor; J.D., Harvard Law School.

Winter 2018 Rise of the Crypto Hedge Fund 113

114 Stanford Journal of Law, Business & Finance Vol 23:1

Introduction ......................................................................................................................... 115

I. The Evolving State of Cryptocurrency Regulation ..................................................... 118

II. The Current State of Hedge Fund Regulation ............................................................ 130

IV. Best Practices for Crypto Funds .................................................................................. 152

Winter 2018 Rise of the Crypto Hedge Fund 115

V. Conclusion ...................................................................................................................... 156

116 Stanford Journal of Law, Business & Finance Vol 23:1

decentralized currency, operating via peer-to-peer transactions.6 While the technology

Winter 2018 Rise of the Crypto Hedge Fund 117

118 Stanford Journal of Law, Business & Finance Vol 23:1

I. The Evolving State of Cryptocurrency Regulation

As a preliminary matter, a consistent terminology must be established for crypto

17. See infra Part 3(A).

Winter 2018 Rise of the Crypto Hedge Fund 119

At the most basic level of understanding, a cryptocurrency is a “digital or virtual

120 Stanford Journal of Law, Business & Finance Vol 23:1

property of the person who tenders. In contrast, a cryptocurrency is validated in

Winter 2018 Rise of the Crypto Hedge Fund 121

Several cryptocurrencies, including Bitcoin and Litecoin, focus primarily on

have criticized as causing cartel-like centralization of mining power and wasting

122 Stanford Journal of Law, Business & Finance Vol 23:1

accept payment in Bitcoin in lieu of dollars. 37 Such cryptocurrencies enable that

Several cryptocurrencies, including Ether and NEO, facilitate smart contracting,

a computerized transaction protocol that executes terms of a contract.

Thus, the purpose is to facilitate peer-to-peer transactions, but with added

Other cryptocurrencies support decentralized applications built on top of such

Winter 2018 Rise of the Crypto Hedge Fund 123

applications created by the public.41 It thus supports a variety of applications,

Many cryptocurrencies are also issued primarily as a means of fundraising for

124 Stanford Journal of Law, Business & Finance Vol 23:1

C. SEC Regulation of Security Tokens

Winter 2018 Rise of the Crypto Hedge Fund 125

disclose sufficient information about such assets 60 or made fraudulent representations

126 Stanford Journal of Law, Business & Finance Vol 23:1

Moreover, the DAO Token went significantly beyond fundraising, essentially

2. Application of the Howey Test to the DAO Tokens

The DAO Tokens were determined to be “investment contracts,” a form of

69. See Christoph Jentzsch, Decentralized Autonomous Organization to Automate

Winter 2018 Rise of the Crypto Hedge Fund 127

79. Id. at 12-13.

128 Stanford Journal of Law, Business & Finance Vol 23:1

D. Non-Regulation of Virtual Currencies

a digital representation of value that can be digitally traded and

Winter 2018 Rise of the Crypto Hedge Fund 129

130 Stanford Journal of Law, Business & Finance Vol 23:1

by the end of 2015.93 In addition to the problem of numerosity, the pseudonymous

II. The Current State of Hedge Fund Regulation

Winter 2018 Rise of the Crypto Hedge Fund 131

97. 17 C.F.R. §§ 230.504-.506 (2017).

132 Stanford Journal of Law, Business & Finance Vol 23:1

non-exhaustive list of typical disclosures to investors includes each fund’s investment

1. Investment Advisers Act

Winter 2018 Rise of the Crypto Hedge Fund 133

115. The Investment Company Amendments Act, 15 U.S.C. § 80 (1970).

134 Stanford Journal of Law, Business & Finance Vol 23:1

Winter 2018 Rise of the Crypto Hedge Fund 135

2. Investment Company Act