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(I) Regulating Crypto Hedgefunds (CaLR)
(I) Regulating Crypto Hedgefunds (CaLR)
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DOI: https://doi.org/10.15779/Z38M03XX77
Copyright © 2019 California Law Review, Inc. California Law Review, Inc. (CLR) is a
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* Drew Schaefer: J.D. 2019, University of California, Berkeley, School of Law. My deepest
gratitude to Robert Bartlett, Karl Cole-Frieman, Anthony Wise, and the editorial staff of the California
Law Review for their helpful comments and suggestions.
1381
INTRODUCTION
In the wake of the Bernard Madoff Ponzi scheme, the Securities and
Exchange Commission (SEC) adjusted its rules to prevent future fraud.1 Despite
blindsiding the SEC and many in the financial industry, the culprit was all too
familiar: a bad adviser fleecing his trusting clients.2 The problem goes back
millenia. In 1754 B.C., Hammurabi had already prescribed a way to circumvent
bad financial actors. To protect the grain and precious metal stored in another’s
house for safekeeping, the Code required a system of contracts and third-party
verification.3 Law 122 read: “If a man wishes to give silver (or) gold or anything
whatsoever to a man for safe custody, he shall show anything whatsoever that he
gives to witnesses, he shall draw up a contract and (thus) give (them) for safe
custody.4“ Now, nearly four thousand years later, hedge funds and regulators
must revisit what is considered safe custody when they eschew transactions in
grain or bonds for the cryptographic technology behind Bitcoin and other
cryptocurrencies.
For traditional investment funds, the SEC has protections in place to assure
investors that their accounts contain the assets their advisers say they contain.5
In securities parlance, this is known as the custody rule.6 The rule requires
registered investment advisers with possession of their clients’ assets to
implement controls to protect those assets from being “lost, misused,
1. See Press Release, U.S. Sec. & Exch. Comm’n, The Securities and Exchange Commission
Post-Madoff Reforms (Apr. 2, 2012), https://www.sec.gov/spotlight/secpostmadoffreforms.htm
[https://perma.cc/ZDT3-5U7Y] [hereinafter Post-Madoff Reforms].
2. See Diana B. Henriques & Alex Berenson, The 17th Floor, Where Wealth Went to Vanish,
N.Y. TIMES (Dec. 14, 2008), https://www.nytimes.com/2008/12/15/business/15madoff.html
[https://perma.cc/5USX-KGUD].
3. See K.V. Nagarajan, The Code of Hammurabi: An Economic Interpretation, 2 INT’L J. OF
BUS. & SOC. SCI. 108. (2011).
4. Id. at 111.
5. See Post-Madoff Reforms, supra note 1 (“The rules provide greater assurance to investors
that their accounts contain the funds that their investment adviser and account statements say they
contain.”).
6. See Advisers Act Rule 206(4)-2, 17 C.F.R. § 275.206(4)-2 (2019)).
This Note will review why it is difficult to apply the current custody rule to
cryptocurrency hedge funds, and how the rule can be modified to better fit the
peculiarities of this new asset class. First, this Note looks at the present state of
the rule and its general application to hedge funds. Second, it examines how
cryptocurrency is “held” and the challenges this presents to hedge fund managers
and their custodians. Third, it analyzes why the current rule does not meet these
challenges. Finally, this Note presents an alternative mechanism that the SEC
can adopt for applying the rule.
I.
THE CUSTODY RULE: CURRENT FRAMEWORK
The SEC first began to regulate custodial practices in 1962, when it adopted
Rule 206(4)-2 under the Investment Advisers Act of 1940 (“IAA” or “the
Act”).16 This rule, which included adviser disclosure and surprise examinations,
remained fundamentally unchanged until 2003,17 when the SEC amended the
rule to introduce the concept of a qualified custodian.18 In 2010, following the
Madoff scandal, the SEC again amended the rule to add additional controls.19
Under the IAA, an “investment adviser” is any person who advises others
on the purchase or sale of securities in exchange for compensation.20 Although
this definition is quite broad, there are important exemptions. For example, most
hedge fund managers will fall under the definition of “investment adviser,” but
may nevertheless be exempt from required SEC registration. Since the custody
rule only applies to SEC-registered investment advisers (“registered advisers”),
managers falling under one of the exemptions may be able to avoid the
requirements of the custody role.
16. Robert E. Plaze, Regulation of Custodial Practices Under the Investment Advisers Act of
1940 Rule 206(4)-2, Investment Adviser Association Investment Adviser Compliance Conference,
Crystal City, VA at 1 (March 6–7, 2014), https://docplayer.net/17221319-Regulation-of-custodial-
practices-under-the-investment-advisers-act-of-1940-rule-206-4-2.html [https://perma.cc/WH5D-
8356].
17. See id.
18. See id. at 2.
19. See Staff Responses to Questions About the Custody Rule, U.S. SEC. & EXCH. COMM’N,
https://www.sec.gov/divisions/investment/custody_faq_030510.htm [https://perma.cc/PJ5L-UEQN];
see also DOUGLAS L. HAMMER ET AL., U.S. REGULATION OF HEDGE FUNDS 325 (2013).
20. HAMMER, supra note 19, at 9.
21. See Advisers Act Rule 206(4)-2(a), 17 C.F.R. § 275.206(4)-2(a) (2018); HAMMER, supra
note 19, at 325; Plaze, supra note 16, at 5.
1. Qualified Custodian
A registered investment adviser with custody of a client’s assets must hold
those assets with a “qualified custodian” in either (a) separate accounts under
each client’s name or (b) accounts in the adviser’s name that hold only the
clients’ assets.22 Qualified custodians include banks, broker-dealer firms, futures
commission merchants, and foreign financial institutions that customarily hold
financial assets for their customers in segregated accounts.23
An adviser may hold client assets with more than one qualified custodian.24
However, the assets must be held in such a way that the custodian can provide
account information to the clients.25 In 2003, the SEC stated that stock
certificates kept in an adviser’s bank safety deposit box would not be considered
held in “accounts” with the qualified custodian, and therefore would not satisfy
the rule.26 This will be at issue when we look at the unique characteristics of how
cryptocurrency is held.
2. Notice to Clients
Once a registered investment adviser with custody opens an account on the
client’s behalf or makes changes to the custodial arrangement, they must
promptly notify the client in writing. This notice must provide the qualified
custodian’s name, address, and information about how the funds are being held.27
For hedge funds, discussed in more detail in Section B, limited partners who do
not wish to receive these notices can elect an independent representative to act
as an agent and receive the notices on their behalf.28
4. Surprise Examination
Each adviser must ensure that an independent public accountant performs
at least one surprise examination per year to verify their clients’ assets.32 The
accountant must schedule the examination at a different time each year to
maintain the “surprise.”33 Under the agreement with the adviser, the accountant
must (1) file Form ADV-E with the SEC within 120 days of the examination; (2)
notify the SEC within one business day of finding any material discrepancy
during the exam; and (3) if the engagement is terminated, notify the SEC of the
date and reason for the termination.34 Essentially, an independent accountant will
make sure the assets that the adviser is telling its clients are there are actually
there.
cryptocurrency hedge funds launched in 2016 and 2017 had well under $150
million in assets under management. Their managers were therefore exempt from
the custody rule.38 But with the explosion in the price of Bitcoin and other
cryptocurrencies that began in the summer of 2017, along with continued
investor interest, many of these funds held above $150 million in assets by 2018
or aspired to do so.39 The SEC will have to decide how to apply the custody rule
to these newly emerged funds as they surpass $150 million.40
In addition, even if the investment adviser is registered and has custody of
client funds, the custody rule’s requirements are different for hedge funds. If the
registered investment adviser advises a limited partnership and sends each of the
fund’s clients audited annual financial statements within 120 days of each fiscal
year, the adviser is not required to notify clients of the qualified custodian’s
information, have the qualified custodian deliver quarterly account statements,
or have their clients’ assets verified by a surprise examination.41 The accountant
performing the audits must be independent from the adviser and registered with
the Public Company Accounting Oversight Board (PCAOB), and the financial
statements must be prepared in accordance with generally accepted accounting
principles (GAAP).42 As long as the hedge fund’s accountant is able to comply
with GAAP in their reporting, the fund’s manager will likely take advantage of
the exemption.43 As most funds will comply with GAAP and fall under the
exception, we end up with two hard rules: first, the hedge fund manager must
maintain its clients’ assets with a qualified custodian; and second, the manager
must arrange for a PCAOB-registered accountant44 to audit the fund’s assets
every year.
Further complicating the application of the rule, there has been much debate
as to whether cryptocurrency is a security at all. If a hedge fund does not engage
in the “purchase or sale of securities,” its manager will be exempt from
such trust account must be maintained with a Qualified Custodian.”). See also HAMMER, supra note 19,
at 332.
38. See Cryptocurrency Investment Fund Industry Graphs and Charts, CRYPTO FUND RES.,
https://cryptofundresearch.com/cryptocurrency-funds-overview-infographic [https://perma.cc/Q8VX-
NY9Q] (“The vast majority of crypto investment funds are small. Half have less than $10 million in
assets under management (AUM).”).
39. See, e.g., Cryptocurrency Fund L.P., Notice of Exempt Offering of Securities (Form D) (July
7, 2017), http://pdf.secdatabase.com/2809/0001711332-17-000001.pdf [https://perma.cc/G2D5-
V8YQ] (seeking a total offering of 200mm).
40. Form ADV is used by investment advisers to register with the SEC and state securities
authorities. See Fast Answers: Form ADV, U.S. SEC. & EXCH. COMM’N, https://www.sec.gov/fast-
answers/answersformadvhtm.html [https://perma.cc/Q28G-XRGP].
41. 17 C.F.R. § 275.206(4)-2(a)(4) (2019).
42. Id.
43. See HAMMER, supra note 19, at 330.
44. The Public Company Accounting Oversight Board is a non-profit corporation established
by Sarbanes-Oxley Act of 2002 to supervise the audits of public companies and broker-dealers. The
SEC approves the PCAOB’s rules, standards, and budget. See About the PCAOB, PUB. COMPANY
ACCT. OVERSIGHT BOARD, https://pcaobus.org/About/Pages/default.aspx
[https://pcaobus.org/About/Pages/default.aspx].
regulation under the IAA. In addition, there is an argument that certain coins are
not “client funds.”45
When hedge funds are not investing in traditional securities, like stocks or
bonds, but rather in cryptocurrency operating on a digital ledger, how do they
comply with these rules? To answer this question, we must first look at how
cryptocurrency is held and stored and how that differs from traditional securities.
We will then look at challenges in applying the rule to this novel financial
instrument.
II.
CRYPTOCURRENCY AND CUSTODY
Unlike traditional financial assets, cryptocurrencies are not based on
institutional trust. This difference is important in the custody context. With
traditional assets, we believe that a central party —whether a bank, Paypal, or a
grain storage facility—is maintaining a ledger that is properly recording the
assets they hold and marking which of those assets belong to us. We do not
expect to see the ledger—we trust that the institution has protections in place to
prevent internal fraud and attacks from outsiders. Blockchain, the technology
that underpins cryptocurrencies like Bitcoin, is based on a fundamentally
different premise. This Part will first describe how cryptocurrency functions in
general, and then zero in on private keys, which relate directly to the application
of the custody rule.
45. The rule states “If you are an investment adviser . . . it is a fraudulent, deceptive, or
manipulative act, practice or course of business . . . for you to have custody of client funds or securities
unless . . .”17 C.F.R. § 275.206(4)-2(a) (emphasis added).
46. See PEDRO FRANCO, UNDERSTANDING BITCOIN 9–10 (2015).
47. Id. at 9.
48. See WINKLEVOSS BITCOIN TRUST, AMENDMENT NO. 8 TO FORM S-1 REGISTRATION
STATEMENT 14 (Dec. 7, 2016),
https://www.sec.gov/Archives/edgar/data/1579346/000119312516786685/d302498ds1a.htm
[https://perma.cc/T8NS-YL5T].
“altcoins,”49 including Ethereum, Ripple, and Litecoin. They often vary the
protocol and structure of Bitcoin, such as how the coins are generated, which
programming language is used, or the number of coins issued.50 Nonetheless, an
examination of what comprises each individual Bitcoin sheds light on the
operation of other cryptocurrencies. And although this decentralized data
structure can have many applications, for the purposes of hedge funds and the
custody rule, we only need to examine how it is used to manage and “hold”
cryptocurrency.
To “hold” one Bitcoin, you need (1) access to a blockchain, (2) a Bitcoin
address, (3) the private key, and (4) some type of storage device, such as a
Bitcoin wallet.51
The blockchain is essentially the ledger. It uses an algorithm to record all
cryptocurrency transactions and appends them as cryptographic “blocks” onto
the existing ledger.52 Like pages in a book, each block of information adds new
data to the list of transactions.53 The data in these blocks is then used to both
prove current ownership and record transfer of ownership.54 This ledger is shared
and updated simultaneously for each user, or “node.”55 While the grain merchant
may be required to call in his witness in the event of a dispute, here a multitude
of users all act as witnesses, free of individual influence.56
Rather than posting the name of each owner on the ledger, the blockchain
is made up of numbers, known as addresses. This is like the bank account number
to which you can send funds.57 Each address is represented by a long string of
letters and numbers resembling the following:
1Jc3MuGF3ALn12anPN3Xzqq13PP1e
49. “Cryptocurrencies” are often referred to as coins, tokens, or altcoins. Bitcoin and other
cryptocurrencies used as a transfer of value are referred to as “coins.” Cryptocurrencies that are built on
top of platforms, like Ethereum, do not themselves facilitate the transfer of value and are referred to as
“tokens.” “Altcoins” refers generally to cryptocurrencies that are modifications of Bitcoin’s code, such
as Litecoin. For the purposes of this paper, we will refer to all three as cryptocurrencies, unless the topic
requires further specificity. See Altcoin, INVESTOPEDIA,
https://www.investopedia.com/terms/a/altcoin.asp [https://perma.cc/7PAB-G8WQ].
50. Sarah J. Hughes & Stephen T. Middlebrook, Advancing a Framework for Regulating
Cryptocurrency Payments Intermediaries, 32 YALE J. ON REG. 495, 505 (2015).
51. See CONRAD BARSKI & CHRIS WILMER, BITCOIN FOR THE BEFUDDLED 7–14 (2015).
52. Id. at 19.
53. See DANIEL DRESCHER, BLOCKCHAIN BASICS 63–69 (2017).
54. See id. at 77.
55. In fact, there is an additional database called the “Unspent Transactions Outputs cache” that
records available funds for each address. IMRAN BASHIR, MASTERING BLOCKCHAIN 125 (2017);
FRANCO, supra note 46, at 15. However, like much of the overview here, a more simplistic overview is
sufficient for purposes of applying the custody rule.
56. See DRESCHER, supra note 53, at 29–32, 79.
57. BARSKI & WILMER, supra note 51, at 10.
to authorize a single transaction, the use of multiple keys can also minimize the
risk posed by bad internal actors.74 Thus, multiple keys allow holders to avoid
leaving the power for malfeasance in one individual. For example, a multiple-
signature address could create five private keys that are all necessary to unlock
one address. The qualified custodian could then distribute these keys to
designated employees, giving the fifth key to a director. Similarly, a custodian
could achieve the same effect by “fragmenting” the private keys. In this
approach, the private key is split into multiple pieces, with a certain number of
pieces required to come together to authorize a transaction. For example, the key
could be split into three fragments with two necessary to perform a transaction,
or a “2 of 3” private key.
The use of private keys is illustrated by the Winklevoss Bitcoin Trust
exchange-traded fund75 registration statement filed with the SEC in 2016.76 The
fund planned to use the Gemini Trust Company, LLC, as a custodian
implementing a “Cold Storage System.”77 The fund would issue shares tracking
the price of bitcoin on the Winklevosses’ Gemini Exchange.78 The fund’s
management of the private keys listed the following features (emphasis added):
Private Key Management. The Custodian generates, stores and manages
the private keys that control the Trust’s bitcoin . . . . The Cold Storage
System only uses HSMs . . . used by the Custodian to digitally sign
(i.e., authenticate) any transfer of the Trust’s bitcoin. The Custodian’s
Cold Storage System utilizes multiple-signature (“Multisig”)
technology with a “2-of-3” signing design that requires a signature from
at least two (2) of three (3) potential Signers in order to move the Trust’s
bitcoin.79
From this language, we can see that “holding” cryptocurrency safely requires
some technical sophistication and that digital assets have fundamentally different
properties than traditional asset classes.
III.
CHALLENGES IN APPLYING THE CUSTODY RULE
The unique way that cryptocurrency is held and stored affects the ability of
fund managers to comply with the rule. Several of these problems stem from the
qualified custodian requirement. First, there is a lack of qualified custodians with
experience in cryptocurrency. Second, even if the custodian has developed
services in this area, different coins require different storage, and the custodian
may not be able to hold every asset a manager wishes to invest in. Finally, a
custodian who does accept a fund’s cryptocurrency faces additional challenges
from forks, airdrops, and liquidity.
80. Although there are frequent news stories about large custodians developing cryptocurrency
products, as of writing, none of the largest hedge fund custodians act as qualified custodians for
cryptocurrency assets. Neer Varshney, Coinbase’s Cryptocurrency Custodial Service is Open for
Business, HARD FORK (July 2, 2018), https://thenextweb.com/hardfork/2018/07/02/coinbases-
cryptocurrency-custody [https://perma.cc/T7RL-QRHC] (“There has been a lack of reliable custodian
services for cryptocurrencies all across the globe due to uncertainty in the regulations.”).
81. Qualified Custodian Kingdom Trust Now Accepting Investments in cash and Stellar
Lumens, KINGDOM TRUST (JULY 5, 2018), https://www.kingdomtrust.com/news/news-qualified-
custodian-kingdom-trust-now-accepting-investments-in-zcash-and-stellar-lumens
[https://perma.cc/F5WW-K4ZB].
82. See Vault: We’ve Built a Fortress for You, XAPO, https://www.xapo.com/en/security#vault
[https://perma.cc/3TVH-QYZK].
83. Joon Ian Wong, Photos: The Secret Swiss Mountain Bunker Where Millionaires Stash Their
Bitcoins, QUARTZ (Oct. 17, 2017), https://qz.com/1103310/photos-the-secret-swiss-mountain-bunker-
where-millionaires-stash-their-bitcoins/ [https://perma.cc/R8XW-JBFJ].
84. Sam McIngvale, Coinbase Custody is Officially Open for Business, THE COINBASE BLOG
(July 2, 2018), https://blog.coinbase.com/coinbase-custody-is-officially-open-for-business-
182c297d65d9 [https://perma.cc/UB4T-E5DT].
85. Alex Morris, Coinbase Custody Now Holds More Than $500 Mln in Digital Assets, U
TODAY (Feb. 21, 2019), https://u.today/coinbase-custody-now-holds-more-than-500-mln-in-digital-
assets [https://perma.cc/5QC8-V5VP].
86. 17 C.F.R. § 275.206(4)-2(a) (2019).
87. See David Hundeyin, BitGo Receives Approval to Operate as Regulated Cryptocurrency
Custodian, CCN (Sept. 16, 2018), https://www.ccn.com/bitgo-receives-approval-to-operate-as-
regulated-cryptocurrency-custodian [https://perma.cc/NZA9-R2HY]; Yogita Khatri, TokenSoft to Offer
Coincase Custody as STO Client Option, COINDESK (Dec. 20, 2018),
https://www.coindesk.com/tokensoft-to-offer-coinbase-custody-as-sto-client-option
[https://perma.cc/52QD-VEDV].
88. See Learning About Xapo – General: Does Xapo Support Other Cryptocurrencies Besides
BitCoin?, XAPO, https://support.xapo.com/learning/about-xapo/general/does-xapo-support-other-
cryptocurrencies-besides-bitcoin [https://perma.cc/K6SE-4GS5] (“While you have access to any
currency across the entire world with your Xapo account, the only cryptocurrency you can use and store
is bitcoin (BTC)”).
89. Laura Shin, Can’t Invest in a Crypto Hedge Fund? DIY With Shapeshift’s Prism, FORBES
(Aug. 7, 2017), https://www.forbes.com/sites/laurashin/2017/08/07/cant-invest-in-a-crypto-hedge-
fund-diy-with-shapeshifts-prism/ [https://perma.cc/78W4-HDF7].
then having to pull all those off the exchanges if you want to be secure.90
After that, one might need to download “wallet software for 10 different
cryptocurrencies and syncing with those blockchains.”91
Monero, a privacy-focused coin, illustrates why handling multiple coins
can be challenging. Like Bitcoin, Monero uses a ledger to record transactions.92
However, to achieve superior privacy, it also uses a tool called “ring signatures”
to mix the address of a transacting party with other addresses, making it more
difficult to determine which address in the group produced the signature.93 To
achieve this design, Monero uses a different codebase than Bitcoin and its
derivatives.94 As a result, multisignature signing for Monero is not yet
supported.95 Because the code base is frequently updated by the developers,
keeping abreast of the changes requires maintenance.96 For coins without
widespread adoption, it may not be worthwhile for even technologically savvy
custodians to commit the manpower to hold these assets. Fund managers would
thus be put in the difficult position of holding some assets with a qualified
custodian while managing others in ways that violate the custody rule.
Some custodians might simply charge more. Coinbase Custody, which
intends to offer support for most major cryptocurrencies, plans to charge a startup
fee of $100,000 along with a monthly fee based on assets.97 For a smaller fund,
this could be significantly higher than a typical fee of five to ten basis points on
the assets under management.98 These fees are indirectly billed to investors as a
90. Id.
91. Id.
92. See Private Digital Currency, MONERO, https://getmonero.org [https://perma.cc/R3UY-
7L2W] (“Monero is a decentralized cryptocurrency, meaning it is secure digital cash operated by a
network of users. Transactions are confirmed by distributed consensus and then immutably recorded on
the blockchain.”).
93. See Moneropedia, MONERO,
https://getmonero.org/resources/moneropedia/ringsignatures.html [https://perma.cc/Y5BT-ULMR]
(“One of the security properties of a ring signature is that it should be computationally infeasible to
determine which of the group members’ keys was used to produce the signature . . . . So, ring signatures
ensure that transaction outputs are untraceable.”).
94. GenericShill, Monero Wallets in 2018: Finally Some Progress in Light Wallets, ALTCOIN
TRADING (Jan. 3, 2017), https://www.altcointrading.net/monero-wallet [https://perma.cc/C896-
SMKV].
95. The Next Monero Client Release Will Have Full Multisig Support, NEWSBTC (Dec. 18,
2017), http://www.newsbtc.com/2017/12/18/next-monero-client-release-will-full-multisig-support
[https://perma.cc/6UJT-USA9] (“Monero, the coin known for its privacy and anonymity, will receive
multisig support soon.”).
96. GenericShill, supra note 94.
97. It will be interesting to see how Coinbase Custody handles technological challenges and
how many different coins it ultimately supports. See Frank Chaparro, Coinbase is Going After Big Hedge
Fund Money with its New Cryptocurrency Security Platform, BUS. INSIDER (Nov. 16, 2017),
http://www.businessinsider.com/coinbase-going-after-hedge-fund-money-with-new-cryptocurrency-
security-platform-2017-11 [https://perma.cc/5H7S-G2KS].
98. William F. Jarvis, Understanding the Cost of Investment Management: A Guide for
Fiduciaries, COMMONFUND INSTIT. 6 (Oct. 2015),
https://www.caia.org/sites/default/files/understanding_the_cost_of_investment_management.pdf
fund expense.99 For funds like Carlson-Wee’s Polychain, which has expertise in
handling numerous digital assets, managers as well as investors may be
interested in avoiding the expense and likely limitations of a qualified custodian.
[https://perma.cc/MW7X-75WC] (“As an example, these costs, which are generally 5 to 10 basis points
for U.S. funds, rise to 10 to 25 basis points for large international funds and can easily exceed 25 basis
points for small international funds.”).
99. Kent Oz, Independent Fund Administrators as a Solution for Hedge Fund Fraud, 15
Fordham J. Corp. & Fin. L. 329, 355 (2009).
100. See NARAYAN PRUSTY, BUILDING BLOCKCHAIN PROJECTS 32 (2017).
101. FRANCO, supra note 46, at 108–09.
102. IG Analyst, What are Bitcoin Forks and How Do They Work?, IG (Nov. 20, 2018),
https://www.ig.com/au/trading-opportunities/what-are-bitcoin-forks-and-how-do-they-work--181120,
[https://perma.cc/QJZ8-XFMA].
103. See, e.g., Ermos Kyriakides, All You Need to Know About Airdrops, HACKERNOON (July
31, 2018), https://hackernoon.com/all-you-need-to-know-about-airdrops-98b1b5af7941
[https://perma.cc/C5RN-PG2K].
104. See Bitcoin Cash – Frequently Asked Questions, COINBASE,
https://support.coinbase.com/customer/portal/articles/2853600-bitcoin-cash---frequently-asked-
questions [https://perma.cc/LW4E-4TDH].
have a conflict of interest balancing the security of the fund with the desire to
meet certain high-water marks and hurdle rates. With traditional asset classes,
fund managers already have an incentive to massage results through
discretionary valuation of assets at the end of an accounting period.111 Here, a
qualified custodian may alleviate this concern: the custodian would have less
incentive than a fund manager to take control of new assets before their security
or viability could be verified.
Apart from the issue of whether or not to adopt a token arising from an
airdrop or fork, the custodian and hedge fund manager may disagree on whether
the new token is a fraudulent offering, which could violate securities laws. In
1999, the SEC acted against “free stock” offerings,112 in which companies sought
promotion by giving away free stock through their websites.113 Because future
SEC actions could similarly target the companies involved in airdrops, a
qualified custodian would be hesitant to hold these potentially fraudulent assets.
If the fund manager disagreed with the qualified custodian’s risk assessment,
they would once again be left choosing between violating the custody rule and
forgoing holding the asset.
111. DONALD R. CHAMBERS ET AL., ALTERNATIVE INVESTMENTS: CAIA LEVEL 1 399 (3d ed.
2015); Vikas Agarwal, Naveen D. Daniel & Narayan Y. Naik, Role of Managerial Incentives and
Discretion in Hedge Fund Performance, 64 J. OF FIN. 2221 (2009).
112. Press Release, U.S. Sec. & Exch. Comm’n, SEC Brings First Actions to Halt Unregistered
Online Offerings of So-Called “Free Stock” (July 22, 1999),
https://www.sec.gov/news/headlines/webstock.htm [https://perma.cc/KHN4-T8S3].
113. See id. (“In each of the four cases, the investors were required to sign up with the issuers’
web sites and disclose valuable personal information in order to obtain shares. . . . Through these
techniques, issuers received value by spawning a fledgling public market for their shares, increasing
their business, creating publicity, increasing traffic to their websites, and, in two cases, generating
possible interest in projected public offerings.”).
114. Houman B. Shadab, The Law and Economics of Hedge Funds: Financial Innovation and
Investor Protection, 6 BERKELEY BUS. L.J. 240, 252 (2009).
115. See Staff Letter, supra note 109.
party wallet.116 If fund managers are forced to comply with the custody rule, they
may have difficulty executing certain trading strategies or acting in times of
heavy volatility. For example, if the fund is relying on a prime broker that is not
also a qualified custodian, it may have difficulty meeting margin calls within the
required timeframe.
Secondly, even though hedge funds have discretionary liquidity
restrictions, such as side pockets and gates,117 fund managers may struggle with
liquidity restrictions in periods of mass sell offs. This highlights a problem with
the current custody rule. In the event of a market crash, more nimble funds
holding their own keys would be able to exit the market, further lowering the
market. Meanwhile, non-exempt funds in excess of $150 million would be left
holding the bag as their qualified custodians worked to retrieve their keys from
the vault. Foreseeing this illiquidity, prime brokers may be less willing to extend
long-term credit.118
116. Vault: We’ve Built a Fortress for You, supra note 82.
117. A gate limits the amount of a hedge fund’s assets that can be withdrawn by investors. A side
pocket is a type of account used by hedge funds to separate liquid and illiquid assets. See James Chen,
Gate Provision, INVESTOPEDIA (Mar. 26, 2018),
https://www.investopedia.com/terms/g/gateprovision.asp [https://perma.cc/Q3ZA-YNXP]; James
Chen, Side Pocket, INVESTOPEDIA (Jan. 22, 2018),
https://www.investopedia.com/terms/s/sidepocket.asp [https://perma.cc/2PS2-CSHD].
118. See GEORGE O. ARAGON ET AL., U.S. SEC. & EXCH. COMM’N, STAFF PAPER: HEDGE FUND
LIQUIDITY MANAGEMENT (2017), https://www.sec.gov/files/dera_hf-liquidity-management.pdf
[https://perma.cc/Y72P-DQKT] (“Interestingly, the committed period of financing from a fund’s
creditors is unrelated to portfolio illiquidity. A possible interpretation for this ‘non-result’ is that, while
funds pursuing illiquid strategies have a greater demand for longer-term financing, its creditors are less
willing to extend long-term loans due to the illiquid nature of the fund’s assets.”).
119. 17 C.F.R. § 275.206(4)-2 (2019).
120. SEC. & EXCH. COMM’N, REPORT OF INVESTIGATION PURSUANT TO SECTION 21(A) OF THE
SECURITIES EXCHANGE ACT OF 1934: THE DAO, RELEASE NO. 81207 (July 25, 2017),
https://www.sec.gov/litigation/investreport/34-81207.pdf [https://perma.cc/4MXK-C4YL] [hereinafter
the DAO Report].
121. SEC v. W.J. Howey Co., 328 U.S. 293 (1946).
122. The Dao Report, supra note 120, at 11.
123. SEC v. Shavers, No. 4:13-CV-416, 2013 WL 4028182, at *2 (E.D. Tex. Aug. 6, 2013),
adhered to on reconsideration, No. 4:13-CV-416, 2014 WL 12622292 (E.D. Tex. Aug. 26, 2014);
Alexander B. Lindgren, Blockchain Regulation: Growing Pains of A Financial Revolution, 59 ORANGE
COUNTY LAW. 38, 40 (October 2017).
124. See A Securities Law Framework for Blockchain Tokens, COINBASE (Dec. 7, 2016),
https://www.coinbase.com/legal/securities-law-framework.pdf [https://perma.cc/AEL9-ZBG3].
125. Id.
126. Public Statement, Jay Clayton, Chairman, Sec. & Exch. Comm’n, Statement on
Cryptocurrencies and Initial Coin Offerings (Dec. 11, 2017), https://www.sec.gov/news/public-
statement/statement-clayton-2017-12-11#_ftn5 [https://perma.cc/VMJ2-VMNR].
127. Id.
128. As mentioned previously, custody is defined as “holding, directly or indirectly, client funds
or securities, or having any authority to obtain possession of them.” Advisers Act Rule, 17 C.F.R.
§ 275.206(4)-2(d)(2) (2019) (emphasis added).
129. Form ADV: Uniform Application for Investment Advisor Registration and Report by
Exempt Reporting Advisers, Item 9(F), https://www.sec.gov/about/forms/formadv-part1a.pdf
[https://perma.cc/2BVM-CKP7] (added in 2011); see Rules Implementing Amendments to the
Investment Advisers Act of 1940, Investment Advisers Act Release No. 3221, 76 Fed. Reg. 42,950,
42,972 (July 19, 2011).
130. See Gina Clarke, Why Debit Cards and Visa Could Save Cryptocurrencies, FORBES (Oct.
22, 2018), https://www.forbes.com/sites/ginaclarke/2018/10/22/why-debit-cards-and-visa-could-save-
cryptocurrencies/ [https://perma.cc/7AAT-EESN].
131. See Kurt Wagner, World’s First Bitcoin ATM Opens In Vancouver, Canada, MASHABLE
(Oct. 30, 2013), https://mashable.com/2013/10/30/bitcoin-atm-2/#uLHkI4tLRsqC
[https://perma.cc/WUX8-Y96N].
132. See Paying With Bitcoin, EXPEDIA.COM,
https://www.expedia.com/Checkout/BitcoinTermsAndConditions [https://perma.cc/72PZ-B3K6]
(“Our acceptance of Bitcoin is powered by our partner, Coinbase. We do not guarantee and are not
responsible for the availability of Coinbase’s services.”).
133. See, e.g., Cryptocurrency Fund L.P., Notice of Exempt Offering of Securities, Form D (July
7, 2017),
https://www.sec.gov/Archives/edgar/data/1711332/000171133217000001/xslFormDX01/primary_doc
.xml [https://perma.cc/83H5-MCRH].
134. See Advisers Act Rule 206(4)-2(b)(2), 17 C.F.R. § 275.206(4)-2(b)(2) (2019); HAMMER,
supra note 19, at 326.
135. 17 C.F.R. § 275.206(4)-2(b)(2).
136. See JUAN BATIZ-BENET, JESSE CLAYBURGH & MARCO SANTORI, THE SAFT PROJECT:
TOWARD A COMPLIANT TOKEN SALE FRAMEWORK 15 (Oct. 2, 2017),
https://saftproject.com/static/SAFT-Project-Whitepaper.pdf [https://perma.cc/SD6P-AZP7] (“In short,
the SAFT provides investors with the right to fully-functional utility tokens, delivered once the network
is created and the tokens are functional. The SAFT is very likely a security, namely an investment
contract.”); see also Carolynn Levy, Safe Financing Documents, Y COMBINATOR (Sept. 2018),
https://www.ycombinator.com/documents [https://perma.cc/RM2E-97MQ].
137. See SAFT for Filecoin Token Presale (Series S-2), PROTOCOL LABS,
https://coinlist.co/assets/index/filecoin_index/Protocol%20Labs%20-
%20SAFT%20for%20Filecoin%20Token%20Presale-
0f43e05c4ad1c0bd8993b60c4d6bf3cbd4f3d278dd7a62dde1972c9d82c65184.pdf
[https://perma.cc/A3W6-UBFD] (“The offer and sale of this security instrument has not been registered
under the U.S. Securities Act of 1933, As Amended (The “Securities Act”), or under the securities laws
of certain states. This security may not be offered, sold or otherwise transferred, pledged or hypothecated
except as permitted under the act and applicable state securities laws pursuant to an effective registration
statement or an exemption therefrom.”) (alteration in original). The original SAFT template can be
downloaded at https://saftproject.com/static/Form-of-SAFT-for-token-pre-sale.docx
[https://perma.cc/U7SQ-WEJL].
138. See SAFT for Filecoin, supra note 137, at 2.
would meet the criteria of the private placement exemption and therefore would
not require a qualified custodian. This would be attractive to fund managers who
invest in a diverse range of pre-ICOs and would otherwise struggle finding
custodians able to accommodate these yet-to-be-released tokens. However, other
difficulties would arise, such as the applicability of a mandatory “holding
period” under Rule 144.139
IV.
INTRODUCING AN ALTERNATIVE MECHANISM FOR COMPLIANCE WITH RULE
206(4)-2
In light of the complications of applying the current custody rule to
cryptocurrencies, the SEC has three possible options. First, it could institute a
period of no action while the market for specialized qualified custodians
develops. Funds would continue operating without fear of immediate censure in
the hope that a mature and sophisticated set of qualified custodians would
develop. Second, a more aggressive SEC could take enforcement action
immediately and fine fund managers that are not complying with the rule. But in
the absence of fraud or tangible harm to investors, wide-reaching fines and cease-
and-desist orders may be hard to justify. Solving the fundamental inconsistency
between the rule and practice requires a more comprehensive regulatory
response. The third option is to issue a no-action letter that specifically sets out
new requirements for the custody rule for investment advisers managing
cryptocurrency hedge funds. This is the best choice. The rule should be adjusted
to allow fund managers to maintain their client’s digital assets on exchanges and
in their own custody, provided certain policies and procedures are met. These
requirements can follow the spirit of the custody rule by mitigating the sorts of
abuses the rule originally set out to prevent: investor funds being “lost, misused,
misappropriated or subject to the advisers’ financial reverses.”140 Where the rule
cannot protect investors, the SEC should encourage the use of insurance to
mitigate losses. This Part explores both the regulatory basis and rationale for
changing the rule and what those modifications should entail.
139. Rule 144 is an SEC regulation that provides an exemption from registration for the sale of a
security if certain conditions are met. One of those conditions set under 144(b)(1)(ii) and (d)(1)(ii) is a
one-year holding period for securities issued by a non-reporting company, which includes the majority
of ICOs. See 17 C.F.R. § 230.144 (“Persons deemed not to be engaged in a distribution and therefore
not underwriters”); Rule 144: Selling Restricted and Control Securities, U.S. SEC. & EXCH. COMM’N,
(Jan. 16, 2013), https://www.sec.gov/reportspubs/investor-publications/investorpubsrule144htm.html
[https://perma.cc/TB63-PYXP].
140. Custody of Funds or Securities of Clients by Investment Advisers, Investment Advisers Act
Release No. IA-2876,68 Fed. Reg. 56,692 (Oct. 1, 2003).
rules for digital assets would necessarily discriminate between funds with
traditional assets and funds with digital assets. But doing so is in line with the
SEC’s regulatory goals and prior actions.
The SEC’s long-running mission has three prongs: (1) protect investors; (2)
maintain fair, orderly, and efficient markets; and (3) facilitate capital
formation.141 Under the leadership of Chairman Jay Clayton, the SEC has
focused this mission on the protection of “[m]ain [s]treet” investors.142 To
determine whether the three prongs are being met, the Commission has indicated
that it will look to the “long-term interests of Mr. and Ms. 401(k).”143 Reflecting
this focus, SEC enforcement actions have concentrated on fraudulent initial coin
offerings and other schemes preying on the enthusiasm of retail investors.144 For
hedge funds, the recent focus has been on retail-investor facing funds, namely
cryptocurrency-linked ETFs, as demonstrated by a January 2018 staff letter on
cryptocurrency-related fund innovation.145
In terms of investor protection, hedge fund investors may not demand the
same protections as main street investors. For one, investors in hedge funds are
wealthier than the average individual. Most fund investors will be “accredited
investors,”146 which means they have income in excess of $200,000 per year
($300,000 if filing jointly) or a net worth over $1,000,000.147 Unlike main street
investors, investors in hedge funds bring an understanding of options,
leveraging, and the financial tools and risks that come along with them. Even
when they do not understand the risk, they likely have the assets to recover from
complete loss. Six months after Tim Draper lost forty thousand Bitcoins he held
on the Mt. Gox exchange, he purchased nearly thirty thousand more from a US
141. What We Do, U.S. SEC. & EXCH. COMM’N, (June 10, 2013),
https://www.sec.gov/Article/whatwedo.html [https://perma.cc/F6SZ-LYQL].
142. DIVISION OF ENFORCEMENT, U.S. SEC. & EXCH. COMM’N,: ANNUAL REPORT: A LOOK
BACK AT FISCAL YEAR 2017 (2017), https://www.sec.gov/files/enforcement-annual-report-2017.pdf
[https://perma.cc/E3XL-CMDW].
143. Jay Clayton, Chairman, U.S. Sec. & Exch. Comm’n, Remarks at the Economic Club of New
York (July 12, 2017), https://www.sec.gov/news/speech/remarks-economic-club-new-york
[https://perma.cc/CW8V-RFJJ].
144. See Testimony on “Virtual Currencies: The Oversight Role of the U.S. Securities and
Exchange Commission and the U.S. Commodity Futures Trading Commission”: Hearing Before the S.
Comm. on Banking, Hous., & Urban Affairs, 115th Cong. (Feb. 6, 2018) (statement Jay Clayton,
Chairman, U.S. Sec. & Exch. Comm’n) (“Cryptocurrencies, ICOs and related products and technologies
have captured the popular imagination – and billions of hard-earned dollars – of American investors
from all walks of life. In dealing with these issues, my key consideration – as it is for all issues that come
before the Commission – is to serve the long-term interests of our Main Street investors.”).
145. See Staff Letter, supra note 109 (“As you know, the U.S. investment fund market is one of
the most robust, varied and successful markets for investment products in the world. Its success can be
attributed, in significant part, to the commitment of fund sponsors to responsible innovation and
continuous improvement of the products they offer. This commitment is especially important because
many of America’s Main Street investors rely on registered funds to help them build toward education,
retirement and other important goals.”).
146. See HAMMER, supra note 19, at 104.
147. 17 C.F.R. § 230.501(a)(5)–(6) (2019).
Marshals’ Service auction of confiscated Silk Road assets.148 Though not a hedge
fund investor, Tim Draper exemplifies a certain appetite for risk in emerging
technologies that we may not want to discourage.
As a counterpoint, although hedge funds were traditionally the target of
wealthy individuals, institutional investors now make up more than 60 percent
of hedge fund assets. 149 These institutions include pension funds, endowments,
and other groups150 where the underlying assets reach retail investors’ savings.
In addition, even if Bernard Madoff and other pre-Dodd-Frank scandals are in
the rearview mirror as far as hedge fund investors are concerned, the securities
rules should not adjust to the often-myopic mood of the hour. The idea of
allowing investment advisers to manage their own funds “under the radar and
outside the vision of regulators”151 is as unappealing today as it was before Dodd-
Frank and Bitcoin.
On the other hand, by not modifying the rule, the SEC would be inhibiting
capital formation in a promising industry, contrary to its third goal of facilitating
capital formation. In Chairman Clayton’s remarks at the Economic Club of New
York in July 2017, he noted that in times of technological change, the SEC must
“strive to ensure that our rules and operations reflect the realities of our capital
markets.”152 In order to facilitate capital formation (prong three), it is necessary
to adjust the typical investor protections.
This has happened before. In the past, the SEC has allowed modifications
to the custody rule when the circumstances were compelling and protections
were adequate. 153 For example, in 2007, the SEC modified the custody rule for
148. Polina Marinova, DFJ’s Tim Draper on Bitcoin’s Rise, Steve Jurvetson’s Exit, and His
Biggest Investing Regret, FORTUNE (Jan. 31, 2018), http://fortune.com/2018/01/31/dfj-tim-draper-
bitcoin [https://perma.cc/KJM3-WQD5]; Robert McMillan, Someone Just Bought $19M in Silk Road
Bitcoins From the Feds, WIRED (July 1, 2014), https://www.wired.com/2014/07/silkroadauction/
[https://perma.cc/4HHQ-6Q2U].
149. See U.S. SEC. & EXCH. COMM’N, STAFF REPORT, IMPLICATIONS OF THE GROWTH OF
HEDGE FUNDS (2003), https://www.sec.gov/news/studies/hedgefunds0903.pdf [https://perma.cc/5UE7-
JQDS] (“The growth in hedge funds has been fueled primarily by the increased interest of institutional
investors such as pension plans, endowments and foundations seeking to diversify their portfolios with
investments in vehicles that feature absolute return strategies”).
150. See id.
151. See Press Release, U.S. Sec. & Exch. Comm’n, SEC Adopts Dodd-Frank Act Amendments
to Investment Advisers Act (June 22, 2011), https://www.sec.gov/news/press/2011/2011-133.htm
[https://perma.cc/7MR6-MHTA].
152. Jay Clayton, Chairman, U.S. Sec. & Exch. Comm’n, Remarks at the Economic Club of New
York (July 12, 2017), https://www.sec.gov/news/speech/remarks-economic-club-new-york
[https://perma.cc/CW8V-RFJJ].
153. See Depository Trust Company of Delaware, LCC dba Delaware Depository, SEC No-
Action Letter, (Sept. 12, 2016) https://www.sec.gov/divisions/investment/noaction/2016/depository-
trust-company-of-delaware-091216.html [https://perma.cc/7SX5-3X8]; Investment Adviser
Association, SEC No-Action Letter, File No. 132-3, at 1 (Sept. 20, 2007),
https://www.sec.gov/divisions/investment/noaction/2007/iaa092007.pdf [https://perma.cc/9YGB-
U3ET].
company was a licensed depository for gold and silver, had advanced internal
control procedures, underwent a third-party audit by a PCAOB-registered
auditor, and possessed a $2 million cybersecurity liability insurance policy.166
The SEC agreed to refrain from enforcement action as long as a majority of the
fund’s board agreed that keeping custody with the company was in the best
interest of the fund and its members.167 This included agreement that the precious
metals would be subject to “reasonable care” and that the company’s custody
was “at least equal in nature and quality to the services that could be provided
by bank custodians . . . after consideration of all of the relevant factors.”168
The SEC has also provided an exception to the 17(f) custody rule for funds
holding cash or securities with the Chicago Mercantile Exchange or other
clearing members while they cleared swaps.169 After Dodd-Frank, the CFTC was
charged with making new rules for the centralized trading of swaps.170 While the
custody issue was in flux during the rule-making process, the SEC issued a
temporary no-action letter, finding “it was appropriate to flexibly apply the
custody requirements” as the CFTC actively worked to improve protections for
customer assets.171 Once a framework for centralized swap clearing was worked
out, the SEC made the no-action letter permanent.172 However, the no-action was
contingent on each clearing member following certain policies and procedures
that brought the Exchange in line with the requirements of 17(f).173
166. Id.
167. Id.
168. Id.
169. See Chi. Mercantile Exch., SEC No-Action Letter (Dec. 19, 2017),
https://www.sec.gov/divisions/investment/noaction/2017/chicago-mercantile-exchange-121917.htm
[https://perma.cc/4YE5-TY26] [hereinafter Chi. Mercantile Exch., No-Action Letter (Dec. 19, 2017)].
170. See Chi. Mercantile Exch., SEC Staff No-Action Letter (July 29, 2011),
https://www.sec.gov/divisions/investment/noaction/2011/cme072911-17f.htm
[https://perma.cc/G4RF-YGW6] [hereinafter Chi. Mercantile Exch., No-Action Letter (July 29, 2011)];
Chi. Mercantile Exch., SEC Staff No-Action Letter (Mar. 24, 2011),
https://www.sec.gov/divisions/investment/noaction/2011/cme032411-17f.htm [https://perma.cc/FPA4-
LUXA]. [hereinafter Chi. Mercantile Exch, No-Action Letter (Mar. 24, 2011)]. Swaps are over-the-
counter (not traded on an exchange) contracts through which two parties exchange cash flows or
liabilities from two different financial instruments. For an assessment of the post-Dodd-Frank CFTC
rules on swaps, see J. CHRISTOPHER GIANCARLO, PRO-REFORM RECONSIDERATION OF THE CFTC
SWAPS TRADING RULES: RETURN TO DODD-FRANK (Jan. 29, 2015),
https://www.cftc.gov/sites/default/files/idc/groups/public/@newsroom/documents/file/sefwhitepaper0
12915.pdf [https://perma.cc/LM4L-7KFG].
171. See Chi. Mercantile Exch., SEC No-Action Letter (Dec. 19, 2017), supra note 169.
172. See Chi. Mercantile Exch,. SEC No-Action Letter (July 29, 2011), supra note 170; Chi.
Mercantile Exch., SEC No-Action Letter (Mar. 24, 2011), supra note 170.
173. These included following regulation for swap collateral, promptly furnishing copies of asset
records, and preserving the ability of the fund to withdraw assets if the custodial arrangement ever falls
out of line with 17(f). See Chi. Mercantile Exch,. SEC No-Action Letter (July 29, 2011), supra note 170;
Chi. Mercantile Exch., SEC No-Action Letter (Mar. 24, 2011), supra note 170.
174. “Company Act section 3(c)(1) excludes any pooled investment vehicle from the definition
of ‘investment company’ if it does not have more than 100 beneficial owners of its outstanding securities
(‘the 100-Owner Limit’) and does not make or propose to make a public offering of its securities.”
HAMMER, supra note 19, at 70.; see also 15 U.S.C. § 80a-3(c)(1).
175. See Depository Trust Co. of Delaware, supra note 151; see also Chi. Mercantile Exch., SEC
No-Action Letter (July 29, 2011), supra note 170; Chi. Mercantile Exch., SEC No-Action Letter (Mar.
24, 2011), supra note 170.
176. See Investment Adviser Association, supra note 151; see also U.S. SEC. & EXCH. COMM’N,
STAFF REPORT, IMPLICATIONS OF THE GROWTH OF HEDGE FUNDS vii (2003),
https://www.sec.gov/news/studies/hedgefunds0903.pdf [https://perma.cc/5UE7-JQDS].
177. See Chi. Mercantile Exch., SEC No-Action Letter (Dec. 19, 2017), supra note 169. For a
list of security breaches on cryptocurrency exchanges, see Alex Munkachy, 30+ Cryptocurrency
Exchange Hacks — A Comprehensive List, COINIQ (June 21, 2018), https://coiniq.com/cryptocurrency-
exchange-hacks [https://perma.cc/SK3U-BQTE].
178. See HAMMER, supra note 19, at 328.; see also Custody of Funds or Securities of Clients by
Investment Advisers, Adviser Act Release No. 2176, 68 Fed. Reg. 56,692, 56,694 (Oct. 1, 2003).
179. For a simple explanation, see Bob Pisani, Here’s Why Bitcoin Prices are Different on Each
Exchange, YAHOO FINANCE (Dec. 12, 2017), https://uk.finance.yahoo.com/news/apos-why-bitcoin-
prices-different-221200635.html [https://perma.cc/B6U4-SNVD].
180. APIs, or application programming interfaces, are sets of protocols and standards that
applications use to communicate with other applications. Several exchanges provide free APIs that can
be used to gather real-time and historical market data with time stamps. See, e.g., BITTREX,
https://bittrex.com/home/api [https://perma.cc/B3A8-PAZA]; COINBASE,
https://developers.coinbase.com [https://perma.cc/2AY3-Z4CT]; GDAX,
https://docs.gdax.com/#pagination [https://perma.cc/DEL9-BKK2].
3. Quarterly Audit
Third, like the surprise examination, a quarterly audit would help make sure
that the assets that the adviser is telling its clients are there are actually there.
Increasing the frequency of audits from annually to quarterly would extend
protections to investors by decreasing an ill-intentioned fund manager’s window
of opportunity for fleecing their clients. Rather than extending a fraudulent
scheme for years, as in the case of Bernard Madoff, a quarterly audit would detect
misallocation or misappropriation of cryptocurrency and flag the issue for
gatekeepers and regulators. While the procedures for storing cryptocurrencies
are plagued with technological difficulties and malicious actors, accounting
firms are fully capable of auditing digital assets. The only barrier to competency
is whether accounting firms are willing to commit resources to learning the field.
Many firms have already heeded the SEC’s Chief Accountant’s 2017 call for
“lighting a lamp” to see how cryptocurrency affects financial reporting and have
performed audits for cryptocurrency hedge fund clients.182
5. Disclosure of Risks
Fifth, the fund must provide investors with a special disclosure stating risks
stemming from the custody arrangement and trading on exchanges. Hedge funds
file disclosures on Form ADV and/or Form PF.183 In addition to traditional risks,
fund managers who plan to have custody of their clients’ digital assets should
make an additional, separate disclosure stating the risks involved in that
arrangement. This would put potential investors on notice that the fund manager
is relying on an SEC no-action letter and that, by investing into this arrangement,
the investor is potentially subjecting their digital assets to complete loss.
7. Insurance
These requirements alone might still be insufficient. Do these rules provide
a custodial framework that is “at least equal in nature and quality to the services
183. See HAMMER, supra note 19, at 189–97. Form PF is used by hedge funds to report assets
under management to the Dodd-Frank-established Financial Stability Oversight Council. For an
example, see Reporting Form for Investment Advisers to Private Funds and Certain Commodity Pool
Operators and Commodity Trading Advisors, FORM PF (Paper Version),
https://www.sec.gov/rules/final/2011/ia-3308-formpf.pdf [https://perma.cc/8LWE-TJGQ].
184. Depository Trust Co. of Delaware., supra note 151.
185. Id.
186. Id.
187. See Investment Adviser Association, supra note 151.
188. See Munkachy, supra note 177.
189. Custody of Funds or Securities of Clients by Investment Advisers, Investment Advisers Act
Release No. IA-2876, 68 Fed. Reg. 56,692 (Oct. 1, 2003).
190. Peter Rudegeair & Nicole Friedman, Riders in Alphabet’s Driverless Car Will Be Insured
by Startup Trov, WALL STREET J. (Dec. 19, 2017), https://www.wsj.com/articles/riders-in-alphabets-
new-driverless-car-will-be-insured-by-a-startup-1513688581?tesla=y&mod=e2tw
[https://perma.cc/92WP-TBP8].
191. 2015 Power Broker, RISK & INSURANCE, http://riskandinsurance.com/2015pb-financial-
service [https://perma.cc/L72A-6DGH].
192. Depository Trust Co. of Delaware., supra note 151.
CONCLUSION
As hedge funds continue to invest in cryptocurrency, the market for
custodial services will adapt to the changing landscape. In the meantime, the
SEC will have to manage the challenge of applying the custody rule to a
technologically complex asset class that was not contemplated during the rules’
inception. My proposed alterations of the custody rule will allow hedge funds to
continue to invest in cryptocurrency while providing investors a higher degree
of security. These requirements might still fall short of achieving protections that
are “at least equal in nature and quality to the services that could be provided by
bank custodians”196 holding traditional assets. Still, they are preferable to the two
likely alternatives: hedge funds acting as their own bank by holding
cryptocurrency themselves, or a rigid application of the rule that stifles the
industry. The question will be whether the SEC can stomach the idea of allowing
funds to hold assets in a way that is known to contain significant risk of loss.