Rise of the Crypto Hedge Fund: Operational Issues and Best Practices for Emergent Investment Industry

38 Pages Posted: 20 Oct 2017 Last revised: 21 Dec 2017

Edmund Mokhtarian

Independent

Alexander Lindgren

Independent

Date Written: October 19, 2017

Abstract

In the last several years, a discreet $100 billion financial system has emerged in the form of cryptocurrency markets. The extraordinary returns generated by cryptocurrencies such as Bitcoin has 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 funding, (iii) internal procedures for safeguarding client assets, (iv) optimizing 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.

Keywords: Cryptocurrency, SEC, CFTC, Hedge Fund, Virtual Currency

JEL Classification: K22

Suggested Citation

Mokhtarian, Edmund and Lindgren, Alexander, Rise of the Crypto Hedge Fund: Operational Issues and Best Practices for Emergent Investment Industry (October 19, 2017). Stanford Journal of Law, Business, and Finance, Forthcoming. Available at SSRN: https://ssrn.com/abstract=3055979

Edmund Mokhtarian

Independent ( email )

No Address Available

Alexander Lindgren (Contact Author)

Independent ( email )

No Address Available

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