Crypto clouds may part as result of directive

A new White House directive on digital assets raises the likelihood of regulatory clarity and added investor protections in the growing cryptocurrency landscape, stakeholders said.

Whether institutional investors, which to date have largely steered clear of the asset class, jump in when and if further regulations are adopted is unclear, but the crypto industry is optimistic following a March 9 executive order from President Joe Biden outlining a federal digital assets strategy.

The order establishes a national policy for digital assets across six areas: consumer and investor protection; financial stability; illicit finance; U.S. leadership in the global financial system and economic competitiveness; financial inclusion; and responsible innovation.

Craig Salm, New York-based chief legal officer at Grayscale Investments LLC, which touts itself as the world's largest digital asset manager with $35.7 billion in assets under management, said the executive order was an "incredibly powerful" statement.

"America is unique in that we have several regulators that cover different use cases (in crypto) and to receive that level of coordination from the White House is important," Mr. Salm said. "It really boils down to the White House recognizing that crypto is here to stay and wanting America to be a leader in this space and be competitive with the rest of the world.”

Regulators at the Securities and Exchange Commission, Commodity Futures Trading Commission and Treasury Department are on the front lines with respect to crypto oversight. The SEC announced May 3 it will add 20 positions to the newly renamed crypto assets and cyber unit, which aims to protect investors in the crypto markets. The unit will now have 50 dedicated positions.

The White House order covers a wide range of issues and in part directs the Treasury Department and other regulators to assess and develop policy recommendations on how the digital asset sector could impact financial markets for consumers, investors, businesses and equitable economic growth. It also encourages regulators to ensure sufficient oversight and safeguard against any systemic financial risks posed by digital assets.

It’s a strategy crypto stakeholders can get behind, said Timothy Spangler, a Los Angeles-based partner with Dechert LLP. “It’s an acknowledgment that crypto is here to stay,” Mr. Spangler said. The executive order “seemed to be a pretty middle-of-the-road, pro-crypto response from the Biden administration, and the industry was pleased by that.”

For the institutional investor community, Mr. Spangler said additional crypto regulation is not likely to change things because existing law and regulation is sufficient; it’s more about education.

“This is an area where to invest in at scale there is a real learning curve that any investor needs to spend time moving up,” Mr. Spangler said. “This an area where analogies can be very dangerous. Blockchain is a different technology than anything that’s proceeded before it … education is key.”

Anthony Tu-Sekine, Washington-based head of Seward & Kissel LLP’s blockchain and cryptocurrency group, said more institutional investors will likely get involved in crypto in the coming years as scale ramps up. “Even though cryptocurrency has grown a lot over the last few years, the asset class is still pretty small,” Mr. Tu-Sekine said. “For some of the large institutions that place large trades … large trades can move the market by themselves. I think (crypto adoption) is going to take a little a longer for institutional investors.”

The SEC’s approval of a spot bitcoin exchange-traded fund would go a long way to getting institutional and other types of investors to become comfortable with crypto, Grayscale’s Mr. Salm said.

“As an investment vehicle, ETFs are very well understood, have a strong regulatory history, and enjoy robust support in global markets,” Mr. Salm said in an email. “The approval of a spot bitcoin ETF would allow investors the opportunity to gain exposure to bitcoin in an SEC-regulated investment vehicle which will not only more efficiently track the price of bitcoin, but will also bring the U.S. up to speed with global bitcoin ETF offerings.”

Grayscale is seeking to convert its flagship Grayscale Bitcoin Trust to an ETF; the SEC has a July 6 deadline to decide. To date, the SEC has permitted only bitcoin futures ETFs, while rejecting spot bitcoin ETFs, though Grayscale’s and several other applications are pending.

Canadian regulators in early 2021 approved the first spot bitcoin ETF in North America, the Purpose Bitcoin ETF, which has C$1.5 billion ($1.2 billion) in AUM.

Also of note, Fidelity Investments launched the Fidelity Advantage Bitcoin ETF in Canada in December.

“If America is going to lead in this next wave of innovation, well what better way than further bringing bitcoin into the regulatory perimeter through products like bitcoin ETFs?” Mr. Salm said.

One institutional investor, Katherine Molnar, chief investment officer of the $1.9 billion Fairfax County Police Officers Retirement System in northern Virginia, is no stranger to digital assets.

In 2018, the police fund, along with a sister pension fund, the $5.1 billion Fairfax County Employees’ Retirement System, became the first known public pension funds to commit to a dedicated fund that invests primarily in blockchain technology firms — the Morgan Creek Blockchain Opportunities Fund, managed by Morgan Creek Digital Assets, a subsidiary of Chapel Hill, N.C.-based Morgan Creek Capital Management LLC. The employees fund committed $10 million and the police fund committed $11 million to the Morgan Creek fund in 2018.

Since then, the two Fairfax funds have made five additional digital asset-focused allocations, including two in recent months.

The employees fund invested $32 million in October and the police fund invested $18 million in November to Parataxis Capital, a multistrategy hedge fund focused on the digital assets sector. The two Fairfax funds also entered into a revenue-sharing agreement with Parataxis Capital, though Ms. Molnar declined to provide specifics. “We were happy to invest as a limited partner, but then we were particularly happy when we could negotiate a revenue share with them and be a strategic partner to them,” she said.

In January, the employees fund committed $40 million and the police fund committed $20 million to Polychain Ventures III, a venture capital fund managed by Polychain Capital focused on digital assets.

Ms. Molnar said her pension fund has seen solid returns from the digital assets to date and is bullish on its future. “We just think that there’s going to be a tremendous amount of growth in the digital asset space so we think that over time, many assets, and not just assets, but many things will become digitized,” Ms. Molnar said. “So it’s not just artworks or NFTs, but you’ll be able to buy digital or fractional shares of many different things, and it’s not just equities and bonds and typical financial assets, it’ll be anything and everything.”

She said her board will consider two additional digital asset funds at its May 11 meeting, though she declined to provide specifics ahead of time. She said the pension fund can’t share specific returns from digital asset funds.

Ms. Molnar said because her pension fund is not investing directly in a cryptocurrency such as bitcoin, it avoids the day-to-day volatility while getting exposure to the asset class.

Price volatility was one of the reasons the Department of Labor cited when telling 401(k) plan fiduciaries to “exercise extreme care” before selecting cryptocurrency as an investment option in plan menus in March 10 guidance.

Fiduciaries who include such investment options or who allow such investments through self-directed brokerage accounts “should expect to be questioned about how they can square their actions with their duties of prudence and loyalty in light of” potential risks associated with cryptocurrencies, the guidance said, referring to the Employee Retirement Income Security Act of 1974’s requirements.

Allison Itami, Washington-based principal and co-chairwoman of Groom Law Group’s plan sponsor practice, said the guidance should have an “intended chilling effect” on plan sponsors considering adding crypto funds to plan lineups.

“Basically, this release says if you’re offering crypto as a designated investment alternative, it amounts to volunteering for an audit,” Ms. Itami said. “We’re not aware of particular investment options that have an automatic ticket to an audit and all the monetary and time costs that go along with it.”

Incorporating the assets in retirement funds presents “significant risks and challenges to participants’ retirement accounts, including significant risks of fraud, theft, and loss,” the Labor Department guidance said. The risks exist because cryptocurrencies are speculative and volatile investments; pose custodial and record-keeping challenges; present valuation concerns; and contend with an evolving regulatory environment, the DOL added.

Ali Khawar, acting assistant secretary of the DOL’s Employee Benefits Security Administration, said in a March interview with Pensions & Investments that the White House’s executive order is “a whole-of-government effort” to solve for the concerns outlined in the guidance.

“It’s not about us being Luddites, it’s not about us being anti-technology or saying, ‘innovation is bad,’ but uncontrolled innovation with no consumer protections in place, that shouldn’t be a thing that we’re encouraging participants to do with their retirement assets,” Mr. Khawar said in the interview.

A group of 11 trade associations, including the American Benefits Council, the ERISA Industry Committee, and the Securities Industry and Financial Markets Association, sent a letter April 12 to Mr. Khawar asking EBSA to withdraw its crypto guidance and “instead develop guidance in this area through notice-and-comment rule-making.”

The groups specify that “at this time, we express no view on the appropriateness of retirement plan investments in cryptocurrency,” but instead take issue with “what we perceive to be a trend at EBSA away from rule-making based on a robust notice and comment process.”

While EBSA is still reviewing the trade groups’ letter, the duties of prudence and loyalty discussed in the guidance are well-established under ERISA, a spokesman said in an email. As noted in the guidance, “these duties should lead 401(k) plan fiduciaries to exercise extreme care before including options to invest in cryptocurrencies at this early stage of their development,” the spokesman said. “We look forward to further engaging with stakeholders on this important issue.”

On the other side, a group of 13 organizations, including the AFL-CIO, Better Markets, Consumer Federation of America and Public Citizen, sent a letter April 26 to Mr. Khawar in support of the crypto guidance. “We share the department’s well-founded concern about instances where plan fiduciaries may be exposing participants to direct investments in cryptocurrencies, or other products whose value is tied to cryptocurrencies,” the organizations stated in the letter.