Cryptocurrency supporters welcome more regulation

Updated with correction

Key players in the cryptocurrency market are leaning toward added regulatory scrutiny to head off potential investor concerns.

Fidelity Digital Assets, launched in late 2018 by Fidelity Investments as the first major firm in institutional asset servicing to offer cryptocurrency custody and trade execution operations, was granted a charter in October from the New York State Department of Financial Services to operate as a limited liability trust company.

Obtaining the charter allows more potential institutional clients to do business with Fidelity Digital Assets, said Tom Jessop, its New York-based president. "We think it's a high bar and a signal to the market that we meet fairly stringent regulatory requirements, and that's important to us," he said. "We want our clients to know not just what we say about our business, but that we are regulated and have certain regulatory obligations that over time we need to maintain."

New York-based Grayscale Investments LLC — which touts itself as the world's largest digital asset manager with $2.6 billion AUM and offers 10 cryptocurrency investment products to institutional and accredited investors, four of which trade publicly and are available to all investors — had a similar thought when it applied for its Grayscale Bitcoin Trust to become a Securities and Exchange Commission reporting company, a designation it officially received on Jan. 21.

Grayscale Bitcoin Trust, the first digital currency investment vehicle to attain the status of an SEC reporting company, will now file quarterly and annual reports as well as audited financial statements such as 10-Qs and 10-Ks.

"We want to be signaling to folks that if you are demonstrating and consistently have a track record of operational excellence and the ability to create products with the appropriate level of disclosure and reporting, that there are very viable ways to work within the existing regulatory frameworks, despite the fact that digital currencies and digital assets are new," said Michael Sonnenshein, managing director of Grayscale in New York.

The process took roughly a year to complete, Mr. Sonnenshein said. The voluntary filing became public in November and after some SEC questions were answered, took effect last month.

Grayscale Bitcoin Trust is the firm's largest investment vehicle, with $2.4 billion in assets as of Jan. 17. A more stringent reporting system "is what investors are expecting of a product of this size and scope," Mr. Sonnenshein added.

Craig Salm, director of legal at Grayscale, said many institutional investors are not able to even consider an instrument that isn't reporting to the SEC, so this development should widen the trust's investor base.

"Because many institutional investors do not have the legal or operational wherewithal to hold the assets directly, they must use instruments or third-party custodians for almost everything that they invest in," Mr. Sonnenshein said. "Now that there is a bitcoin product that is SEC reporting and has that (higher) level of disclosure, they may now be able to consider it."

Bitwise Asset Management Inc., a San Francisco cryptoasset manager, like several other digital asset firms has tried to register a bitcoin exchange-traded fund with the SEC but thus far has come up short. In October, the SEC rejected Bitwise's proposal because it did not meet the legal requirements to prevent fraud or market manipulation, the SEC said. To date, no bitcoin ETF has been approved.

Matthew Hougan, vice president and global head of research at Bitwise, said his firm applied for the ETF to access financial advisers in wealth management. Bitwise surveyed roughly 400 advisers before filing the application in early 2019 and found that two-thirds would prefer to buy cryptoassets through an ETF, Mr. Hougan said.

Mr. Hougan said Bitwise is reviewing the SEC response to its application, which it officially withdrew in January, and will reapply "as soon as possible." He declined to provide Bitwise's assets under management.

Cyptoasset-focused stakeholders have formed groups in recent years to raise industry standards, like the Association for Digital Asset Markets and the Crypto Ratings Council.

ADAM, which launched in late 2018, is putting the final touches on a code of conduct that will inform market participants on best practices on matters like compliance, risk management and conflicts of interest. The code will be signed by members in the first quarter, said Jonah Crane, an adviser to the 15-member group and former deputy assistant secretary of the Treasury Department's financial stability oversight council.

In establishing the code of conduct, ADAM is hoping, in part, that institutional players will become more comfortable with digital assets. The code can be "a piece of the puzzle in trying to make these markets feel stable enough for them to come in," Mr. Crane said.

The Crypto Ratings Council, made up of businesses that service the crypto industry, has created a framework that can consistently assess whether a given cryptoasset has characteristics that make it more or less likely to be classified as a security, said Grayscale's Mr. Salm, who is involved with the council.

The two most widely held cryptocurrencies — bitcoin and ethereum — are not subject to U.S. securities law, but the landscape is less clear for smaller currencies, Mr. Salm said. "The fact that organizations like this exist shows there's a lot of uncertainty in this space and we're working toward providing more clarity," he added.

The council has rated 25 currencies on its website and is working on classifying more, Mr. Salm said.

Led by hedge funds, with a smattering of family offices and endowments, some institutions have entered the crypto world. At Fidelity Digital Assets, Mr. Jessop said the firm is a seeing interest from institutions, though he declined to name clients. He mentioned that no pension funds have come on board, but one is interested in making a "small allocation" and he's meeting with others often.

"People have been saying for the last couple of years this is going to be the year for institutional adoption and our perspective is it's hard to predict because it's more of a rolling wave as opposed to an event," Mr. Jessop said.

John D'Agostino, a New York-based global leader of investor management for DMS Governance, which provides governance services to alternative managers, said one of the main issues preventing institutions from getting involved is lack of capacity in the market.

"For a large institution, the question is whether you can put an amount to work that will move the needle enough to warrant the research effort, expense and potential backlash if something were to go wrong," Mr. D'Agostino said.

Another major issue is money laundering, since the crypto market was built on decentralization and a level of anonymity, according to Mr. D'Agostino. To ease those concerns, the crypto world will have to evolve and adapt. "The asset side of the industry will have to adjust to the regulatory side, not vice versa," he said. "I don't think the regulatory community can or should change the core principles that guide investor protection. I think the asset class should adjust to the regulatory standard."