While traditional currencies in the form of paper or coin-based money have been the main means of transactions for many decades, cryptocurrency – digital or virtual currency, consisting of a line of computer code – is on the rise. Cryptocurrencies offer several advantages over traditional fiat currencies. Transactions involve no third-parties or delays, and are therefore immediate and cheap. There is no threat of identify theft or issuance/oversight by a central authority, making it immune to government interference. People are rapidly adopting them, and not surprisingly, investment vehicles incorporating cryptocurrencies (known as tokenized investments) have caught the attention of eager investors.
However, tokenized investment vehicles are still in a nascent stage and some fund managers view them as complex and confusing. In our view, tokenized funds have the potential to be the next big thing in investing, a unique opportunity for investors to diversify their holdings and grow their personal wealth. But there are several hurdles that must be overcome first, in these three key areas:
- Technology – Blockchain, the distributed public ledger supporting cryptocurrencies, provides the majority of the technology support needed to create and manage tokenized vehicles, but other technology advances are needed, such as those enabling the safe storage and securing of tokens. Additionally, in response to investor concern about cryptocurrencies’ lack of backing, a new asset class known as price-stable cryptocurrencies is emerging (SmartCoins is one example). The value of these cryptocurrencies is pegged to that of another asset, making them an excellent option for investors and fund managers who are excited about the gains potential of tokenized investing, but still nervous about cryptocurrency price fluctuations. New technologies are needed to peg price-stable cryptocurrencies to other assets, like the spot price of gold or the U.S. dollar. In the interim, this will help increase investors’ comfort level.
- Legal – In July, the U.S. Securities Exchange Commision (SEC) issued the results of an investigative report into DAO’s initial coin offering (ICO) in the first half of 2016. This investigation represented a landmark because for the first time, the SEC was addressing the issue of whether cryptocurrencies constituted a security and should therefore be regulated under existing securities laws.
Specifically, the SEC stated that if certain transactions meet the criteria, then they are deemed securities and subject to a raft of regulatory requirements. However, this statement left substantial room for interpretation, especially since every cryptocurrency is different and has different attributes. Regardless, the report succeeded in providing a warning to all, reinforcing the SEC’s view that just because something is “virtual,” doesn’t exempt it from being a security.
We don’t view increased SEC regulation of cryptocurrency as a bad thing – in fact, more regulation is actually a positive sign that a market is maturing. However, increased regulation can make fund managers without the proper legal counsel and knowledge skittish, especially with regulation language and guidance being so vague and non-uniform. Increasingly, the creation and management of tokenized vehicles will require specialized legal knowledge and counsel on the unique regulations of individual countries.
- Structuring – There are four main types of funds, including open-end funds (where a fund manager can invest new cash from investors, and new shares of the fund are continually created for new investors); closed-end funds (similar to open-end funds in that their assets are invested in a wide range of securities, but the fund behaves more like a stock in that market value is driven by supply and demand, and no new shares are created); exchange-traded funds (or ETFs –comprised of securities and trades on a stock exchange); and unit investment trusts (UITs) which are somewhat of a hybrid offering fixed portfolios comprised of stocks and bonds, as redeemable units to investors for specific periods of time.
Tokenized funds can be significantly more cost-efficient to maintain than more traditional funds, due to lower infrastructure and set-up costs, and fewer intermediaries. However, establishing and maintaining a proper structure can be tricky, creating the potential for regulatory risk. The industry requires standards for establishing tokenized funds of varying structures, and ensuring adherence to the rules and guidelines governing each structure type.
Long-term, we believe that cryptocurrencies have a strong future in the investing world, and as more people get into them, their value will grow along with their appeal to investors and fund managers. But integrating cryptocurrencies into the mainsream investing world will be gradual and not happen overnight. Easing and facilitating this process will require new solutions and approaches to address both the real and perceived risks of crypto-investing, ultimately helping investors capitalize on the rise of blockchain markets to achieve real gains.
By Oleg Seydak, CEO, Blackmoon Financial