Like it or not, digital assets such as bitcoin are an increasingly important asset class. As the Federal Reserve expands its balance sheet at record speed, more and more investors are looking to add digital assets as a complement to or substitute for commodities and real assets. Global macro legend Paul Tudor Jones has invested in bitcoin futures. Many other institutional investors are likely to follow suit. Digital assets offer a store of value and a true hedge against systemic risk.
As early as 3 years ago, Coinbase had more registered users than Charles Schwab. Exchange traded products offering direct digital asset exposure have raised over $1 billion in Sweden, and $100 million in Switzerland. Many digital asset themed hedge funds have had successful fund raises in the US. CME has successfully offered trading in cash settled bitcoin futures. The Grayscale Bitcoin Trust, a holding company traded on OTC Markets that owns bitcoin consistently trades at a large premium to net asset value, and demand is rising for the whole suite of products offered by its sponsor. There is clearly pent up investor demand for digital asset exposure.
Existing solutions are inadequate for most retail investors in the US. Setting up a digital wallet, or opening an account at Coinbase is too much work for most investors. Few investors want to deal with trading on exchanges outside the US, or investing in hedge funds offered via private placement. Futures are highly leveraged instruments that require constant monitoring and are unsuitable for buy and hold investors. Even if one is willing to pay a large premium to own GBTC, it lacks the protections under the 1940 Act that are offered to investors in registered funds.
The SEC has some understandable concerns about allowing digital assets into registered funds. At least nine different fund sponsors have tried to register bitcoin ETFs, and been rejected. It might be a while before the market for digital assets is mature enough to fit into ETFs. Fortunately, closed end funds, especially interval funds offer a better solutions for retail investors that want to access digital assets within a 1940 Act structure.
Flexibility to innovate is also a key feature of the Investment Company Act of 1940. As the Division with primary responsibility for regulatory policy regarding registered funds, we seek to foster innovation that benefits investors and preserves the important protections that Congress established in the 1940 Act.SEC Staff Letter Engaging on Fund Innovation and Cryptocurrency-related Holdings
Why Closed End Funds are a Better Solution
A closed end fund is actually the ideal vehicle for providing retail investors with digital asset exposure. Unlisted structures such as interval funds and tender offer funds are especially fitting. Here are two reasons why.
Since digital assets are a nascent asset class, the SEC has expressed concerns about market liquidity.
Mutual funds need to be able to provide daily liquidity to their investors. ETFs have a complex creation and redemption process that the SEC believes would be difficult to manage with bitcoin. Under Rule 22e-4, mutual funds and ETFs have an effective 15% cap on illiquid securities. In contrast, closed end funds have much greater flexibility, and are not subject to any explicit cap on illiquid securities. Traded closed end funds and tender offer funds have no fundamental policy related to repurchase offers. Interval funds have a fundamental policy requiring repurchases at fixed intervals disclosed in the initial prospectus. Most interval funds offer quarterly repurchases, but in theory an interval fund could offer liquidity only once per year. Consequently, a fund sponsor using a closed end fund structure would be far better positioned to navigate temporary illiquidity in the digital asset markets.
Valuation is important because funds use it to measure performance, and to determine the price at which investors can enter and exit a fund. The SEC has expressed concerns that funds would not have the necessary information to perform valuation. They cite volatility, fragmentation, general lack of regulation and limited trading volume in digital asset markets . CBOE has pointed out that the valuation challenges that digital asset funds face are similar to those faced by other commodities funds. Nonetheless, it is a serious concern for the SEC, and closed end funds are better positioned to deal with it than mutual funds and ETFs.
Mutual funds and ETFs must calculate NAV daily. However, under Rule 23c-3, interval funds can calculate NAV once per week, except in proximity to repurchase dates. There are several price indices that aggregate quotes from exchanges around the world. The CME indices used for bitcoin futures are one example. Therefore an interval fund holding digital assets, or derivatives should have no more valuation difficulty than typical alternative funds.
Digital Assets Interval Funds
So far the SEC has still not allowed any Registered fund to invest directly into digital assets. Cipher Technologies attempted to register an interval fund that invested directly into bitcoin, but the SEC rejected them. However, the sEC has allowed registered funds to invest in bitcoin futures, provided they follow strict compliance procedures.
So far the SEC has approved one interval fund that invests in bitcoin futures- the Stone Ridge Trust VI (NYDIG Bitcoin Strategy Fund). This fund which has close connections with former regulators, is actively raising capital. It will buy bitcoin futures so that the value of the underlying bitcoin is equal to approximately 100% of net assets. Stone Ridge’s cofounder is CEO of the New York Digital Investment Group, which has over $330 million in AUM in private funds. The prospectus fore Stone Ridge Trust VI limits the fund’s total capital raising based on the total trading volume in the bitcoin futures market.
Additionally, there are two more funds pending registration that plan to invest in bitcoin futures. The Entoro Gray Swan will invest up to 25% of its assets into gold, bitcoin and ethereum futures as part of a broader macro strategy The Yleana Bitcoin Strategy Fund will follow a strategy similar to Stone Ridge Trust VI investing in bitcoin futures. The registration statements for these funds also describe procedures to limit their total share of the volume in bitcoin futures trading.
Digital assets are still small part of the $30+ billion interval fund sector. However, its worth recalling how fast reinsurance interval funds grew from zero to one of the largest categories. We expect to see more assets go into digital asset interval funds in the future. At the end of this quarter, we’ll add digital asset funds as their own separate category. For additional data and research on digital asset interval funds, please see our Premium Offering.