With the ever-increasing popularity of cryptocurrency exchanges around the globe it seems that the use of virtual currencies is only set to become the norm in the future.
As such, it is no wonder why more and more entrepreneurs are looking to establish investment funds that trade cryptocurrencies If properly executed, these investment funds have the potential to earn billions. However, to be successful in such an endeavor, one should be aware of the 3 key considerations that can affect the success of your investment fund:
- the external regulations that will govern the investment fund;
- the internal regulations that govern the investment fund; and
- the cost of establishing the fund.
Key 1: External Regulations:
When deciding upon a forum within which to establish an investment fund, it is prudent to consider the size of the market along with how stringent the regulations will be. Europe, for example, has a large potential pool of investors but there are federal regulations such as Directive 2014/65/EU on Markets in Financial Instruments and Regulation (EU) No.600/2014 on Markets in Financial Instruments (also known as “MiFID II” and “MiFIR” respectively), which every EU Member-State must abide by and then there are national regulations, which will govern investment funds. Establishing an investment fund in Cyprus, which intends to trade virtual currencies is relatively simple to set-up and will be governed by EU directives and the regulations set forth by the Cyprus Securities and Exchange Commission (CySEC).
Presently, virtual currencies are unregulated in Cyprus. However, this may be set to change in the near future. On January 9, 2019, the European Securities and Markets Authority (ESMA) published its Advice to the European Institutions regarding Initial Coin Offerings (ICOs) and crypto-assets. There is an ongoing global conversation on the nature of virtual currencies and whether or not they qualify as securities. ESMA’s Advice is essentially opening up a dialogue between the EU Member States to adopt regulations for crypto-assets, as some crypto-assets, e.g. those with profit rights attached, may qualify as transferable securities or other types of MiFID financial instruments. However, Member States have defined the term “financial instrument” differently, hence created challenges to both the regulation and the supervision of crypto-assets.
In addition, in October 2018, the Financial Action Task Force (FATF) adopted changes to its Recommendations and Glossary such as “virtual assets” and “virtual asset service providers”, to explicitly clarify, that the Recommendations apply in the case of financial activities involving virtual assets. The FATF Recommendations also set out comprehensive requirements for combating money laundering and terrorist financing, including those that make use of virtual assets. Moreover, FATF will consider in February 2019 whether and how to provide further clarifications in the standards to guide implementation, and will also update by June 2019 its 2015 Risk-based Approach Guidance on Virtual Currencies.
In the United States, for example, the notion of a utility token versus a security token has greatly evolved in accordance with the Howey Test (Securities and Exchange Commission v. W. J. Howey Co., et. al., 328 U.S. 293 (1946)). According to this test, the Supreme Court examined the substance over the form of a particular transaction to decipher, whether that particular transaction is in fact an “investment contract”. If so, then it would fall within the ambit of the securities regulations.
Given that securities-trading is a global phenomenon that often involves trading by citizens of various countries, it may be envisaged that the EU will adopt laws to conform with the U.S. model. Therefore, in future crypto-assets being traded as securities (as opposed to utility tokens) may be expected to fall under EU national and supra-national securities regulations. The ongoing dialogue, advice and evolution of securities regulations serves to have each nation ensure that investor protection and market integrity remain paramount.
For the moment, virtual currency-trading investment funds should be aware that each EU Member-State has its own regulations (or lack thereof) regarding virtual currency trading specifically. However, in its Advice, ESMA stated that if crypto-assets are determined to qualify as transferable securities or other types of MiFID financial instruments, a full set of EU financial rules, including the Prospectus Directive, the Transparency Directive, MiFID II, the Market Abuse Directive, the Short Selling Regulation, the Central Securities Depositories Regulation and the Settlement Finality Directive, are likely to apply to their issuer and/or firms providing investment services/activities to those instruments.
Key 2: Internal Regulations:
The internal compliance procedures of an investment fund are as significant as the external regulations, that govern the fund. Regardless of whether or not national regulations impose rules on the trading of virtual currencies, investment funds generally should implement internal compliance procedures addressing risk-management and legal/regulatory compliance monitoring.
Risk management procedures should ensure, that risk limits always remain in accordance with the risk profile the fund discloses to investors and monitoring adherence to risk limits. Ongoing legal and compliance monitoring entails devising anti-money laundering and counter-terrorist financing policies and procedures, and remuneration policies. If there are transactions with foreign investors such as US citizens, then it is also important to consider adherence to bi-lateral treaties such as FATCA (Foreign Account Tax Compliance Act). Additionally, there is European Market Infrastructure Regulation (EMIR) compliance for sub-funds and ISDA agreements.
Implementing proper compliance procedures allows investors to feel more confident in investing with your fund.
Key 3: Cost of Establishment:
Once you navigate the external and internal regulations, the cost of setting-up the investment fund is a key factor in determining the choice of jurisdiction. Each EU Member State has different regulatory and legal set-up costs. For example, in Cyprus the process of obtaining a trading license is relatively straight forward. The regulator in Cyprus (the Cyprus Securities & Exchange Commission) will require a certain amount of initial capital for the investment fund to be established but this depends on the type of investment fund to be established, what assets (or mix of assets) the investment fund will trade and the type(s) of investors the investment fund will trade with (i.e. retail vs. professional or well-informed investors). Furthermore, in Cyprus, the legal costs in establishing an investment fund and providing ongoing compliance support is cost-effective and generally competitive with other EU member-states. In fact, trading licenses may be obtained within 6-8 months (and possibly within 3 months through the fast-track method).
Although ESMA has issued its Advice on Crypto-Assets, in reality it may pass some time before the regulations change. Given the dynamic securities regulations both in the European Union and in other nations, it is imperative to consult experienced securities regulations attorneys with knowledge of the regulations within the EU and even in other countries, in which the investment fund intends to trade virtual currencies. Furthermore, devising proper internal compliance procedures and knowing which federal and national regulations apply to your investment fund, will help in furthering your business goals.