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Saturday, April 17, 2021

Getting a handle on how to hold cryptocurrencies

For purposes of this article, the term “cryptocurrencies” is used generically to refer to DLT (distributed ledger technology) platforms, such as bitcoin and ethereum, tokens or coins that have been developed on or derivative to a DLT platform, as well as other digital assets that represent something of value or are required for a user to access a software platform or service.

As cryptocurrencies start to become more accepted as an investable asset class, existing and new private fund sponsors, professional investors and institutional investors are examining the challenges of holding cryptocurrencies as part of existing portfolios or newly dedicated allocations. Many of these challenges are operational in nature, for example, how can these assets be held and accounted for? Others are regulatory in nature, for example, how do existing securities laws require investment advisers hold and safe-keep these assets?

An age-old dilemma presents itself again in the area: How do you apply rules and laws to new technologies that did not exist at the time the laws were written?

Without analyzing the pros and cons of the various methods of holding and controlling cryptocurrencies, we can break them down into two basic approaches.

Holding the assets directly (via private keys), generally in a hardware wallet or on paper, is the “direct method.” Using third parties to hold private keys, such as opening accounts on exchanges (GDAX, Kraken, etc.) or with custodians (Xapo, Kingdom Trust, etc.), is the “custodian method.”

Aside from the many technical issues involved in deciding to use a direct method or a custodian method, there are special legal considerations that must be reviewed by investment advisers when considering whether to employ either method. These legal considerations arise out of an investment adviser’s status under the Investment Advisers Act of 1940, as amended (the “Advisers Act”), as either a registered investment adviser or an exempt reporting adviser (a limited reporting status available to investment advisers that only advise private funds and have less than $150 million of assets under management).

The legal considerations are further complicated for exempt reporting advisers as they may have different legal requirements depending on the state in which they are located. For example, certain exempt reporting advisers in Texas have to comply with the same “custody rules” promulgated under the Advisers Act, while exempt reporting advisers in California or New York may only be required to comply with a subset of those rules.

With respect to registered investment advisers (registered with either the Texas State Securities Board or the Securities and Exchange Commission), under Advisers Act Rule 206(4)-2, an investment adviser is required to maintain client “funds and securities” with a “qualified custodian.” To the extent that cryptocurrencies are treated as either “funds” or “securities” for purposes of the Advisers Act, those cryptocurrencies over which the adviser has custody must be maintained in a segregated account in the name of the client with an institution satisfying the Advisers Act’s definition of “qualified custodian.”

However, only a limited number of custodians in this space may currently meet this definition. And such a custodial service may come at a premium price.

As a result, in addition to the host of security and operational considerations involved in the selection of a custodian, extreme care must be taken in light of these regulatory obligations applicable to investment advisers.

In a rush to take advantage of the emergence of a new technology and capitalize on its investment prospects, investors should take care to evaluate the practical challenges to safeguarding their assets and consult legal counsel when investing on behalf of others.

Andrew Rosell and Gavin Fearey work in the Fort Worth offices of Winstead PC, a business law firm based in Texas with over 300 attorneys. Recently, both Rosell and Fearey have counseled a number of investment managers and other businesses that are either active in the cryptocurrency space or exploring blockchain opportunities.

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