1. What benefits are there to running a cryptocurrency-backed fund (so funds that only hold cryptocurrency, no fiat)? Is it easier to make cross-border investments?
Regulations regarding cryptocurrency and cryptocurrency funds are mixed across jurisdictions. For instance, China has essentially completely prohibited anything related with cryptocurrency. Other jurisdictions like Japan, have been more proactive about regulating cryptocurrency as a kind of “Digital Asset”. I sometimes refer to this as the “Blockchain Digital Asset” (BDA) approach. Other countries don’t have any regulations as to these crypto currencies, or BDA Funds. Obviously you would avoid a jurisdiction like China, and then it is a choice on whether to establish in a jurisdiction which is a taking a positive approach to regulation, or to head out to what may be essentially the wild west, Mongolia, East Timor. This approach would let you establish every thing very easily, and operations will be easier, but it carries a risk that the government may decide to regulate and crack down at any moment.
As the fund invests only in cryptocurrencies, or DBAs there aren’t really any issues for cross border investments. The investment is in the country where the fund entity is located. Potential investors just have to get money to the fund. Because these are not traditional investment products, there are fewer regulations. Hosting the fund in an unregulated country is of course a lot easier. Hosting in a regulated country requires all regular steps for compliance with local laws as to regulation of securities.
2. Have you seen any regulations around custodianship of cryptocurrency? I have heard from some fund managers that this is one of the value-adds they offer institutional investors.
China doesn’t have these regulations because they have essentially outlawed all BDA activities. Of course the major risk with Bitcoin and other BDAs is the risk of hacking. We have already seen this with major exchanges being hacked and losing value. If I’m a BDA fund, I have an obligation to protect my client as much as possible, that includes protecting the investment from theft wherever possible. Only a few major exchanges are offering custodianship and it is restricted to large institutional investors. I haven’t seen any regulatory requirements in this regard, it’s just good business for the exchange to be able to provide security for large investors.
3. In China, there has been increasing regulation on ICOs and cryptocurrency exchanges – what kind of risk does that pose for cryptocurrency VC funds (if any)?
China has had regulation on the books restricting ICOs and cryptocurrency exchanges since September 2017, and for all appearances in serious about enforcing that ban to the fullest extent possible. This obviously creates risks for those attempting to do these activities in China. We have already seen movement of some of our clients out of China and into the more “Wild west” jurisdictions mentioned above. The risk in China is huge, these exchanges had been given time to essentially give all money back to the customers and close down. If they continue doing it, they risk seizure of bank accounts and possibly jail time.
4. What are some legal risks/challenges that VC funds need to consider before raising a cryptocurrency fund (no fiat)? Can you share any cases you’ve looked at?
What jurisdiction is the fund established in? Is investing in the fund treated as a security in that jurisdiction? How to avoid being labeled a security? What additional regulations or requirements does the fund need to meet as a result of being labeled a security in a particular jurisdiction. KYC, who is investing in the fund, are the on any international blacklists or subject to sanctions? Money Laundering, where did the investment money come from? FCPA anti-corruption, can regulators be offered a few tokens to “look the other way”? What legal disclaimers are part of the agreement where the investor knows the underlying fund is investing in a high volatile and speculative digital asset. What warranties does the potential investor demand?