The impacts of cryptocurrencies on the investment fund industry
Cryptocurrencies, i.e. digital currencies issued peer-to-peer with no need for a central bank, can be used in a decentralised and highly secure computer system that is updated 24 hours a day, such as the blockchain. This new asset class raises questions about the evolution of the fund industry. Insights from Jean-Pierre Gomez, Head of Public and Regulatory Affairs for Societe Generale Securities Services in Luxembourg.
Cryptocurrencies, the first and most famous of which being bitcoin, have attracted and continue to attract numerous investors – professionals and amateurs alike – looking to simply and quickly diversify their private investments. Retail investors are attracted to the idea of making substantial profits on a modest initial investment. UCITS1 andAIF2 fund managers could also be attracted by this new asset class, seeking to include cryptocurrencies in their portfolios.
Focus on Luxembourg
In Luxembourg, the CSSF has responded to the wave of enthusiasm for cryptocurrency by publishing an FAQ3 on cryptoassets. Demonstrating the Luxembourg authority's openness to innovation, the document sets out the main safeguards by listing the conditions for obtaining the authorisation to work with this new type of asset in full transparency.
The seven-page document (version 2, published on 4 January 2022) answers the five following questions:
Can a UCITS open to the public invest in virtual assets?
Can an AIF that meets the criteria of the AIFM Directive4 and is organised under Luxembourg law invest in digital assets?
Does a Luxembourg AIFM require authorisation from the CSSF to manage digital or virtual assets?
Are specific considerations to be taken into account, such as the risk of money laundering or terrorist financing?
Is additional authorisation required to act as a virtual asset custodian?
The answer to the first question is “No” and to the next four questions “Yes”. The creation of a cryptofund is subject to specific CSSF approval and limited to portfolio managers operating in the alternative investment sector with an AIFM licence.
Custodians and virtual asset managers
For future cryptocurrency UCIs marketed under the AIFM Directive, the custodian and the fund manager will remain the two major players in an investment fund. The custodian is responsible for the custody of the UCI's assets and for the supervisory and control requirements imposed by the AIFM Directive, transcribed into Luxembourg law in July 2013.
For financial instruments, the custodian – a financial banking institution – holds transferable securities and other derivatives listed in its own network of sub-custodians. If other assets are involved, i.e. “tangible” assets such as real estate, private equity and other “non-custodial” assets, the custodian bank or financial professional authorised in Luxembourg shall record in its books the position or account keeping reflecting the investments. Without holding them directly, custodians are thus able to record these “tangible” assets not considered as financial instruments.
As a virtual asset, cryptocurrency may not be held as a financial instrument within the meaning of the AIFMD, nor is it possible for custodians to keep a cryptocurrency position on their books as they would with real estate investments or investments in unlisted private companies.
The question for custodians, then, is how to track the value of digital assets. How can they be controlled? And how to ensure non-physical custody when there is no legal qualification of the cryptocurrency product?
Legal opinions vary on how to classify cryptocurrencies and how, literally, to hold them in accordance with European investment fund guidelines. The key issue is to determine who is responsible for what, the aim being to avoid disputes and misfortune in the event of, for example, investment losses, fraud and money laundering.
Regulation to protect investors in cryptofunds
As with investing in real estate funds or private equity, individual investors will not have access to the very first Luxembourg cryptofunds. According to the CSSF FAQ, these funds will continue to be reserved for institutional clients and certain professional or informed clients. They will not be available to the general public.
In the United States – the world leader in UCI assets under administration with €30.7 trillion, ahead of Luxembourg with €5.6 trillion5– retail investors are authorised to buy units of cryptofunds. Europe remains reluctant and cautious in this respect.
How will European investment funds handle cryptocurrency?
The growth of the cryptocurrency market is such that European regulators will soon be required to introduce clear rules on the matter. How can investment funds benefit from a risky but attractive asset such as cryptocurrency? What can reasonably be expected in the coming years?
As is often the case, the first thing to do to help custodians is to legally and technically define virtual assets, so that they can be properly recorded, valued, held and controlled on behalf of UCIs and AIFs. With legal interpretations diverging widely and from one country to the next, setting common rules will be complicated.
Lacking legislative clarification, it is difficult to make comparisons of UCIs with cryptos in their portfolio. It is also difficult to harmonise the creation, active management, monitoring and control of these new cryptofunds within the European Union.
Further issues include anti-money laundering, market abuse and cybercrime, each of which raises complex questions. Different protocols will, in all likelihood, need to be introduced for providers of conventional services (administrative agents, registrars, custodians and financial trading counterparties) that for now possess scant knowledge of the new investment category.
Working with this virtual asset also requires the adoption of new technologies worlds away from those currently used by the UCI industry. Clearing up these hazy areas will make it possible to attract the right players to Luxembourg with complete peace of mind and establish a truly secure cryptocurrency ecosystem, similar to that implemented for UCITS funds since 1985 (and transposed into Luxembourg law with the first UCI law of 30 March 1988).
Article published in Agefi Lux in February 2022.
1UCITS: Undertakings for Collective Investment in Transferable Securities
2AIF: Alternative Investment Fund
3FAQ Virtual Assets - Undertakings for collective investment
4AIFM: Alternative Investment Fund Managers
5ALFI, data from September 2021