An Introduction to Cryptocurrency Funds | Timothy Spangler | Lunch & Learn

© 2018 Dechert LLP
March 2, 2018
Preparing for Cryptocurrencies and
Digital Assets
Timothy Spangler

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Agenda
 Overview
 Legal and Regulatory Framework
 Cryptocurrency Funds – Terms and Issues
2March 2, 2018 Preparing for Cryptocurrencies and Digital Assets

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The Bitcoin Origin Story
 2008
• Bitcoin was first proposed by Satoshi Nakamoto as a
combined digital asset and peer-to-peer (“P2P”) payment
system that uses its own currency (“bitcoin”) to transact
business
̶ See S. Nakamoto, Bitcoin: A Peer-to-Peer Electronic Cash
System (Oct. 2008).
 2009
• The technology behind bitcoin was introduced as open
source software, meaning that its computer code is public
and anyone can collaborate to enhance the software
• The first bitcoin was mined and the first payment made
Preparing for Cryptocurrencies and Digital Assets 3March 2, 2018

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Bitcoins and Other Virtual Coins or Tokens
 A bitcoin is one type of virtual coin or token; there are hundreds
 Some tokens, such as bitcoins and ethers, function like virtual
currency; i.e., digital representations of value that can be
electronically traded and function as mediums of exchange,
units of account, or stores of value
 Other tokens represent a right to tangible assets, like gold or
real estate
 They are not legal tender or e-money

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Blockchain: The Technology Behind Bitcoin
 A blockchain is a decentralized and distributed digital ledger or list of
entries – much like a stock ledger – that is maintained by various
participants in a network of computers
 Data in the blockchain are shared, replicated and synchronized across
multiple digital locations

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Blockchain Technology: Decentralization
Preparing for Cryptocurrencies and Digital Assets 6
 Decentralization means the network can operate on a P2P basis, taking
out the middle man who facilitates transactions in a traditional network
 Decentralized ledgers are considered secure because there is no single
point of failure
March 2, 2018

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Blockchain Technology: Distribution
 Distribution means that data do not exist in one place but are
duplicated or shared
 Distributed ledgers are accurate because multiple users validate each
transaction
March 2, 2018

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How Blockchains Work
 A blockchain gathers and orders data into “blocks” and chains them
together chronologically using cryptography, providing comfort to
blockchain users that the entries are secure
 “Miners” verify transactions on the ledger, providing comfort to blockchain
users that the entries are accurate
1. Validation 2. Block formation 3. Time stamp 4. Encryption 5. Link
March 2, 2018

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Other Distributed Ledger Technologies (DLTs)
 Not all virtual currencies are on blockchains
 Blockchains are just one type of DLT
 A “tangle” or directed acyclic graph (DAG) is another type of DLT
 Unlike a blockchain, a tangle has no blocks and no mining and it
scales almost infinitely
 Like the blockchain is the foundation of bitcoin, the tangle is the
foundation for IOTA, a cryptocurrency for the Internet-of-Things
(IoT)
Serguei Popov, The Tangle
March 2, 2018

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Mining and Trading of Coins and Tokens
 Cryptocurrencies based on a blockchain are created through "mining;“
IOTAs are not mined
• Miners use software algorithms to add transaction records to the blockchain’s
ledger and to verify legitimate transactions
• For their efforts, the miners receive transaction fees
• If the miner finds a new "block," the miner is awarded new coins/tokens
• A finite number of coins/tokens can be mined as determined by the
blockchain’s algorithm
 Coins/tokens can be bought and sold online or at physical locations
 Coins/tokens reside in a digital "wallet" where they can be used to
purchase items from establishments that accept them
 Coins/tokens can be traded for traditional currency at exchange rates
that fluctuate; typically widely because virtual currencies have been
extremely volatile

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The “Howey” Factors
 The SEC applies the four factors of the Howey test to determine
if tokens are “investment contracts” and, therefore, securities,
under the 1933 Act and the 1934 Act
• SEC v. W.J. Howey Co., 328 U.S. 293, 301 (1946); see also SEC
v. Edwards, 540 U.S. 389, 393 (2004)

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The “Howey” Factors, cont’d
 Factor 1: An Investment of Money
• Even where investors purchased tokens using the ethers, a virtual
currency, the purchase of tokens can involve an investment of money
under the Howey test
̶ An investment does not need to be in the form of cash
– See Uselton v. Comm. Lovelace Motor Freight, Inc., 940 F. 2d 564, 574 (10th
Cir. 1991)
̶ Bitcoin has been found to constitute a form of money because it can be
used to purchase goods or services.
– SEC v. Shavers, No. 4:13-CV-416, 2014 WL 4652121 at 1 (E.D. Tex. Sept. 18,
2014)
 Factor 2: Common Enterprise
• Without analysis, the SEC simply states that the investors who
purchased tokens were investing in a common enterprise

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The Howey Factors, cont’d
 Factor 3: Solely from the Efforts of Others
• The SEC finds that the issuer’s management was critical in
monitoring operations safeguarding investor funds, and
determining whether proposed contracts should be put for a vote
• In addition, token-holders’ voting rights were mostly perfunctory,
and they were widely dispersed with limited ability to communicate
with each other
̶ SEC v. Glenn W. Turner Enterprises, Inc., 474 F.2d 476, 482 (9th
Cir.1973)
 Factor 4: With a Reasonable Expectation of Profits
• Potential investors were given promotional materials stating that
the issuer was a for-profit entity that sought to provide capital to
projects for a return on investment

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Initial Coin Offerings
 Virtual tokens or coins may be issued by a virtual organization or
other capital raising entity
• A virtual organization is an organization embodied in computer
code and executed on a blockchain or distributed ledger
 The code, often called a “smart contract,” serves to automate
certain functions of the organization, which may include the
issuance of certain virtual coins or tokens
• Smart contracts code transactions that will execute automatically
when specific conditions are met

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Virtual Currencies as Commodity Options and
Swaps
 In 2015, the Commodity Futures Trading Commission (“CFTC”) first
found that bitcoin and other virtual currencies are commodities
• In the Matter of Coinflip, Inc., d/b/a/ Derivabit, and Francisco Riordan (Sept. 17, 2015)
 The CFTC’s jurisdiction is implicated when a virtual currency is used in
a derivatives contract, or if there is fraud or manipulation involving a
virtual currency traded in interstate commerce
• LabCFTC, A CFTC Primer on Virtual Currencies (Oct. 17, 2017)
̶ “There is no inconsistency between the SEC’s analysis and the CFTC’s determination that
virtual currencies are commodities and that virtual tokens may be commodities or
derivatives contracts depending on the particular facts and circumstances.”

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Internal Revenue Service Virtual Currency
Guidance
 Virtual currency is treated as property for U.S. federal tax
purposes. Accordingly, the general rules for property
transactions apply.
• See IRS Notice 2014-21 (March 25, 2014)
 A taxpayer who receives virtual currency as payment for goods
or services must include the fair market value of the virtual
currency in computing gross income.
 Virtual currency is not treated as currency that could generate
foreign currency gain or loss for U.S. federal tax purposes.

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A Brief History of Cryptocurrency Funds
 First dedicated cryptocurrency hedge fund (Pantera Capital,
seeded by Fortress Investments) launched in 2013
 Relatively few followed until 2017
 Steep increase in value of Bitcoin generated
• Widespread media coverage
• “Gold rush” mentality
• Bitcoin holder’s desire to diversify

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What Do Cryptocurrency Funds Do?
 Buy-and-hold bitcoin and nothing more
 Capture arbitrage opportunities as currencies move up and
down in value
 Participate in ICOs
 Invest more broadly?
18Preparing for Cryptocurrencies and Digital AssetsMarch 2, 2018

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Structuring Considerations
 How do we adapt traditional private fund documentation to deal
effectively with digital assets?
 Federal security law issues
 Whether the particular coins/tokens are securities drives
analysis
 Given SEC scrutiny, funds are setting up with the presumption
that at least some of the coins/tokens will be deemed securities
 Due diligence of service providers is crucial for fund managers
 Technology varies significantly from once service provider to
another

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Basic Terms
 Open-end (hedge fund style) appears most popular, although
with limits on liquidity due to volatility
 Customary Delaware/Cayman structure being adopted
• IRS position that cryptocurrencies are “property” means that non-
US investors may face Effective Connected Income (ECI) issues,
and substantial withholding tax
 Customary fee structures (2/20)
 Great potential for terms and structures to evolve significantly
from this approach
 If fund only holds cash and coins/tokens, then fund arguably not
covered by Investment Company Act

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Disclosure and Risk Factors
 Existing funds should review closely to determine if coins/tokens
are within their permitted investments
 Due to volatility and rapid developments, adequate disclosure
(risk factors, conflicts of interest etc.) is extremely important
• Technological and cybersecurity risks
• Regulatory risks
• Investment risks – e.g. liquidity, volatility, and valuation
 Regulators are focused on this space – and soon plaintiffs’
lawyers will be, too, with claims of 10b-5 violations
 Regardless of whether a particular coin/token is a security, the
shares/interest/units of a DE/Cayman fund vehicle definitely are

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Auditor Issues
 Concerns include:
• Valuation
• Security
• KYC/AML
 Unique issues for audits
• Determining existence of digital assets
• Demonstrating control over the digital asset
• Custody
 Auditors will need to examine blockchain and wallet to establish
what the fund holds

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Custody Issues
 Traditional concept of “custody” is not a natural fit for digital
assets
• Who is going to hold (or facilitate the holding) of the private keys?
 Rule 206(4)-2 and SEC custody requirements for registered
advisers
• Funds and securities must be held with a “qualified custodian”
• Only a limited number of firms meet this definition
• Self-custody: additional requirements
 Hot wallet (online) vs. cold wallet (offline)
 Can two different funds be raised based on the digital assets of
a single wallet?

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Administrator Issues
 Traditionally, calculate NAV and oversee subscriptions and
redemptions
 Not a regulatory requirement, but an investor expectation
 In-kind subscriptions of bitcoin or other digital assets?

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Pre-Trade Issues
 Process by which specific investment decisions are made
 Will fund invest in only cryptocurrencies – e.g. bitcoin, ether?
 Will fund invest in ICO tokens or other digital assets?
 What about securities of companies monetizing blockchain
opportunities more widely?
 In addition to research analysts, investment team may require
data scientists who understand blockchain technology and
cryptography.

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Execution Issues
 Direct transactions or via an exchange
 Pre-ICO vs. Post-ICO
 Order flow connectivity – i.e. how many exchanges will you be
transacting with
 Liquidity will be a recurring concern
 Risk management

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Post-Trade Issues
 Should your digital assets be held in a ledger wallet?
 Hacking risk – hot wallet vs. cold wallet
 Store coins/tokens on an exchange?
 Trading frequency

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Speaker
Financial Services
timothy.spangler@dechert.com
+1 949 442 6044
Partner
Timothy Spangler
Timothy Spangler focuses his practice on the intersection of
alternative investment management and financial technology
innovations. He assists clients with the formation, structuring and
negotiation of private investment vehicles across numerous
jurisdictions around the world. Mr. Spangler regularly advises fund
sponsors and promoters on the structuring and launch of hedge
funds, private equity funds and venture capital funds, as well as
with respect to their co-investment arrangements, internal
partnerships and personal investments.
Dividing his time between the firm's Orange County and Silicon
Valley offices, Mr. Spangler also advises clients on the impact of
blockchain, cryptocurrencies and digital assets on the financial
services industry and the innovation economy.
March 2, 2018

For further information, visit our website at dechert.com.
Dechert practices as a limited liability partnership or limited liability company other than in Dublin and Hong Kong.

An Introduction to Cryptocurrency Funds | Timothy Spangler | Lunch & Learn

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