Many hands choosing cryptocurrency coins from box labeled ICO

While bitcoin’s price has fallen sharply from its high of US$19,343 in December 2017, interest in cryptocurrencies and blockchain remains. And fund managers still seek to add these new assets to their funds. But investment dealers must be prepared to ask fund managers the right questions before adding these products to their list of approved funds, according to experts who spoke at the 2018 IIAC FinTech Summit in Toronto on Friday.

Before deciding to approve funds that hold cryptocurrencies or blockchain investments, dealers must consider several factors, said Julie Mansi, partner with Toronto-based Borden Ladner Gervais LLP, who spoke as part of a panel at the conference. These issues range from the strategy employed by these funds to the marketplaces in which they operate. There are a few different ways in which fund managers are entering or attempting to enter this new investment space. Some investment funds are focused solely on investing directly in cryptocurrencies, while in other cases traditional hedge funds are adding cryptocurrencies to their portfolios as an asset class.

There are even investment funds that are looking to accept cryptocurrency as payment, says Mansi, because portfolio managers of those funds believe they can attract more investors by accepting cryptocurrency rather than just fiat currency.

One of the first questions to ask about these funds is what exactly their strategy is. Some funds, for example, employ a straightforward buy-and-hold strategy regarding cryptocurrencies. A new strategy emerging in the crypto fund space, however, is arbitrage. These arbitrage strategies attempt to take advantage of the difference in price in the crypto coins themselves, or they can be employing arbitrage between cryptocurrency markets.

“The pricing between exchanges is so severe in this space that it is a significant opportunity,” Mansi said.

With that in mind, the second question dealers should ask cryptocurrency fund managers is how they are valuing the coins and markets that they trade in, and the policies and procedures they have in place for that decision.

“That’s actually quite difficult in this space because there can be no consistency among the exchange pricing,” Mansi said. “You have to then ask: well, how did you pick your exchange? What were the criteria that you used to pick that exchange?”

Another consideration when conducting due diligence on these new funds is the liquidity of the cryptocurrency being invested in. Bitcoin and Ether, for example, are among the largest cryptocurrencies available and therefore are more liquid than other coins in the market.

“The concern you would have as a fund manager is that you could have client redemptions in very volatile markets,” Mansi said, “So, again, [this is] part of your ‘know your product’ due-diligence reviews.”

Dealers looking at these new funds should also take a close look at the registration of the managers.

“You have to consider how these entities are being registered,” Mansi said.

The first thing to think about, according to Mansi, is whether the cryptocurrency is being treated as a security, a commodity or a derivative. For example, bitcoin is often considered a commodity, meaning only an investment fund manager registration and exempt-market dealer registration are required. That was the case for Vancouver-based First Block Capital Inc., which focuses on cryptocurrency investing. However, Mansi said, regulators may start to consider whether a portfolio manager registration is required as arbitrage strategies become more common.

Finally, Mansi said, dealers should not be scared away from cryptocurrency funds because of the perceived anti-money laundering (AML) compliance risks. “Don’t presume that bitcoin, crypto, is an [AML] risk,” she said. “It’s not necessarily a risk.”

For example, Mansi said, a long-term client who expresses an interest in investing a small amount in cryptocurrency shouldn’t raise AML red flags.