In 2000, Pets.com, a dotcom darling that sold pet supplies online, went public at $11 per share. Less than 12 months after its IPO, Pets.com was in liquidation and with it $300 million of investor capital disappeared. Pets.com – along with the likes of Flooz.com, etoys.com and Webvan – were all poster children of the dotcom bubble where companies net of any tangible assets or viable strategies amassed millions of dollars in fundraising, simply by virtue of having a website.
Inevitable comparisons are being made today between the profligacy witnessed during the dotcom bubble, and what is happening currently with Bitcoin, or #Bitcoin as it is known by some of its excitable celebrity backers on various social media circles. With bitcoin now trading at levels approaching $20,000, many experts are forecasting an imminent implosion in its value. That CBOE Global Markets and CME Group have incorporated Bitcoin futures trading onto their exchanges has also fuelled the hype.
Hedge funds however, have been early movers in Bitcoin. Autonomous NEXT data from October 2017 suggests there are 124 managers focused on crypto-currencies collectively running around $2.3 billion, a fairly small number in comparison to the $3 trillion controlled by the industry globally. Nonetheless, interest has been sufficiently robust for data provider Hedge Fund Research to incorporate a cryptocurrency index into its benchmarks, which is reportedly delivering whopping gains of 1,522%, compared to the 7.5% industry average.
The growing hedge fund exposures in Bitcoin is beginning to create tensions at AIFMD (Alternative Investment Fund Managers Directive) depositaries, many of whom are increasingly alarmed at the activities of crypto-funds. “The European depositaries which I have spoken to are steering clear of crypto-funds. This is not necessarily because they are taking a negative view about Bitcoin being a bubble, but because there are some fundamental questions which need answered when it comes down to how depositaries oversee and verify ownership of Bitcoin or other similar assets,” said Bill Prew, founder of INDOS Financial, a UK-based depositary.
A depositary cannot be held responsible for investment risk under AIFMD, so will not be liable if Bitcoin holdings decline precipitously in value. However, the rules do make depositaries financially accountable if assets get lost or stolen in custody, including at the sub-custodian. While AIFMD allows depositaries to discharge liability to sub-custodian providers, it can only do so under very specific and rare circumstances.
This then boils down to whether Bitcoins – stored in digital wallets at specialist exchanges – would technically be classified as being held in custody, said one funds’ lawyer. Prew said he believed Bitcoin “would constitute a non-custody ‘other’ asset under the AIFMD framework.
This is not so much of an issue for Bitcoin futures now being traded on regulated exchanges, but it is an issue for direct holdings of Bitcoin,” explained Prew.
Aside from the massive investment risk associated with Bitcoin, crypto-currencies are vulnerable to obvious operational risks. A report by Lloyds of London identified cyber-crime as a major threat to institutions holding Bitcoins. The study warned such organisations were vulnerable to theft, particularly if criminals acquire an institution’s private keys and gain control of Bitcoins in the matched public addresses.
Lloyds of London also suggested Bitcoin networks were open to manipulation through the creation of fraudulent transactions. Bitcoin exchanges have been subject to repeated hacks over the years. In December 2017, NiceHash, a Slovenia-based Bitcoin exchange had $70 million worth of Bitcoins stolen, although the most notorious example was Mt Gox in Tokyo, which saw hackers steal around $450 million in Bitcoins.
Given the plethora of cyber-breaches, some depositaries may be uncomfortable at letting managers retain Bitcoin accounts at these exchanges. Cyber-security is of course a focal point for depositaries as it is unlikely they would be able to discharge liability in the event of a hack at a custodian provider.
“One large Bitcoin exchange was hacked in 2014 and a significant amount of Bitcoins were stolen, and depositaries are understandably nervous about that. Because depositaries do not appear to be willing to act at present, managers running crypto-funds are establishing funds so that they are not within the scope of the AIFMD depositary rules,” said Prew.
The concept of Bitcoin is new to many depositaries who are more accustomed to verifying assets are being held at more conventional providers such as global custodians, agent banks, central securities depositories (CSDs) and central counterparty clearing houses (CCPs). Depositaries will therefore need to monitor Bitcoin exchanges, and familiarise themselves more with this new market infrastructure.
Even so, a number of depositaries are still uneasy. Prew acknowledged non-traditional providers of custody have evolved to hold the Bitcoin encryption keys in a secure environment. “This new approach to custody and the interaction with the AIFMD depositary rules for crypto-currencies needs further analysis,” said Prew.
As more asset managers including hedge funds explore opportunities in Bitcoin, depositaries are going to have to redouble their efforts around getting up to speed with the world of cryptocurrencies. Many are clearly alarmed about the potential of having to reimburse investors if a Bitcoin exchange defaults or suffers a hack, and as a consequence are probably going to avoid managers partaking in Bitcoin investments.