As the digital asset and registered fund spaces continue to intersect — with the first Bitcoin (BTC) regulated fund launching just over a year ago — there is much to sort through and many ongoing lessons to learn as to which products make sense for which types of investors. From crypto winters and RIC qualification, to futures contracts and taxes, below offers perspective on what the investment industry has learned over the past 12 months and what lies ahead.
This past year has brought on the third crypto winter, resulting in many of the major coins dropping as much as 70% in 2022 and an estimated $1.9 trillion in lost market value. This plunge has largely been the result of aggressive interest rate hikes from the Federal Reserve to stave off historic inflation and the broader market downturn. Additionally, the collapse of everything from stablecoins to exchanges has created substantial turmoil in the markets.
There is some room for optimism, however, both in the markets overall and with respect to the regulated products in the digital assets space. BTC has remained relatively flat over the past five months, and many in the industry are encouraged by its reduced volatility. Furthermore, many believe a pivot from the Fed regarding interest rate hikes could result in substantial buying. With respect to funds, despite a substantial reduction in assets, demand seems to remain strong. The first ETF to launch, Proshares Bitcoin Strategy ETF (BITO), has had net inflows in 10 in its first 12 months, despite market uncertainty and the performance of the underlying asset.
Funds electing to be taxed as Regulated Investment Companies (RICs) are subject to various limitations and requirements. The passive income requirement forces a RIC to use a subsidiary corporation to hold the futures contracts. RICs are also prohibited from having any one investment (including a wholly owned subsidiary) that exceeds 25% of the RIC’s gross assets (measured quarterly). Managing that 25% limitation can be burdensome, especially when you consider the inherent volatility in the asset class and the substantial amount of inflows and outflows that occur with a listed ETF. As a measurement date approaches, management can be left with a choice of exiting a position early, which results in additional fund level expenses, or using leverage to “stuff” the gross assets of the fund, which also results in additional cost. Either way, fund shareholders are paying the price, literally, to meet a requirement intended to protect them.
In general, the use of futures contracts as opposed to direct investment in the underlying assets typically adds a layer of cost for investors. Because the futures contracts are reset monthly, there is a substantial cost to the fund (and ultimately the shareholder) to roll the contracts. In its October 2022 article, “The Bitcoin Futures ETF at 1: $1.8 Billion Lured, Over Half Lost,” Bloomberg Intelligence estimated that maintaining exposure via monthly resetting BTC futures contracts could result in futures contracts underperforming the underlying asset by as much as 10 to 20%.
In addition, given the perceived volatility of the asset class, many of the larger Futures Clearing Merchants (FCMs) are requiring margins in amounts upwards of 50% of the notional value of the contracts. Between the cost of capital and the lost return on not deploying capital elsewhere, this can result in a significant drag on returns. Some smaller FCMs have entered the fold who require less margin; however, these tend to have higher fees and are less sophisticated than their larger counterparts. Either way, fund shareholders ultimately bare the cost of this inflated margin requirement.
The tax consequences of many of these products, unfortunately, are not always efficient. Losses at the subsidiary level are not carried forward and essentially lost. Should BTC even have a modest rebound in the next year, a situation could arise where a shareholder who has been in since the beginning and suffered substantial losses will receive a distribution taxed at ordinary rates. This would very much be an unwelcomed outcome.
Additionally, ETFs are viewed by many as the tax efficient alternative to a traditional mutual fund. At a high level, this is mostly the result of a provision that allows a RIC to avoid recognizing gain on appreciated assets (as opposed to cash) distributed to redeeming shareholders. This is a RIC specific provision and does not apply to the non-RIC subsidiary, who ultimately holds the futures contracts. As a result, the fund, and ultimately the shareholders, is unable to benefit. Given the additional costs that could arise from the intra-day liquidity associated with ETFs, such as buying and selling futures contracts based on those inflows and outflows throughout the day, it might be worth considering if an ETF is the appropriate wrapper, as opposed to a traditional mutual fund, which does not have intra-day subscriptions and redemptions.
Given the additional costs regarding futures contracts, it would seem that a Spot ETF would be much more efficient for investors. However, the SEC still is not convinced and has not yet approved a spot product. The agency continues to cite that a direct investment product lacks the ability to protect investors from fraud and manipulation. They addressed this further in an approval letter of another BTC Futures product, stating their concern over fraud and manipulation could be addressed “if an exchange proposing to list and trade a spot bitcoin [product] identifies the regulated market with which it has a comprehensive surveillance-sharing agreement, [then] the exchange could overcome the Commission’s concern.” This begs the question, however, if a large crypto exchange would be open to such oversight, especially considering the entire industry was created around the concept of a decentralized system.
While crypto winters, regulatory obstacles and tax complexities will always be part of the investment industry world, there is still a silver lining. What is clear from all of the activity between the digital assets and regulated fund space is that there is strong investor appetite for a product offering both the protection of the SEC and the liquidity of intra-day trading. The ’40 Act Bitcoin product, and more importantly ongoing product innovation, is likely here to stay.
Contact Matt Romano at firstname.lastname@example.org or a member of your service team to discuss this topic further.
Cohen & Company is not rendering legal, accounting or other professional advice. Information contained in this post is considered accurate as of the date of publishing. Any action taken based on information in this blog should be taken only after a detailed review of the specific facts, circumstances and current law.
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