Article I: Digital Asset Overview and Methods to Gain Exposure to Digital Assets
Given the growth of markets for cryptocurrencies and other blockchain-based assets, often referred to as “digital assets,” we see growing interest from traditional investment managers in gaining exposure to this emerging asset class. We have seen development of many new products and service offerings to facilitate institutional investment in digital assets over the past year. With the recent announcement of the first bitcoin-exchange traded fund, this week, we expect continued and expansive growth in this area. This article aims to serve as an introductory guide to digital asset investing for institutional investors by describing at a high level the available service offerings and potential avenues for investment managers to gain exposure to the digital assets space.
We will first describe service offerings related to digital asset futures and over-the-counter (OTC) derivatives. We will also discuss a developing range of services referred to as digital asset “prime brokerage” — describing the suite of services typically provided by these prime brokers and comparing them to traditional offerings of prime brokers in the securities space. Finally, we will address decentralized finance, or “DeFi,” which has been discussed in financial circles recently due to the eye-popping returns yielded by investors in certain DeFi assets and other DeFi arrangements.
I. CME Futures on Bitcoin and Ethereum
Earlier this year, the Chicago Mercantile Exchange (CME) Group began offering futures and options on Bitcoin as well as futures products on Ether. For institutional investors that trade futures using a futures customer agreement with a registered futures commission merchant, or FCM, this offering can be an appealing way to access digital assets markets because it uses a familiar product and documentation.
FCMs who offer institutional customers access to CME’s cryptocurrency products typically require a futures customer agreement (we note that many institutional investment managers may already have these in place) and possibly an accompanying side letter or addendum to specify terms of the futures customer agreement that apply exclusively to a customer’s digital asset futures positions. Building off an existing futures trading relationship and its documentation presents advantages for the institutional investment manager. A customer with an existing futures customer trading relationship can avoid doing diligence on a new trading counterparty and spending significant time learning and negotiating a new trading agreement. Another benefit is that the product is traded on a regulated futures exchange, which means regulatory and clearinghouse rules determine margin and position limits designed to reduce systemic risk to all customers exposed to the exchange overall. Some of the disadvantages of this product are, at least as of this writing, that it provides access only to Bitcoin and Ether and no other digital assets. Futures also do not provide direct access to the underlying Bitcoin or Ether. Also, futures customer agreements tend to be very one-sided arrangements in favor of the FCM with terms that permit the FCM to ask for unlimited margin and to terminate open positions at any time to allow it to reduce its exposures. Investment managers seeking access to the crypto markets by way of an FCM will want to be aware of some of these limitations.
Interestingly, the ProShares Bitcoin Strategy ETF that started trading on October 19, 2021, tracks the price of Bitcoin futures traded on the CME. The ProShares ETF effectively provides retail investors access to the same exposure to Bitcoin futures that is directly available to institutional investors who are able to trade Bitcoin futures through an FCM.
II. Traditional OTC Derivatives
We are starting to see development of digital asset derivatives contracts using traditional documentation published by the International Swaps and Derivatives Association (ISDA). We have also seen some long-form confirmations for OTC options and other bespoke trades on digital assets that incorporate by reference a deemed ISDA Master Agreement between the parties. At this time, we have not seen clear “market standard” terms develop in these agreements, and they still raise numerous questions. A threshold issue is how the derivatives regulations applicable to swaps and security-based swaps in the U.S. apply to derivatives on digital assets, which will prospectively guide some of the terms on which these products trade. For example, we see customer interest in posting digital assets as collateral for derivatives transactions on digital assets; however, we think this will not be permissible if the digital asset derivatives are regulated swaps or security-based swap transactions. Further, market standard terms need to develop relating to some of the unique features that have bearing on the economic value of a digital asset, events such as “hard forks1” or “airdrops,2” for example. We expect the quality of this documentation will improve quickly, especially as more seasoned market participants enter this market and consider how the regulatory regime for swaps and security-based swaps also applies to OTC derivatives on cryptocurrencies. In fact, in Q3 of 2021, ISDA initiated a survey among its members about digital assets trading over the prior 12 months as a step toward developing a whitepaper for this emerging asset class.
III. Digital Asset Prime Brokerage Offerings
Some of the larger, well-known cryptocurrency market participants and service providers are beginning to offer institutional versions of their products to investment managers and their funds. The documentation, which often bears the familiar title “prime brokerage and custody” agreement, presents some key differences from the product offerings under traditional securities brokerage and custody agreements. As we discuss further, many of the differences an investment manager will observe with respect to the prime brokerage offerings in the traditional securities versus digital assets space relate to the fundamental nature of digital assets and prevailing market structure in addition to regulatory uncertainty related to digital assets. Traditional prime brokerage typically involves some combination of execution, margin, stock lending, clearing, and custody through relationships with certain securities intermediaries or other market participants. In contrast, digital asset prime brokerage services, in our experience, are currently limited to trade execution and physical custody of digital assets by the prime broker, although we have recently seen development of certain types of short-term credit offered to investment funds or other institutional customers.3 Below we provide a high-level overview of the typical execution and custody offerings of digital asset prime brokers and compare some novel aspects of these offerings to traditional prime brokerage.
a. Overview of Trade Execution Services Offered Through Digital Asset Prime Brokerage
In contrast to the robust regulatory regimes and market structure governing trading in traditional commodities and securities, the framework for digital asset investment is evolving. This has many implications for institutional investors choosing to invest in digital assets, as well as some of the service providers for these assets, and is a topic that warrants its own series of articles. Foremost among the issues raised by the uncharted regulatory landscape is that an institutional investor cannot count on the many customer protection benefits provided when trading securities with a U.S. regulated broker-dealer. For example, protections such as Securities and Exchange Commission or Financial Industry Regulatory Authority (FINRA) rules requiring that a broker provide best execution and regulations mandating disclosures related to a broker’s conflicts of interest are nonexistent when it comes to obtaining digital asset execution services.
While the lack of regulatory clarity related to digital asset trade execution may intimidate some investment managers, the good news is that in our experience, the leading digital asset service providers appear to be interested in establishing themselves as the “next generation” of financial service providers and therefore are motivated to provide legitimate services that genuinely consider the needs of their new customers. In our view, these service providers and market participants have been accommodating to reasonable requests to negotiate the terms of their prime brokerage documentation. Thus, investment managers will find it important to have in-house and outside counsel that possess a keen understanding of not only the digital asset space but also the expansive network of rules governing trade execution in traditional markets and the policies and reasoning underlying the provisions of each relevant rule. This will ensure that counsel can negotiate for provisions in prime brokerage documentation that will allow investment managers to operate under agreements that, as much as possible, benefit from the long history of regulatory developments and protections afforded to customers in traditional securities and commodities markets. For example, while no regulation exists to prevent digital asset prime brokers from engaging in front running of their customers’ large transactions, skilled counsel should be able to craft provisions in prime brokerage agreements that restrict information sharing related to open limit orders and specify appropriate conduct for execution of marketable orders to provide similar protections afforded by applicable regulations in the securities space, such as FINRA Rules 5270 and 5320 and other related rules and guidance.
When trading digital assets on a brokerage platform, institutional investors should be mindful of some core differences in the trade execution process for traditional securities versus digital assets. When trading securities, the investor will typically enter into an arrangement to buy or sell the securities from an executing broker. The price at which an executing broker can buy or sell will be established at the market or exchange on which those securities are traded. While it is possible that different executing brokers may offer slightly different prices depending on the size, volume, and time of day at which they execute, an institutional customer can at least rely on regulations imposing requirements that executions occur within a reasonably narrow range called the National Best Bid and Offer (NBBO), during a normal trading day for exchange-listed securities, and the fact that a broker’s duty to provide “best execution” will usually require such broker to check a range of different market venues before buying and selling securities for which no NBBO exists. In contrast, digital assets are not traded within a national market system. In fact, digital assets trade on a disparate set of international market venues including exchanges and OTC liquidity providers, each of which may be governed by a unique set of rules, served by many or only a few market makers, trade only a limited set of digital assets, or present other novel barriers to trading. As a result, different market venues may offer vastly different prices for the same digital asset. A competitive point of distinction that will become increasingly important for institutional investors in selecting a prime broker for digital assets will be the amount of venues that such prime broker is able to utilize and whether the prime broker offers any type of “smart order routing” or other aggregation tool, which will include a means for the broker to access pricing and liquidity from multiple sources to ensure that the institutional customer executions benefit from competitive pricing.
b. Overview of Custody Services Offered Through Digital Asset Prime Brokerage
The terms governing a financial institution’s custody of customer assets is a key element to counterparty risk management for the institutional investor. For traditional asset classes, most institutional investors focus closely on whether the broker has any right to rehypothecate the assets it has in custody, what rights the investor has to call for return of such assets, the financial institution’s authority to transfer assets out of a customer’s account, as well as the standard of care the financial institution uses with respect to subcustody of its assets. The answers to these questions are critical in terms of gauging whether a customer will have a right to recovery of its custodied assets in the event of an insolvency at the financial institution. While similar questions are appropriate to ask with respect to custody of digital assets, other factors need to be considered in this analysis as well. The driver of these other factors for digital assets is the nature of the asset itself. Whereas the beneficial ownership of the most widely traded securities can be sourced to the Depository Trust Company (DTC) and its affiliates and/or to the transfer agent of a securities issuer (and further to the books and records of other custodians, carrying brokers, and other service providers), the ownership of a digital asset is traced to the relevant blockchain. Transactions on the blockchain do not occur on the centralized systems of DTC or other market participants — instead, they are a result of an interaction among strings of information called “keys” in a decentralized manner, and there is no central organization or authority that has complete control over the transaction record or the ability to reverse unintended/invalid transactions.
Digital assets held in accounts managed by a registered investment adviser generally must be held by a “qualified custodian,” as defined in the rules under the Investment Advisers Act of 1940. While the underlying safety and soundness concerns are similar to those with respect to digital assets held in brokerage accounts, the rules that apply to advisers involve additional considerations.
In digital asset custody, it is important for a prime broker or any digital asset custodian to secure “private key”4 information related to a digital asset. Allowing public access to such private key is tantamount to allowing unauthorized parties to have physical access to cash. Thus, in-house or outside counsel must carefully review prime brokerage documentation to ensure it provides reasonable assurance that private keys are protected. Digital asset prime brokers typically store private key information in either “hot” or “cold” storage5 and often offer a structure where different varieties of hot and cold storage may interact. Any time a broker or custodian is using hot storage, the customer’s assets are at risk of being hacked, and thus it is important for digital assets to be stored in cold storage at appropriate times. However, there are moments where holding assets in hot storage is unavoidable, especially around the moments when the owner of a digital asset wishes to effect a trade, as such asset will need to be online to enable a transfer to occur. Given the potential complexities and the sensitivity around private key storage, it is important that investment managers and their counsel understand the information storage structure provided by any prime broker or custodian.
In addition to managing the potential risks related to private key storage, an institutional investor will need to consider issues related to the insolvency of its digital asset prime broker or custodian. The fact that the most widely traded digital assets are currently not considered securities means that there is generally no protection provided by the Securities Investor Protection Corporation for digital assets held for trading. Instead, investment managers must ensure that their prime brokerage service provider or custodian is equipped with an appropriate insurance policy and further that the prime brokerage or other agreement covering custody provides that digital assets held would be subject to such insurance policy if certain events occur, such as hacking of digital asset wallets.
IV. Obtaining Exposure to DeFi and Assets Beyond Bitcoin
The digital asset space moves at a fast pace. While individual and institutional interest in Bitcoin has increased this past year, returns on certain other digital assets have piqued the interest of investors. Many of these assets claim to have some connection to DeFi. DeFi is a loose category of alternative finance applications where investors and consumers can trade and borrow digital assets independently of traditional financial institutions and the regulatory framework that applies to such institutions. Many of these applications are associated with a unique governance token, which can rise in value if demand for use of the application increases, assuming there is no increase in the supply of the utility token. As of this writing, most DeFi applications are built on the Ethereum blockchain platform (which is the same blockchain platform associated with Ether), but new blockchain platforms have emerged to compete with Ethereum.6
While we understand that investment funds do not generally participate in the DeFi market through pure decentralized applications, we note that some digital asset prime brokers enable investors to buy and sell certain utility tokens or other assets related to the DeFi space. Further, some digital asset prime brokers facilitate limited participation in DeFi markets on an intermediated basis (i.e., through the prime broker entity). For example, certain service providers enable investors to loan their digital assets in exchange for interest payments. As part of custody-related services, many prime brokers facilitate investors’ ability to receive assets pursuant to an airdrop or hard fork. Some prime brokers also enable investors to participate in “staking,” which involves committing digital assets to support a blockchain network and confirming transactions in exchange for compensation, which are similar to interest payments. We note that while the DeFi space has recently become a focus of lawmakers and regulators, as of this writing there remain many service providers that facilitate some form of exposure to DeFi for their customers.
1 A hard fork is a permanent divergence in a blockchain, usually an outcome of significant updates to the blockchain that make pervious transactions either valid or invalid. In the past, hard forks have resulted in the creation of new digital assets. One example was the creation of Bitcoin Cash, which was the result of a hard fork from Bitcoin.
2 An airdrop is distribution of a digital asset, usually for free, to numerous wallet addresses. Airdrops are often implemented in an attempt to gain mass adoption of a new digital asset. As an example, the FOX token, which relates to a decentralized digital asset exchange, was the larger airdrop and resulted in delivery of tokens to holders of other DeFi tokens used on other decentralized digital asset exchanges.
3 Some prime brokerage offerings include a form of short-term extension of credit (for a period of hours or perhaps one day) for purposes of covering settlement risk, which may save investment funds from having to prefund their account before every digital asset transaction. Also, we are aware of some Some prime brokerage offerings include a form of short-term extension of credit (for a period of hours or perhaps one day) for purposes of covering settlement risk, which may save investment funds from having to prefund their account before every digital asset transaction. Also, we are aware of some digital asset service providers and prime brokers that facilitate digital asset lending, which involves a loan by an investment fund of digital assets to the service provider in exchange for interest payments.
4 A private key is a string of information that enables an individual to initiate a transfer of digital assets.
5 Hot storage refers to storage that can be accessed online, whereas cold storage refers to storage offline on a private device.
6 Unlike the Ethereum blockchain network and other advanced blockchain networks, the Bitcoin network does not facilitate the ability to use smart contracts and to build applications that operate on the Bitcoin network. Hence the development of DeFi has centered around technologies other than Bitcoin.