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“We believe the asset class is here to stay and
will become more mainstream over time, so
clients will eventually want us to develop
products to cover cryptocurrencies.”
PAUL FLEMING, GLOBAL HEAD OF HEDGE FUNDS, STATE STREET
ability for custody mandates that a loss by
a depositary or its delegate of a financial
instrument held in custody will give rise
to an obligation to replace the instrument
or pay the value to the AIF without undue
delay. A depositary can only avoid this
strict liability standard where it can prove
that the loss was as a result of an external
event, beyond its reasonable control,” says
Neil Robson, partner at Katten Muchin
Rosenman.
In order for a depositary to discharge
liability, Robson believes it would have
to meet certain conditions. “The deposi-
tary must meet all AIFMD requirements
relating to delegation. There must also be
a written contract between the depositary
and the delegate transferring liability to
the delegate and permitting direct en-
forcement by the AIF, AIFM or depositary
on its behalf against the delegate. Finally,
the depositary’s contract with the AIF or
AIFM must expressly allow such a dis-
charge and establish an objective reason
for this,” says Robson.
This then boils down to whether cryp-
tocurrencies – stored in digital wallets at
specialist exchanges – would technically
be classified as being held in custody, adds
Robson. The precise legalese governing
Bitcoin’s custody status under AIFMD
is rife with uncertainty. Prew says he
believed Bitcoin “would constitute a
non-custody ‘other’ asset under the AIF-
MD 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,” explains
Prew.
Crypto-currencies are also 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 organi-
sations were vulnerable to theft, particu-
larly if criminals acquire an institution’s
private keys and gain control of Bitcoins
in the matched public addresses.
30
Global Custodian
Spring 2018
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 hold 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 sig-
nificant 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 cryp-
to-funds are establishing funds so that they are not within the
scope of the AIFMD depositary rules,” says Prew. Robson agrees
that cryptocurrencies being stored in electronic wallets were
probably outside of the scope of what depositaries were willing
to service or oversee.
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 counterpar-
ty 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 ac-
knowledged 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,” he said.
As more asset managers including hedge funds explore oppor-
tunities in Bitcoin, depositaries are going to have to redouble
their efforts around getting up to speed with the world of cryp-
tocurrencies. 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 such investments.
The Bitcoin/ICO mania has also spilt over into Blockchain,
with a handful of companies experiencing unprecedented and
arguably speculative increases in their valuations. This mat-
ters to depositary providers who are testing the water with
Blockchain for their own internal and client-facing operational
processes. Equally, many of the custodians which depositaries
oversee are using the technology as well.
If Blockchain’s reputation is blotted by any Bitcoin/ICO fall-
out, depositaries may think twice about using or trusting the
technology. This would be an unfortunate – and arguably unfair
– outcome for Blockchain, particularly as distributed ledger
technology (DLT) is not the same thing as Bitcoin, a point that
has repeatedly been missed by many in the industry. For the time
being, it seems depositaries are erring on the side of caution
about servicing cryptocurrency hedge funds, but expect this to
change very soon.