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The Securities and Exchange Commission (“SEC”) and Commodity Futures Trading Commission (“CFTC”) (collectively, the “Agencies”) jointly proposed a rule (the “Proposed Rule”) that would impact existing confidential reporting obligations of private equity funds and other collective investment vehicles not registered as an “investment company” (referred to as, “Private Funds”). The rule proposes changes to the Form PF, a non-public report for certain SEC-registered investment advisers to Private Funds, which get submitted to the SEC (and CFTC, when applicable). The Agencies use the Form PF’s information to monitor risk and gain general intel about the Private Fund and market more broadly. To be clear, changes here would impact more than digital assets, they are really making a large revamp here of the reporting regime. Checkout the SEC’s Fact Sheet.

In a move that is relatively unusual in the digital assets space, the Agencies have jointly agreed upon a definition of “digital asset”, to include: An asset that is issued and/or transferred using distributed ledger or blockchain technology (“distributed ledger technology”), including, but not limited to, so-called “virtual currencies,” “coins,” and “tokens.”

The definition here is intentionally defined broadly to capture any kind of blockchain-based asset to better facilitate the Form PF in being able to capture not just regulated types of assets, but exposures to these types of assets more generally. Digital assets have become an integral part of the investment strategies of many Private Funds, a fact that has not gone unnoticed by the SEC. In fact, in the Proposed Rule, it was noted that both the SEC and CFTC “have observed the growth and volatility of this asset class in recent years” and that the Agencies “understand that many hedge funds have been formed recently to invest in digital assets, while many existing funds are also allocating a portion of their portfolios to digital assets.”  It was further stated that the Agencies “believe it is important to collect information on funds’ exposures to digital assets in order to understand better their overall market exposure.”

Although the Proposed Rule’s definition for “digital assets” is fairly generic and offers little in addressing the “Is it is a security? Is it a commodity? Is it both?” analysis, the Agencies are asking for comments that could result in a final rule that has more interesting definitions in which the Agencies try to further breakdown different types of digital assets. These more specific definitions, if included in a final rule, could have a major impact on how different products in this space are classified for other purposes.  

Some of the specific questions asked are copied below, and would appear to implicate governance tokens, stablecoins, “wrapped” tokens and CBDCs (Central Bank Digital Currencies) and are the types of inquiries which are consistent with the Financial Stability Oversight Council’s continued focus on financial stability concerns in the digital assets market and of the Biden administration’s actions in the space to date. Market participants considering the implications of the Form PF, or that just want to take advantage of an opportunity to provide feedback and educational information to the Agencies, may wish to consider this as an early opportunity to provide intel about various classes of digital assets and what risk factors can set them apart.

Some of the specific questions asked in the Proposed Rule: Should we require more specific disclosure of what each digital asset represents? If so, what kinds of descriptions would be needed and in what detail? For example, should the description include the rights the digital asset provides to the holder? Should Form PF distinguish, for example, between digital assets that represent an ability to convert or exchange the digital asset for fiat currency or another asset, including another digital asset, and those that do not represent such a right to convert or exchange? For those digital assets that represent a right to convert or exchange for fiat currency or another digital asset, should we distinguish between those where the redemption obligation is supported by an unconditional guarantee of payment, such as some “central bank digital currencies,” and those digital assets redeemable upon demand from the issuer, whether or not collateralized by a pool of assets or a reserve? Should we identify digital assets that do not represent any direct or indirect obligation of any party to redeem or those that represent an equity, profit, or other interest in an entity?

In addition to the questions above, the Agencies have asked for comments on whether Form PF should:

• Define digital assets as proposed and if not, for comments on identifying “alternative elements that would better identify the digital assets held by private funds”;
• Use the term “crypto asset” instead of “digital asset”;
• Include categories for funds that hold digital assets regardless of how the fund characterizes itself based on the assets it is holding or whether proposed investment strategy categories should apply; and
• Require advisers to provide explanations for certain categories, “for example, if advisers report digital assets, should Form PF require advisers to provide the name of the digital asset, or describe the characteristics of the digital asset”?

The Proposed Rule’s implications on the development of the regulation of digital assets may be negligible, at best, but it highlights that the Agencies are aware the “type” of digital asset is more than a regulatory question, but also one of risk.

Although Form PF is confidential, the information gathered can of course be used by the SEC and CFTC in terms of identifying targets/areas of focus for examination, because there continue to be questions around custody or the treatment of digital assets under existing securities laws, such as the Custody Rule or Customer Protection Rules applicable to investment advisers and broker-dealers, these disclosures would almost certainly lead to follow up questions by the Department of Examinations for private funds that report digital asset exposures.

The above risk is heightened due to the SEC’s increased reliance on automated tools used to screen these types of form filings (e.g., ADV and PF).

Here is the SEC Press Release and CFTC Press Release.