Regulators could order hedge funds to disclose crypto exposure

The collapse in cryptocurrency prices this year has left US regulators scrambling to understand the risks that digital asset markets could pose to the broader economy.

They may soon enlist hedge funds in the effort.

The Securities and Exchange Commission issued a proposal on 10 August that would require large hedge funds to report their cryptocurrency exposure through a confidential filing known as Form PF.

Created after the 2008 financial crisis, Form PF was designed to help regulators spot bubbles and other potential stability risks in the otherwise opaque ecosystem of private funds that manage money for wealthy individuals and institutions.

The potential addition of cryptocurrency data to the reporting requirements for hedge funds comes as the SEC and its sibling agency, the Commodity Futures Trading Commission, weigh a broader set of updates that would expand the scope of Form PF.

The two agencies settled on the changes after consulting with the Treasury Department and Federal Reserve on potential financial stability risks in the private funds industry. SEC chair Gary Gensler noted that private funds’ total assets are nearing the size of the banking sector’s assets, which have grown more slowly in the wake of post-crisis regulatory requirements.

“A very significant part of our financial system is growing — and growing faster, and is about to overtake the entire commercial banking system — that has far less regulation and far less transparency,” Gensler said 10 August.

The rule proposed would add “digital assets” as a new asset class on Form PF and define the term. It requests comments on whether funds should report detailed information about the cryptocurrencies they hold, such as identifying them by name or describing their characteristics.

In the proposal, SEC staff noted that many hedge funds have been formed recently to invest in crypto, while some existing hedge funds have begun adding it to their portfolios.

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Gensler, a Biden appointee, has likened cryptocurrencies to the Wild West and frequently highlights the need for more investor protections in the market. Asked in a virtual press conference if regulators currently have enough visibility into hedge funds’ exposure to crypto, he responded, “No”.

So far, the recent crash in prices for digital tokens like bitcoin has been relatively contained to the crypto market. But the implosion of a crypto-focused hedge fund, Three Arrows Capital, earlier this summer created a chain reaction that dragged a number of its creditors into bankruptcy.

Regulators worry that such ripple effects could extend into traditional markets if mainstream financial institutions increase their adoption of cryptocurrencies before appropriate guardrails are in place.

The total value of the crypto market recently hovered around $1.2tn, down from a November peak of nearly $3.1tn, according to data website CoinGecko.

Beyond crypto, the proposal would require hedge funds with more than $500m of net assets to report more information on Form PF about their investment exposures, portfolio concentrations and borrowing arrangements.

“Gathering such information would help the commissions and [financial-stability regulators] better to observe how large hedge funds interconnect with the broader financial services industry,” Gensler said.

SEC commissioners voted 3-2 along party lines to issue the proposal, which will be made available for public comment before the agencies decide whether to complete the changes. Republican SEC commissioners Hester Peirce and Mark Uyeda voted against it, questioning whether the government truly needs all of the information that the new version of Form PF would gather.

The CFTC, which is also controlled by Democrats, was set to vote on the proposal by 10 August afternoon.

Bryan Corbett, the president of the hedge fund industry’s lobbying group in Washington, said the new requirements would create compliance costs that would ultimately be borne by hedge funds’ investors and would make it harder for new fund managers to enter the market.

“Alternative asset managers currently provide extensive information to regulators,” Corbett said. “The SEC should focus on better utilising this information rather than imposing new burdens on fund managers that are of dubious utility.”

Write to Paul Kiernan at [email protected]

This article was published by Dow Jones Newswires, a fellow Dow Jones Group service

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