SEC Declares Many Cryptos as Securities: Implications for Hedge Funds and Other Investors

Earlier this month, the US Securities and Exchange Commission (SEC) sued two of the largest cryptocurrency exchanges, Binance and Coinbase, for allowing trade in "unregistered securities". The SEC also defined close to 20 cryptos as securities right at the same time, just to make its goal of suing the exchanges as easy as possible. This move by the regulator has sent shockwaves through the industry. In this article, we have covered the key implications of the ruling for hedge funds that may have cryptocurrency as part of their portfolios.

SEC Adds to Confusion by Exempting the Top Coins from the Security Classification

Before delving into the implications, it is crucial to note that the two largest cryptocurrencies by market capitalisation, Bitcoin (BTC) and Ethereum (ETH), were not classified as securities by the SEC. This preferential treatment can be attributed to the SEC's earlier declaration in 2018, explicitly defining BTC and ETH as non-securities. However, considering the SEC's inconsistent stance on cryptocurrency regulation in general, it is very possible that BTC and ETH could be declared securities in the future. Hedge funds that invest in BTC and/or ETH should remain cautious and not presume that they are exempt from potential regulatory changes.
Additionally, leading stablecoins like USDT and USDC have not been classified as securities either. These stablecoins are actively traded on the crypto market, with USDT being the largest crypto by trading volumes, ahead of BTC. Thus, as of now, funds that invest in BTC, ETH, USDT, or USDC might continue their business as usual, though some contingency plans would not hurt, as discussed below.
Hedge funds that invest in other cryptocurrencies face a more complicated situation, given the SEC's classification of nearly 20 cryptocurrencies as securities. These include popular high-cap altcoins such as Cardano (ADA), Solana (SOL), Binance USD (BUSD), BNB Coin, and Polygon (MATIC).

Implications for Hedge Funds

1. Hedge Fund Registration: Hedge funds that exclusively invest in cryptocurrencies (crypto hedge funds) will now need to seek SEC registration if they invest in, or plan to invest in, the cryptocurrencies recently declared as securities. Prior to this announcement, funds that invested exclusively in crypto and had no stocks or other securities in their portfolios did not need the SER registration.
2. Registration for Derivative Products: Hedge funds that invest in futures and other derivative products based on cryptocurrencies newly declared as securities should consider registering with the Commodity Futures Trading Commission (CFTC). Since coins like BNB, ADA, SOL, BUSD, and MATIC are now considered securities, hedge funds using derivatives based on these coins need to register with the CFTC to avoid potential legal complications in the future.
3. Reporting and Regulatory Requirements: Hedge funds will need to update their reporting and regulatory requirements concerning the cryptocurrencies now classified as securities if they hold or plan to include them in their portfolios. Compliance with securities regulations, including registration, reporting, and disclosure obligations, will become necessary. This, of course, will lead to some increase in compliance costs.
4. Contingency Planning: Hedge funds that have investments in BTC, ETH, USDT, or other leading coins currently not considered securities should prepare for the eventual declaration by the SEC that these coins are securities as well. The recent bulk declaration of some coins as securities serves as a strong forewarning that eventually, all major cryptocurrencies will fall under the classification.

The SEC's decision to classify some of the leading altcoins as securities will have far-reaching implications for hedge funds and other investors. This development has long been expected, but it has certainly arrived abruptly. This should serve as a forewarning to hedge funds and other investors – the SEC might, or rather, will declare BTC, ETH, USDT, and perhaps all cryptocurrencies without any further classification as securities; and when it happens, do not be surprised at a complete lack of prior notification – the SEC does like to strike when you least expect it.