Valuation and Custodian Considerations for Digital Asset ETFs

This year has been historic for both the digital asset and exchange-traded fund (ETF) communities. In January, the SEC approved 11 spot Bitcoin ETFs, followed by eight spot Ethereum ETFs in July. With extensive experience and expertise in both the registered ETF and digital asset private fund spaces, we've eagerly watched, applauded, and celebrated these milestones with the industries and our clients.

These unique ETFs are registered under the Securities Act of 1933, since the underlying assets are not deemed securities by the SEC and are considered grantor trusts for U.S. federal income tax purposes. Under the '33 Act, these entities are still required to file public reports with the SEC, such as quarterly 10-Qs and annual 10-K. Accordingly, audits are performed under PCAOB auditing standards and are subject to the PCAOB's scrutiny and examination.

Since the initial approval, key valuation and custodian considerations have come to light as common management topics of discussion surrounding accounting for digital asset ETFs - topics that could result in pain points during an ETF audit if not properly considered and addressed. Additionally, the SEC has raised concerns over these topics throughout the ETF approval processes earlier this year.

Understanding and Using Valuation Best Practices for Digital Asset ETFs

Digital asset markets never close, but ETF markets do. This can lead to inconsistent pricing and/or the need to adjust pricing of the underlying digital asset on the measurement date, if it falls on a day when traditional markets are closed, such as a Saturday, Sunday or federal holiday.

For digital asset ETFs, U.S. GAAP requires fair value accounting and the use of the principal market in determining fair value of investments, which is defined as the market with the greatest volume and activity level (that is accessible). For digital assets, there is no designation of a principal market, like in traditional financial markets, where there may be a common source for pricing at close of business on the measurement date and time. In other words, principal markets could differ between ETFs depending on the entity's assessment of greatest volume and activity level, and which markets are accessible to the ETF. Prices could vary if different principal markets are determined among the ETFs.

For U.S. GAAP purposes, ETFs must use the principal market price at the cut-off time and measurement date, even if it falls on a non-business day and/or if the price used does not create a material difference to the principal market price. It's a best practice to conduct a routine, periodic review of the pricing source to help ensure it is representative of the principal market.

Carefully Consider the Qualified Custodian for Your Digital Asset ETFs

Recent SEC enforcement actions regarding Registered Investment Advisers (RIAs) of private funds holding digital assets raise the question of whether or not entities holding such assets are satisfying the requirement of using a Qualified Custodian (QC).

The SEC has not explicitly approved any digital asset custodians under current standards, despite many of them going to great lengths to be compliant and, therefore, ultimately claiming to be QCs. Their claims are rooted in the fact that the custodians have registered as New York Trust Charters issued by the New York State Department of Financial Services (i.e., a New York bank). New York state chartered banks meet the SEC's definition of a QC, and in addition, subjects them to routine examination by the state.

Most recently, in late September, the SEC's Office of Chief Accountant did not object to a plan for digital asset ETF custody presented by BNY Mellon. The proposed plan includes use of an individual digital asset wallet structure to ensure assets are safeguarded and segregated from the bank's assets.

Although, as of today, the SEC has not confirmed an approved digital asset QC, the SEC approved the S-1s for the issuers of digital asset ETFs, which explicitly identified certain digital asset custodians. Similarly, Coinbase, a common digital asset custodian for digital asset ETFs, is a public company, which falls under the SEC's regulatory regime.

As we watch more on this topic evolve, careful due diligence in selecting a custodian remains paramount to an ETF's security of its digital assets and overall compliance with the SEC.

Digital assets are still seen as new, especially to Wall Street, and their characteristics do not fit the traditional financial profile. Therefore, when applying standards and guidance written prior to the existence of this technology and these instruments, we must analogize to the existing standards. This presents a host of challenges to traditional methodologies of audit testing and applying accounting best practices to an industry where such practices have yet to be established and are continually evolving.

Delve into key tax considerations for digital asset ETFs in "Bitcoin ETFs: The Known and Unknown."

Contact Jamie Gasiorowski or a member of your service team to discuss this topic further.

Cohen & Company is not rendering legal, accounting or other professional advice. Information contained in this post is considered accurate as of the date of publishing. Any action taken based on information in this blog should be taken only after a detailed review of the specific facts, circumstances and current law with your professional advisers.

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