Connecting the SOFR Curve to SOFR Swaps

Connecting the SOFR Curve to SOFR Swaps

April 09, 2019

In my last blog, I wrote about my experience with building the SOFR curve. Now FINCAD F3 can handle any instrument market data for curve building. But at the moment an important question is, “Which instruments are the right ones to use to build the SOFR curve?”

Right now, the market for SOFR-linked derivatives is just starting to take shape, and market quotes are becoming available for CME SOFR futures and SOFR swaps. There are three types of swaps that are being traded: SOFR OIS, SOFR-FF basis swaps, and SOFR-Libor basis swaps. The first one is an overnight indexed swap which pays SOFR versus fixed, and the last two are basis swaps between SOFR and either the Fed Funds effective rate (FF) or Libor.

The odd thing about introducing SOFR as an alternative benchmark interest rate is that, for now, it makes the USD rate basis much more complicated. This is because it adds two new basis spreads between FF/SOFR and Libor/SOFR, in addition to the previous FF/Libor basis. So now there are many possible ways to build the SOFR curve. These include:

Single curve-building:

1. Use FF OIS to build the Fed Funds effective rate curve.
2. Use ED futures and Libor swaps to build the 3-month Libor curve.
3. Use SOFR futures and either SOFR OIS, FF/SOFR basis, or Libor/SOFR basis to build the SOFR curve.

Global curve-building:

1. Use ED futures, Libor swaps, FF OIS, FF/Libor basis swaps, SOFR futures, and either SOFR OIS, FF/SOFR basis, or Libor/SOFR basis to simultaneously build the 3-month Libor curve, Fed Funds effective rate curve, and SOFR curve.

For many people, their instinct would be that building the curves individually is the easiest. However, the dual dependence of the FF OIS and FF/SOFR basis swaps on the OIS discount and SOFR curves creates a curve construction problem, which necessitates a global solver.
As mentioned in my previous post, I chose to use the global method, because it is actually easier to just let F3 automatically determine how to solve the curves from the instruments selected. This approach also allows using the FF/Libor basis for longer maturities, since often the Fed Funds OIS is not as liquid. But there is still a big question here, “Which SOFR instruments should we choose?”
Imagine swapping Fed Funds into Libor and then swapping Libor exposure into SOFR. Now compare this with swapping Fed Funds into SOFR directly. The question about the new SOFR basis is, “Does it roundtrip so we get the same SOFR in both cases?” The answer right now is that there is not enough trading on SOFR derivatives to closely round-trip these two ways of swapping Fed Funds into SOFR. The symptom of SOFR illiquidity is large bid-ask spreads in the market quotes for basis swaps on SOFR, so that by using mid-quotes as market data, the SOFR curve will look a little different in the two cases.
A recent summary of SOFR swap trading volumes shows that there is a lot of uncertainty regarding where the volume will show up in SOFR-linked derivatives. It is expected that they will become traded more as time goes on, and competitive markets will result in smaller bid-ask spreads. But we don’t know which swaps will be the best to build the SOFR curve. Surely with Libor going away we shouldn’t rely too much on Libor/SOFR basis swaps, but whether the future will show volumes in the FF/SOFR basis or SOFR OIS is unknown. This is another good reason to have a global curve-building solution which can handle any and all instruments you throw at it. Such an approach will help you react quickly to changes in trading volume in SOFR derivatives to continue building the most accurate SOFR curve possible.
In case you missed it, you can check out my previous SOFR blog post here, “Building a SOFR Curve was Easy.” Also, be on the lookout for my next post, “Eliminating the SOFR Basis: What Do We Lose?”

About the author

Bin Hou

Senior Financial Engineer, FINCAD

Bin is a member of the Financial Engineering Hub in Vancouver. Since he joined FINCAD in 2013, Bin has made contributions to FINCAD products through conducting model validations and encoding the best market practice in examples and documents.
Bin holds a Master of Science in Finance degree from Simon Fraser University. He is also a CFA® and FRM® charterholder.

SABR/LIBOR Market Mode

For which class of instruments the SABR/LIBOR Market Model does perform better than the classical LIBOR Market Model?

The LIBOR Market Model

The LIBOR Market Model — also known as Brace, Gatarek, Musiela model — is an interest rate model capable of reproducing the correlation structure of forward rates. One-factor models are unable to reproduce this structure and therefore cannot price accurately derivatives whose prices reflect these correlations. A typical example of such derivatives are swaps paying a non-linear function of the difference two swap rates for two different maturities.
The model is constructed by using a family of LIBOR rates: L0(t),…,Ln(t)
, where Li(t) is LIBOR forward rate starting at ti and ending at ti+1, following

dLi(t)=σi(t)Li(t)dWi+1(t).

The SABR LIBOR-Market Model

An important flaw of the LMM is known as sticky volatilities: if the model is calibrated in a highly volatile market it assumes that this high volatility lasts forever, which leads to inaccurate results.
The SABR LMM attempts to address this issue. In this model, each LIBOR rate is assumed to follow a log-normal dynamic having stochastic volatility:

dLi(t)=σi(t)Lβii(t)dWi+1(t)dσi(t)=αiσi(t)dZ(t)<dW,dZ>=ρdt

dLi(t)=σi(t)Lβii(t)dWi+1(t)dσi(t)=αiσi(t)dZ(t)<dW,dZ>=ρdt

No One Is Buying Your Real Estate Token

Apr. 12, 2019 8:29 AM ET

Summary

Tokenized Real Estate Lacks Features for Success.
Product-Market Fit Remains Deficient.
These Offerings Are Instructive in Seeking Better Offerings.

Tokenized real estate has long been discussed as a leading use for digital securities. Yet, really no successful sales have taken place. Some of the most notable and widely marketed projects were pre-arranged to signal successful optics and had side deals to incentivize investment. Though tokenized real estate will eventually emerge, the benefits over existing financial offerings do not yet offer the level of value needed to overcome market inertia and successfully scale.
It’s no surprise that many real estate owners have an interest in selling their property via a digital security fundraise. By “fractionalizing,” breaking down investments into smaller pieces, real estate sellers can ask for higher prices than they would selling wholesale. Or alternatively, those that can not find buyers in traditional markets turn to digital securities as a last resort à la adverse selection.
Though this looks attractive to sellers, who would buy these offerings? Consider the typical profile of a real estate investor - conservative, interested in wealth preservation, sensitive to margin costs. Generally, they do not want what most perceive to be experimental investment technology. Furthermore, with the extant availability of public REITs, fund managers, real estate crowdfunding, and direct investments, the benefits of liquidity and access to foreign inventory espoused by many security token evangelists are already available. The short-term benefit to the investor is marginal at best and comes with a high degree of perceived technology risk.
Ultimately, the real estate asset class suffers from the lack of high upside to achieve product-market fit. A great real estate investment for a passive investor might yield 20% a year. Why take all of this perceived risk and adopt a new behavior when available investments can offer similar returns without the unknowns? Due to adverse selection, existing public and private market dynamics, and investor characteristics, it’s hard to find a scenario by which both sides of the transaction could find value meaningful enough to exceed the threshold for adopting a new behavior.
The pool of digital security investors today is small and comprised of, predominantly, blockchain/ICO-savvy investors. These people, still nostalgic for their +1000% 2017 returns, have a high-risk tolerance, want high-returns, and understand technology. They don’t want an 8% fixed-income real estate debt product.
The primary exception to this may be those in countries with tight capital controls (aka China), that want to expatriate their wealth into stable, foreign assets. In this case, the primary benefit of security token real estate, in short, is the ability to hide the movement of capital from their government. I don’t know about you, but hiding cash for the wealthy and circumventing national governments is not why I got involved with blockchain.
Though real estate digital securities remain weak, their use-case provides a helpful tool in exploring what a good investment would look like. A “good” deal must benefit both parties in a transaction. The product-market unfit of Real Estate and Security Tokens raises the question of what, currently, a good deal would look like? What is the ideal security token?
Ideally, digital security or not, the best investment has no risk and infinite upside. Though such a perfect investment is unattainable, features like downside risk protection (which can take many forms), a known industry, and available liquidity can help to move an offering in the right direction. At the same time, blockchain-based ownership needs to offer some unique capability that necessitates a digital security approach. This could take the form of high-complexity financial structures, streamlined asset diligence, or blended “utility token” benefits offering added value. This isn’t real estate.
Revenue streams backed by equity or a bond or other conversion options may offer one strong example. In this case, a company may offer investment into a new product-line or intellectual property asset and, if the upside doesn’t manifest (as measured by some predetermined milestone), offer conversion into company equity or other available assets. If successful, the company could finance their CAPEX needs on better terms and without diluting shareholders while investors could gain exposure to high-upside in an otherwise unavailable investment. Additional benefit could come in broadening company exposure or markets via this fundraise as well.
For example, imagine an investment into the future revenues of a new model of SpaceX rocket. The capital intensive requirements for creating such a technology would typically lead to equity dilution and less internal control of the business. In an STO raise, SpaceX could engage the public, find financing on better terms, avoid dilution, and offer high returns upon the successful commercialization of the product. In the event of failed commercialization, investors could convert into the equity of SpaceX at some pre-defined conversion ratio. Compared to the compromises made via traditional means of financing, this approach could make sense.
The market will surely mature. A blockchain-based security can ultimately offer all the features of existing securities with additional ones - reducing costs and increasing distribution. They are fundamentally better. However, incremental benefit in an immature market, like a real estate token, will not catalyze a seismic shift in capital markets. The potential future benefits for portfolio managers of real estate is clear, but how to jumpstart this marketplace remains murky. Real estate is just kinda boring.
Regulatory compliance is unavoidable and important, but those in the industry (myself included) could gain from asking more often, what do people actually want? The ICO world is imperfect, but the stodgy ethos of STOs - middle-aged white men in blazers, their lawyers ever by their side, talking in finance jargon about tranches of multi-asset EB5 blah blah blah - could benefit from the creativity, boldness, and fun of the crypto-craze that got us here.
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The views and opinions expressed are those of the author and do not necessarily reflect the official policy or position of Atomic Capital, Inc. This is not intended as investment advice. Any content provided is not intended to malign any religion, ethic group, club, organization, company, individual or anyone or anything.

What is an Asset-Backed Token? A Complete Guide to Security Token Assets.

Elliot Hill

Feb 15 · 11 min read

Traditional real-world assets, such as gold, are finding higher liquidity by being tokenized.

Utility tokens have traditionally been the modus operandi for new blockchain company funding rounds, through the initial coin offering (ICO). But although utility tokens supposedly have value within the platform they operate on, they often lack a unique value proposition and likewise, by definition they do not represent an actual tangible asset. In fact, utility tokens are so far removed from real world assets, that the U.S. Securities and Exchange Commission (SEC) have recently been cracking down on those ICOs which cross the boundaries into the territory of being a security in their efforts to provide fundamental value to holders.

This is one of the main reasons that the value of utility tokens, either during their token sale or once they are trading on third party exchanges, is driven predominately pure speculation, rather than the robustness of their tokenomic model.

However, asset-backed tokens, often offered during a Security Token Offering (STO) carry an actual value, because they are correlated with an external, real-world asset’s value. Asset-backed and security tokens offer secure, rapid and minimal cost trading of traditional assets via blockchain technology, and increase liquidity for traditional securities.

Why Make an Asset-Backed Token?

Security tokens, or asset-backed tokens, increase the potential initial raise for fund operators and other parties who issue securities. However, the main reason it’s beneficial for crypto fund managers to create cryptographic analogues of traditional assets is to increase the underlying assets liquidity — defined as the ease and speed at which assets are purchased or sold (liquidated) at market price. Generally, bonds and stocks are assets with high liquidity, in contrast to assets such as vehicles, real estate, jewellery, art and collectibles which lack access to high trading volumes, trading opportunities on exchanges, and liquidity.

But why is liquidity so important? Liquidity correlates strongly with an asset’s trading volume, and subsequently affects that assets price. Good liquidity can enhance the underlying assets value, as it negates the risk associated with being unable to exit a position in a given asset quickly. For example, whilst it’s easy to exit a position in a stock via a third-party exchange, liquidating your position in a piece of real-estate is a significantly longer process, as in simplest terms, it takes longer to find a buyer.

A tokenized asset trading market which trades 24 hours a day, 7 days a week and 365 days a year not only provides enhanced price discovery and reduces price volatility, but it may also reduce the risk of a sudden price crash in asset value.

An Overview of Asset-backed Tokens Use Cases

Tokens which are backed by external assets are somewhat comparable to gold backed paper currencies, like many traditional fiat currencies were under the ‘gold standard’. But the situation becomes more complex when we examine tokens associated with assets which are ‘non-fungible’— for example, real estate.

The real estate market is fairly illiquid, and heavily afflicted with multiple inefficiencies; such as middlemen who receive a portion of an investment for taking on counter-party risk. However, these pain points could be alleviated and given greater value with asset-backed tokens, which would tokenize a portion of an individuals position in a real-estate asset.

The most novel use cases for asset-backed tokens are therefore emerging from tokenomic models which are backed by limited liquidity assets — such as derivatives, private equity, real estate, collectibles, and other assets which have been traditionally difficult to find immediate buyers for. Currently, assets which are non-fungible are worth trillions, but are for the most part they are stored in vaults worldwide as hedges against inflation rates.

Illiquid assets aside, the largest use cases for asset-backed tokens, which have the highest potential to raise funds during an STO, generally manifest from tokenizing a portion of a large established company’s debt or equity.

A quick look at some examples of asset-backed token use cases include:

• The issuance of corporate debt or equity via a security token.
• Real estate investment trusts (REITs), for investors that wish to diversify their portfolio to include real estate. Real estate investment trust tokens would also allow customization, and may be purchased by investors willing to accept a certain credit risks, for a pre-determined duration.
• Equity from commercial properties and rental income. Retail investors who have a relatively modest amount of capital are currently unable to diversify into the commercial property and rental market. Ownership fractionalization through security tokens offers the opportunity to democratize commercial and rental investing.
• Intellectual property asset backed tokens, such as film licenses and royalty payments, may be distributed to every party who owns a portion of a patent, film, or book.
• Accounts payable and receivable, represented by security tokens, has the potential to replace supply chain finance and factoring, with tokens and data flowing between accounts receivable and accounts payable, in ERP systems.

Real world assets represented as tokens on the blockchain therefore provides access to potentially large addressable markets.

Smart contracts associated with tokenized assets may likewise improve access to trading opportunities. Although professional investors can currently use the services of lawyers and other service provides to perform due diligence on new investments, investors with lower capital amounts can generally not afford to take on such risk. Tokens with built in smart contracts can automate due diligence to an extent, which in turn has the potential to open markets to retail investors who lack access to due diligence providers— creating even greater liquidity.

Likewise, a private equity backed token can be developed to feature protocols with inbuilt dividend and profit share functions, transforming an asset class with traditionally low liquidity into a passive income generating investment. This offers startups and VC firms a greater opportunity for funding, cost-savings and profit.

Below, we examine the four main asset-backed token categories in greater detail.

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What are the Main Asset-Backed Token Categories?

Fine art could likewise benefit from asset-backed tokens, allowing fractionalization of paintings — for example among multiple recipients of inheritance.

Earlier we introduced an overview of asset-backed tokens, why you would want to tokenize an asset, and looked at some of the most obvious use cases for asset-backed tokens.

Now, we are going to break asset-backed token use cases down further into the following four categories:

• Debt and equity tokenization
• Asset-Backed Tokens for Commodities
• Hard Assets which are Non-Fungible
• Soft Assets which are Non-Fungible

Debt and Equity Tokenization

Debt and equity asset-backed tokens are used predominately for funding start-up companies, which in turn circumvents intermediaries such as investment banks and traditional exchanges (for IPOs).

Fractional ownership for equity isn’t a new concept — stock certificates and mutual funds have already existed for decades. But what asset-backed tokens now offer is a percentage digital ownership of an immutable, liquid and trustless representation of company debt or equity.

Anyone may access the blockchain protocol on which an asset-backed token resides, including security token exchanges, and may verify the ownership of the token and the authority of a specified individual to trade. Arbitrage opportunities for market makers should maintain an asset-backed token’s trading closely within its true net value.

Debt and equity are already assets which can be traded today, but blockchain makes this process more efficient, which could significantly grow the STO market. Subsequently, a 50% decrease in price (via destruction of asset value) could easily be counter-balanced by a thousand percent volume increase (via creation of new market value). This would assist both incumbents and entrepreneurs alike, who would need to react quickly during emerging production and marketing industry shifts, which are expected to enhance value of company assets and company market share.

Holdings of private equity funds are most often low liquidity assets which require investors to hold for over one year. Likewise, hedge funds often hold assets with relatively low liquidity which often require investors to hold assets for at least a few months. Therefore, enhanced liquidity via asset tokenization would increase the value of assets for both private equity funds and hedge funds, enabling private equity ventures to adapt easily to market fluctuations.

Tokenization of Commodities

Exchange traded commodities can likewise be converted into security tokens. Regardless of whether it’s oil, natural gas, wheat, or sugar, commodities which are already traded on third party exchanges can be effectively tokenized.

Trading of other more fringe commodities, like renewable hydro-electric, wind, and solar electric energy can also be facilitated through a blockchain based exchange. As a result, governments, utilities companies, and individuals could participate and transact together on one platform.

However, tokens which are backed by physical assets require verification to establish the tokens validity. A mature market already exists for auditors who verify the security and trustworthiness of custodial storage facilities for commodities. Those same auditors could take advantage of new opportunities using blockchain technology, by utilizing manual assessment methods in conjunction with blockchain tracking — relying upon technology to create confidence in the market.

Although gold commonly trades as paper assets through gold ETFs, gold which has been tokenized is fundamentally different. Each gold backed token represents a whole or fraction of a a gold bar which is stored and audited, through the services of an“oracle” provider, for it’s weight, purity level, and it’s authenticity — Therefore, those who tokenize gold or other commodities have to first solve the issues with oracle providers to realize widespread asset-backed token adoption.

The leading cryptocurrency, Bitcoin, often referred to as ‘digital gold’, may potentially be replaced as the primary store of digital value by using tokenized gold. Current advantages which Bitcoin holds over physical gold, is it’s relatively easy divisibility and transferability. For example, it is simple for token exchanges to take 1% of a Bitcoin, sending the equivalent dollar value of BTC into an individuals cryptocurrency portfolio.

In contrast, it is conceivably of far greater difficulty to take a gold bullion bar, fractionalize it, and send it to an individual. If that gold bar were to be tokenized, one could easily sell and transfer any given percentage of gold in a similar way to traditional paper currencies backed by gold— and the same is true for other real-world commodities.

Hard Asset Tokenization

Hard assets are tangible and physical items or objects of worth that are owned by an individual or company. There are many possibilities for the tokenization of hard assets on the blockchain.

Tokenization of Real Estate

As we briefly touched on earlier, when compared to REITs or private property ownership, real estate token funds could become a borderless, more profitable, and a more democratic way to invest in things such as a portfolio of rental properties, senior-care homes, or a hotel chain.

With the rise of real estate backed tokens and tokenized rental income, investors of every wealth bracket can build out a diverse and flexible real estate portfolio with minimal exchange fees.

Collectibles tokenization

Bitcoin’s are fungible. Every Bitcoin is interchangeable, just as Euros, Dollars, and Pound Sterling. They are indistinguishable from each other, as they are all, at their core, units of currency and exchange.

In contrast, asset-backed tokens have the ability to represent exotic and non-fungible assets, like collectibles, and therefore they are distinguishable from one other tokens by design. Each token is unique, creating digital scarcity, with blockchain network participants knowing how many are in circulation and their distinguishing features.

The back-end component of non-fungible asset tokenization for exotic assets have a sophisticated design. Asset management firms which currently deal with traditional assets may fill new roles as oracles, ensuring the back-end of non-fungible tokens are kept in safe storage, undergoing regular audit certification, asset insurance, and conversion mechanisms from tokens into a physical asset delivery. Auction houses currently fill this role with fine jewelry, furniture, art, wine, and other collectibles.

For example, as it stands, most retail investors lack the opportunity to buy an ownership share of a rare piece of artwork. Incumbent auction houses such as Sotheby’s and Christie’s control a majority of secondary art markets from the world’s financial centres, far from reach for retail investors. However, smart contracts are being used to create joint ownership of artworks or art collections stored in museums. These artworks can still be displayed publicly, but the asset will be encoded on a blockchain.

Likewise, it’s possible for individual objects to be tokenized, acting as appreciating assets. For example, a rare, valuable painting may be inherited by several siblings. With asset-backed tokens, the painting could be tokenized and then distributed to each sibling via the blockchain, becoming “shares” representing a portion of the original painting. These shares, represented by asset-backed tokens, could be sold via a public security token exchange, if a sibling wishes to sell their holdings. In this simplified example, the token holders have access to immediate liquidity, while private investors can add a valuable exotic asset to their portfolio, which they would normally not have exposure to — therefore, a novel class of exotic assets are given previously unrealized liquidity.

Non-Fungible Soft Asset Tokenization

Soft assets, in contrast to hard assets, are intangible assets, which have been traditionally hard to quantify and evaluate. Asset-backed tokens can likewise bring price discovery and liquidity to these assets.

Intellectual Property (IP) Tokenization

Somewhat harder to quantify than other assets we have examined, IP assets, such as copyright licences, trademarks, patents and royalties from music and media rights generally have low liquidity and currently lack a secondary marketplace to trade on. It is not a difficult concept to tokenize the IP ownership, but the realized benefits could be many — such as enhanced liquidity and increased value of IP assets, bringing benefits to media producers and artists.

Digital Asset Collectibles Tokenization

Digital collectibles, such as CryptoKitties, are examples of asset-backed tokens which generate value and scarcity. This is in contrast to ownership of digital collectibles, which is managed via central databases, such as vanity items earned during whilst playing online games. These assets have been traditionally difficult to prove ownership over, as they are often just represented as contracts with the software provider. However, blockchain could offer digital collectibles specialized marketplaces, created with asset-backed tokens.

Stable Coins are not Typical Security Tokens

By certain definitions, stable coins linked to fiat are a form of stable asset-backed token. Stable coin issuers in this case maintain fiat reserves, so they retain a stable ratio with their chosen fiat currency, which is then matched to the circulating supply of the specific stable coin.

Stable coins are distinctly different from security tokens as they’re not a means of investment. Instead, they are created to represent currencies rather than assets. Stable coins provide an easy exit for investors who trade cryptographic assets on token exchanges, and remain fundamentally distinct from security tokens representing assets.

Opportunities and Challenges for Security Tokens

Compared to traditional currency, Bitcoin has been generally regarded as having greater fungibility, divisibility, transferability, scarcity, and durability. Likewise, asset-backed tokens retain most of the same benefits, applying them to real assets.

Regulators are eyeing security tokens with caution. There could be high risks for new user error whilst using exchanges, and investors who are not cautious may lose their tokens through wallet address mishaps for example, something protected against when using traditional third-party exchanges.

As a result of regulatory uncertainty, some countries, such as China and Qatar, have completely banned asset-backed tokens being issued. Other countries, such as Bermuda, Switzerland, Estonia, and Liechtenstein, allow security token issuance, albeit with certain restrictions and confusing regulatory oversight.

Malta, by contrast, places no limitations or restrictions on asset-backed tokens. Approval, fund certification, and fund license requirements are legally well-defined, with regulatory stringency. These conditions make Malta the premier jurisdiction to issue asset-backed or security tokens.

Asset-backed and security tokens are, by design, prone to lower volatility than utility tokens and cryptocurrencies. As discussed, tokens listed on exchanges may trade constantly, offering greatly enhanced price discovery. Markets which operate irrespective of geographical location or time zones may provide security token trading opportunities to investors worldwide. Likewise, established companies may soon begin issuing security tokens worth billion of dollars into token exchanges — creating one of the most exciting asset classes seen in decades.

China's penetration of Silicon Valley creates risks for startups

Heather Somerville

8 Min Read

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SAN FRANCISCO (Reuters) - Danhua Capital has invested in some of Silicon Valley’s most promising startups in areas like drones, artificial intelligence and cyber security. The venture capital firm is based just outside Stanford University, the epicenter of U.S. technology entrepreneurship.

FILE PHOTO: Stanford University's campus is seen in an aerial photo in Stanford, California, U.S. on April 6, 2016. REUTERS/Noah Berger/File Photo

Yet it was also established and funded with help from the Chinese government. And it is not alone.
More than 20 Silicon Valley venture capital firms have close ties to a Chinese government fund or state-owned entity, according to interviews with venture capital sources and publicly available information.
While the U.S. government is taking an increasingly hard line against Chinese acquisitions of U.S. public companies, investments in startups, even by state-backed entities, have been largely untouched.
That may well be poised to change as the U.S. Congress finalizes legislation that dramatically expands the government’s power to block foreign investment in U.S. companies, including venture investments.
The new law would give the U.S. government’s Committee on Foreign Investment in the United States (CFIUS) wide latitude to decide what sorts of deals to examine, eliminating certain ownership thresholds, with a particular focus on so-called “critical” technologies.
“The perception is that a lot of the tech transfer of worry to the U.S. security establishment is happening in the startup world,” said Stephen Heifetz, a former member of CFIUS and now a lawyer representing companies going through CFIUS review.

Sponsored

The latest version of the bill exempts “passive” investors, which would cover many of the limited partners that back venture firms. But limited partners that have some control over the business, or firms whose managing partner is a “foreign person”, could be subject to scrutiny.
The university endowments and family offices that traditionally provide most of the money for venture firms are usually one of many limited partners and have minimal if any involvement in the startups they help fund.
Chinese entities also sometimes take a passive role in big venture funds. But venture capital sources say that Chinese government funds often play a more influential role in the smaller venture firms they back by providing a greater percentage of their funding. That empowers them to request information about startups or help them to open offices in China - potentially opening those startups to CFIUS review.
The possibility of a regulatory crackdown has caused unease in the startup world. Venture firm Andreessen Horowitz is counseling startups that if they raise money from a China-backed investor, they put themselves at risk of government scrutiny, a person with knowledge of the matter said.
“The window for some startups to raise money from China may be closing,” said Chris Nicholson, co-founder of AI company Skymind, which has raised money from Chinese Internet group Tencent Holdings Ltd and a Hong Kong family office.

SENSITIVE AREAS

Until recently, the original source of funds for venture investments has not been an issue in Silicon Valley. Venture firms are not obliged to disclose who their investors are and entrepreneurs rarely ask, leading some dealmakers to question how CFIUS could keep tabs on startup investing.
Danhua Capital, which is backed by the Zhongguancun Development Group, a state-owned enterprise funded by the Beijing municipal government, has holdings in some of the most sensitive technology sectors.
Its investments include data management and security company Cohesity, which counts the U.S. Department of Energy and U.S. Air Force among its customers. Drone startup Flirtey, which in May was selected by the U.S. Department of Transportation to participate in projects to help the agency integrate drones safely into U.S. air space, is also part of the Danhua portfolio.
Shoucheng Zhang, Danhua’s founder and a Stanford University physics professor, declined to answer specific questions from Reuters. In an email, he said: “Most of our (limited partners) are publicly listed companies in New York or Hong Kong stock exchanges. We will of course fully comply with any legislations and regulations.”
Cohesity declined to comment. A spokeswoman for Flirtey said Danhua’s minority investment did not come with any information rights or a board seat, and the firm is not involved in Flirtey’s operations.
“We would not knowingly accept money from the Chinese government; we take investment from Delaware-registered, Silicon Valley-based venture capital firms,” the spokeswoman said.
She added that Flirtey would support any new “mandate that investors must disclose if they have any form of backing from government entities, to help ensure there is never a question in the future.”
The practice of investing through layers of funds, known as funds of funds, can make it all but impossible to know where money is coming from. Westlake Ventures, backed by the Hangzhou city government in eastern China, invests in at least 10 other Silicon Valley venture funds, including Palo-Alto based Amino Capital.
Larry Li, founder and managing partner at Amino Capital, said he took the money that was on offer when he launched his fund in 2012. He said he felt his firm wasn’t the kind of known quantity that could tap the big pensions and endowments.
“We weren’t going to the Harvard endowment or Yale endowment; that’s like mission impossible,” Li said. “You need to have some special source of funds to get started.”
China-backed funds include Oriza Ventures, which belongs to the investment arm of the Suzhou municipal government, and has backed AI and self-driving car startups. SAIC Capital, the venture arm of state-owned auto company SAIC Motor, has invested in Silicon Valley autonomous driving, mapping and artificial intelligence startups.
Even well-known startup accelerator 500 Startups raised part of its main fund from the Hangzhou government.
500 Startups and Oriza declined to comment, while SAIC did not respond to a request for comment.
Capital controls have slowed the flow of Chinese money into the United States since 2016, but sources say venture investments have been more resilient than sectors like real estate, in part due to the Chinese government’s focus on improving its domestic high-tech industry.

‘CROWN JEWELS’

U.S. politicians suspicious of China’s intentions were galvanized by a Department of Defense report released last year that warns that Chinese venture investors are accessing “the crown jewels of U.S. innovation.”
The report helped guide Sen. John Cornyn, a Texas Republican who sponsored the Senate version of the CFIUS reform bill, people with knowledge of the matter said. A spokeswoman said Cornyn “is especially concerned with Chinese state-backed venture capital investments.”
But the report was also panned by many private sector experts as overly simplistic and fear-mongering.
For now, at least, President Donald Trump has backed away from his declared intention to clamp down on a wide range of Chinese technology investments through a special emergency order, saying he would leave the job to CFIUS. But if Congress fails to pass the bill quickly, Trump said he would use his executive powers.

Reporting by Heather Somerville in San Francisco. Additional reporting by the Shanghai newsroom.; Editing by Jonathan Weber and Martin Howell.

Our Standards:The Thomson Reuters Trust Principles.