• The world's largest asset managers are sitting on the sidelines of the marijuana industry in the US.
  • Marijuana is illegal in the US at the federal level, meaning custodian banks are generally reluctant to clear stocks of marijuana companies that have US operations.
  • That could change with the passage of the States Act, which securities lawyers say would give enough clarity about how the federal government would treat the nascent sector for banks and asset managers to do business.

BlackRock, the world's biggest asset manager, says it wants to invest in US marijuana stocks — but not quite yet.

There's one key problem: The $6.4 trillion asset manager can't clear US pot stocks without banking middlemen called custodians. Until that changes, BlackRock's hefty assets, along with those of other mainstream institutional investors, will be stuck on the sidelines of an industry that could skyrocket to $75 billion in the US alone.

"We will be investing, but right now, because of issues with states and the federal government in the US, some of the custodians will not clear cannabis stocks, and we will have to wait until that happens," BlackRock's president, Rob Kapito, said earlier in November at an investor conference in Toronto.

Cannabis is illegal in the US at the federal level, and the government could come down hard on a firm of BlackRock's size — as well as the custodians that support these transactions — for flouting the law.

What do custodians do?

In short, a custodian holds stock and settles trades for funds that invest in the stock market. Think of them like the plumbing that allows investors to buy stock in public companies.

The biggest custodians include State Street, Northern Trust, and Bank of New York Mellon, and tend to be sleepy and conservative.

Read more: BlackRock's president says the $6.4 trillion asset manager wants to invest in cannabis stocks, but there's one key problem

Most custodian banks are federally chartered, so it's little surprise that they wouldn't want to risk flouting federal laws by holding marijuana stocks, said Samuel Dibble, a San Francisco partner at the law firm Baker Botts. If they lost their charter, they'd be out of business.

State Street, Northern Trust, and Bank of New York all declined to comment.

The challenges that marijuana companies face in attracting these middlemen came to a head earlier this year.

The ETF Managers Group in September replaced US Bancorp, a large custody bank, as the custodian for its cannabis exchange-traded fund, ETFMG Alternative Harvest, with Wedbush Securities, a smaller broker-dealer, according to a regulatory filing.

No reason was given for the switch, and representatives for ETF Managers Group and US Bancorp declined to comment.

The episode exposed a problem with investing in publicly traded marijuana companies that operate in the US: Because marijuana is federally illegal, most banks and large institutions don't want to touch it.

While some smaller players like Wedbush may be able to take more risks than a large brokerage like US Bancorp might want to, holding cannabis stocks for a cannabis-specific fund could be like "betting the entire firm on one line of business," Dibble said.

Companies that choose to take this risk are "looking at their risk and their exposure and balancing that with short-term profitability," Dibble said.

A Wedbush spokeswoman declined to comment.

Canada Marijuana
A man showing off his cannabis purchase outside the Quebec Cannabis Society store in Montreal.
REUTERS/Christinne Muschi

Cannabis isn't legal in the US — for now

There's an important distinction between Canadian marijuana firms and their US counterparts. Canada legalized marijuana in October, meaning it's open season for large funds to buy shares of companies that confine their operations to Canada — or at least don't cross the border into the US.

BlackRock has already invested in these types of Canadian firms, holding 4.4 million shares of Aurora Cannabis, a cannabis cultivator listed on the New York Stock Exchange, and over 700,000 shares of Aphria, a medical-marijuana firm listed on the Toronto Stock Exchange, among other Canadian cannabis holdings.

Read more: 'My lips are wet, my mouth is watering to get a piece of that': A war is brewing between US and Canadian marijuana companies to claim a $75 billion market

Vanguard, the largest provider of mutual funds in the world, holds close to 19 million shares of Aurora and 4.3 million shares of Canopy Growth, one of the largest cannabis cultivators.

But because marijuana is federally illegal in the US, companies that cultivate or sell the plant in the US can't list on major stock exchanges like the NYSE or the TSX, Canada's top trading venue. And big investors won't touch them.

Publicly traded marijuana companies in the US like Green Thumb Industries and MedMen, which are listed on a secondary Canadian exchange called the Canadian Securities Exchange, don't have big funds as investors — rather, they're high-net-worth individuals or family offices better able to take on the risks involved with stepping into a federally illegal industry.

While some investors have dabbled personally — the hedge-fund billionaire Leon Cooperman has bought shares of Green Thumb Industries — it's unlikely that any major fund would invest in marijuana companies that operate in the US until the federal government provides some clarity about how it treats the industry, securities lawyers said.

As several states have legalized recreational or medical marijuana, some cannabis investors and CEOs say they expect Congress to soon pass the States Act, a piece of bipartisan legislation that would protect cannabis businesses from federal interference.

Read more: Sessions is out, marijuana wins in midterms: Cannabis investors react to a head-spinning 24 hours in Washington

The States Act isn't full-scale legalization, but it would provide enough certainty for institutional funds to invest and for major US stock exchanges to list cannabis businesses, said Brady Cobb, an attorney and CEO of Sol Global Investments, which focuses on cannabis.

If the States Act is enacted, it might spur major custodian banks, who play a crucial role as middlemen between institutional investors and public companies, to do business in the industry — paving the way for trillion-dollar institutions to jump in.

Beyond regulatory hurdles, stigma remains

But apart from these regulatory hurdles, stigma still exists around the marijuana industry generally.

"There are a lot of institutional investors that do not want to have their name associated with cannabis," said Jordan Wellington, an attorney and chief compliance officer of Simplifya, a cannabis industry consultancy.

Investing in cannabis also comes with an extra due-diligence burden to show regulators that the money isn't flowing into the black market.

While the cannabis industry may be growing rapidly, for some big investors like BlackRock, the US cannabis industry may still be too small to make that headache worth it.

"It really comes down to risk tolerance," said John Vardaman, a former Justice Department attorney who's now the general counsel at Hypur, a fintech startup that serves the cannabis industry.

Some investors, Vardaman said, won't invest until marijuana is federally legal.

"But if you take that position and you're interested in the industry, you've already missed out on a lot of growth," Vardaman said.