Big asset managers like BlackRock are sitting on the sidelines of the $75 billion US marijuana industry because of one big pain point, and fixing it could inject billions into the rapidly growing sector

Courtesy of CannTrust

Marijuana being trimmed at CannTrust's cultivation facility in Ontario, Canada.

• The world's largest asset managers are sitting on the sidelines of the US marijuana industry.
• Marijuana is federally illegal in the US. That means that custodian banks are generally reticent 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 around how the federal government will 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 federally illegal in the US. And the federal 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 law by holding marijuana stocks, said Samuel Dibble, a San Francisco-based partner at 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 attracting these middlemen came to a head earlier this year.

The ETF Managers Group in September replaced large custody bank U.S. Bancorp as the custodian for its cannabis ETF, ETFMG Alternative Harvest (MJ), with smaller broker-dealer Wedbush Securities, according to a regulatory filing. No reason was given for the switch and representatives for ETF Managers Group and U.S. 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 them.

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

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.

REUTERS/Christinne Muschi

A man shows off his cannabis purchase outside the Quebec Cannabis Society (SQDC) store, on the day Canada legalizes recreational marijuana, in Montreal, Quebec, Canada

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 federally in October, which means 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 is already invested in these types of Canadian firms, holding 4.4 million shares of Aurora Cannabis, a Canadian cannabis cultivator listed on the NYSE, and over 700,000 shares of Aphria, a TSX-listed medical marijuana firm, 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 world's 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 New York Stock Exchange or Canada's top trading venue, the Toronto Stock Exchange. And big investors won't touch them.

US publicly traded marijuana companies 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 who are better able to take on the risks involved with stepping into a federally illegal industry.

While some major investors have dabbled personally (hedge fund billionaire Leon Cooperman has personally 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 on how it treats the industry, securities lawyers said.

After a number of states legalized either recreational or medical marijuana in the midterms, 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 in, and for major US stock exchanges to list cannabis businesses, said Brady Cobb, an attorney and the CEO of cannabis-focused Sol Global Investments.

If the States Act passes, 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 still 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 cannabis industry consultancy Simplifya.

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 might still too small to make that headache worth it.

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