Canadian Securities Administrators announce guidance on crypto asset investment funds
On July 6, 2023, staff of the Canadian Securities Administrators (CSA) published CSA staff Notice 81-336 Guidance on Crypto Asset Investment Funds That Are Reporting Issuers (the Notice). The Notice provides an overview of public crypto asset funds (Public Crypto Asset Funds) in Canada, discusses key findings from reviews of Public Crypto Asset Funds, summarizes existing securities regulatory requirements, and outlines staff’s views and expectations regarding the operations of Public Crypto Asset Funds within the framework of National Instrument 81-102 Investment Funds (NI 81-102). The Notice is not meant to create any new legal requirements or modify existing ones. Importantly, the Notice provides guidance relating to staking by an investment fund of its crypto assets.
The Canadian Public Crypto Asset Funds market
The Ontario Securities Commission’s (OSC) decision in 3iQ Corp (Re), 2019 ONSEC 37, dealing with an application for The Bitcoin Fund’s prospectus, ultimately led to the first prospectus receipt for a Canadian Pubic Crypto Asset Fund. The OSC’s decision also led to the launch of the first ETFs in the world that invest directly in bitcoin and ether. CSA staff now report that “[a]s of April 30, 2023, there are 22 Public Crypto Asset Funds in Canada that collectively have approximately $2.86 billion in net assets”. These Canadian Public Crypto Asset Funds currently only invest in bitcoin and/or ether, and achieve this primarily through direct holdings of those crypto assets.
Current regulation of Public Crypto Asset Funds
Public Crypto Asset Funds are subject to the same regulatory framework as other publicly distributed investment funds in Canada. As such, Public Crypto Asset Funds would be subject to securities regulation requiring the fund to have a registered investment fund manager and portfolio manager, prepare and file a prospectus in accordance with NI 41-101 or NI 81-101 if it wishes to distribute securities to the public, comply with the applicable requirements of NI 81-102, and calculate net asset value (NAV) on a daily basis in accordance with NI 81-106. Public Crypto Asset Funds that are ETFs or non-listed mutual funds are alternative funds under NI 81-102 and must appoint qualified custodians and sub-custodians, who satisfy the criteria set out in Part 6 of NI 81-102 to hold their portfolio assets.
CSA’s review of Public Crypto Asset Funds
In reviewing the Public Crypto Asset Funds, CSA staff focused on: (i) liquidity of the portfolio assets (in order to be able to satisfy any redemption or exchanges requests by fund unitholders or dealers); (ii) the ETF structure itself (to be satisfied that the structure of an ETF which involves large subscriptions and redemptions by dealers is appropriate for the liquidity of the underlying portfolio assets); and (iii) custody (to be satisfied that the portfolio assets were held safely and securely, that the assets were shown as belonging to the fund on the custodian’s books and records and that the custodian had insurance over the portfolio assets). As result of the review, staff noted that Public Crypto Asset Funds had not experienced “any material difficulties in meeting redemption requested since their respective inceptions”, and that Public Crypto Asset Funds structured as ETFs traded very closely to their NAVs and none were required to borrow cash to meet redemption requests.
As it relates to custody, staff outlined minimum expectations for practices relating to the custody of crypto assets by a Public Crypto Asset Fund including: (i) the manager should satisfy itself that the custodian has the necessary expertise and experience to safely custody crypto assets; (ii) generally crypto assets should be held in cold wallets or offline storage; (iii) assets of a fund should be segregated and the custodian’s books and records must reflect that the fund is the owner of the crypto assets; (iv) custodians should be using website protection measures to protect the assets from hacking attempts; (v) the custodian should maintain appropriate insurance for crypto assets in its custody; and (vi) the crypto custodian should provide annual system and organizational control reports for review by the fund’s auditor.
Considerations relating to crypto asset suitability for a Public Crypto Asset Fund
CSA staff indicated that, in determining whether a particular crypto asset is suitable for a public investment fund, the following are the most important considerations: (i) the ability to determine the fair value of the crypto asset; (ii) the liquidity of the market for the crypto asset; and (iii) the nature of the crypto asset and the implications arising therefrom. We expand on all three considerations as follows:
(i) Fair Value: CSA staff note that it is important to be able to determine the fair value of the crypto asset. Fair value is determined based on the reported price in the active market or if the market is not an “active market”, then based on the value that would be “fair and reasonable” in similar circumstances. An active market refers to a market where quoted prices are readily and regularly available from an exchange, dealer, regulatory agency, etc., and said prices reflect actual arm’s length market transactions. Going forward, in determining the fair value, CSA staff will consider whether there is “sufficient evidence of an active market for the crypto asset comprising actual and regularly occurring market transactions on an arm’s length basis; the presence of a regulated futures market for that crypto asset; and publicly available indices administered by a regulated index provider for the crypto asset”.
(ii) Liquidity: Under NI 81-102, an investment fund is subject to restrictions on the proportion of illiquid assets that can be held in its portfolio. CSA staff note that a crypto asset may be considered liquid if it may be readily disposed of at an amount that at least approximates the value used in calculating NAV through market facilities”. On the topic of staking (addressed in greater detail below), CSA Ssaff caution that participation in staking could convert a liquid asset into an “illiquid asset”, particularly if the asset is subject to lock-up or penalties. Staff recommend that investment fund managers regularly measure, monitor, and manage the liquidity of the investment fund’s underlying portfolio assets.
(iii) Classification of crypto asset: Public Crypto Asset Funds are required to conduct the appropriate due diligence in determining whether the crypto assets it proposes to invest in are securities or derivatives. Depending on the classification, applicable securities laws involving prospectus and secondary trade restrictions may apply, as well as various provisions on NI 81-102, such as concentration and issuer control restrictions.
Staking
In addition to the considerations listed above, CSA staff have outlined their views on staking and the responsibilities regarding know your product (KYP), know your client (KYC), and ensuring investments are suitable for clients.
Staff define staking as the “act of committing or locking crypto assets in smart contracts to permit the owner or the owner’s agent to act as a validator for a particular proof-of-stake consensus algorithm blockchain”. Staff have noted that staking may involve the issuance of a security or derivative which, as mentioned above, can lead to the application of different securities laws depending on the classification. As such, Public Crypto Asset Funds interested in staking should have established policies and procedures to assess whether staking involves the issuance of a security and/or derivative. Moreover, since staking requires a validator to actively participate in consensus of a proof of stake network protocol, this could be viewed as exerting control over or being involved in the management of the proof of stake protocol. Staff expect that neither the fund nor its investment fund managers should act as its own validator but, instead, the Public Crypto Asset Fund should engage a third party to act as a validator. It is also expected that Public Crypto Asset Funds will conduct their own due diligence in determining whether proposed staking activity complies with applicable securities legislation.
Public Crypto Asset Funds that wish to consider staking should consider whether the prohibitions in section 2.6 of NI 81-102 relating to lending of portfolio assets by an investment fund would apply. The legal nature of the staking arrangement will be important in determining whether section 2.6 would apply. If the crypto asset is a security, then the securities lending provisions in section 2.12 of NI 81-102 governs how and the extent to which securities lending may be undertaken by an investment fund. Public Crypto Asset Funds that wish to stake portfolio assets are directed to contact their principal regulator to discuss possible staking.
As for KYP, KYC, and suitability obligations, CSA staff have indicated that registered firms are required to take reasonable steps to assess and monitor all relevant aspects of the securities on an ongoing basis (i.e., its structure, features, risks, initial and ongoing costs, and the impact of those costs). The KYC obligations addressed in the Notice largely refer to the collection and maintenance of accurate and current information. Once both KYP and KYC obligations are complied with, staff expect that registrants will have sufficient information to determine whether an investment action is suitable for a client. Staff highlight that when Public Crypto Asset Funds conduct KYC, KYP, and suitability determinations, they must “be cognizant that holding crypto assets, including Public Crypto Asset Fund securities, comes with elevated levels of risk that may not be suitable for many investors”. Staff note that registrants must put their clients’ interests first before taking any investment action.
The Notice plays a critical role in shedding light on the CSA's approach to the regulation of Public Crypto Asset Funds. The enhanced transparency and defined guidelines could inspire greater confidence among potential issuers and contribute to the expansion and maturation of the Public Crypto Asset Fund sector.