Evan Thomas, Lori Stein
Nov 1, 2019
In this Update
- On October 30, 2019, the Ontario Securities Commission (OSC) issued a decision allowing 3iQ Corp. (3iQ), a Canadian investment manager, to offer the world’s first publicly traded bitcoin investment fund
- The decision addressed allegations of bitcoin market manipulation, safeguards for protecting cryptoassets, and the auditing of financial statements for companies holding cryptoassets
- Decision distinguishes decisions by the U.S. Securities and Exchange Commission (SEC) refusing to approve the listing of bitcoin exchange traded funds (ETFs)
- We believe that the Panel’s decision sends a strong message in support of innovation in capital markets and encourages the development of new fund products that invest in new asset classes in compliance with applicable regulatory requirements
On October 30, 2019, a panel of the Ontario Securities Commission (OSC) released a decision [PDF] that will allow 3iQ Corp. (3iQ), a Canadian investment manager, to offer the world’s first publicly traded bitcoin investment fund. Osler was counsel to 3iQ before the OSC. In reaching its decision, the OSC Panel considered evidence regarding market integrity concerns surrounding cryptoassets, the custody and safeguarding of bitcoin, and the auditing of financial statements of issuers that hold cryptoassets. The OSC Panel distinguished decisions by the U.S. Securities and Exchange Commission (SEC), which has to date declined applications for the listing of bitcoin exchange traded funds (ETFs). In approving the issuance of receipt for the fund’s prospectus, the Panel upheld a core principle of Canada’s securities laws – namely, it is not the role of securities regulators to approve or disapprove the merits of the securities being offered to the public. In so ruling, we believe that the Panel has encouraged the development of new fund products that invest in new asset classes, and the Panel has sent a strong message in support of innovation in capital markets in Canada.
Since late 2016, 3iQ has been developing The Bitcoin Fund (the Fund), a proposed non-redeemable investment fund that would invest substantially all of its assets in bitcoin. Over approximately two years, 3iQ met with Staff of the OSC’s Investment Funds and Structured Products (IFSP) Branch and submitted various drafts of a preliminary prospectus for the Fund. Ultimately, IFSP Staff advised that they would not be prepared to recommend that the Director of the IFSP Branch issue a receipt for the Fund’s prospectus.
In February 2019, the Director of the IFSP Branch issued a decision accepting Staff’s recommendation not to issue a receipt for The Bitcoin Fund’s preliminary prospectus. The Director concluded that bitcoin was an illiquid asset, as defined in National Instrument 81-102 Investment Funds (NI 81-102), and therefore the Fund could not comply with the restriction against holding illiquid assets set out in NI 81-102.
In addition, the Director concluded that it was not in the public interest to issue a prospectus receipt because of concerns about the integrity of the market for bitcoin; the security and safekeeping of the Fund’s bitcoin; and the Fund’s ability to file audited financial statements.
3iQ exercised its right to seek a hearing and review of the Director’s decision before a Panel of the OSC. This hearing involved additional evidence from 3iQ’s Chief Investment Officer and Staff of the OSC, including cross-examination of witnesses before the Panel.
The Panel heard evidence regarding the structure of the bitcoin market and the trading platforms and other venues where bitcoin is traded. The Panel concluded that bitcoin was not an illiquid asset for the purpose of NI 81-102, stating:
The evidence shows that substantial volumes of bitcoin trade daily on market facilities, many of which are regulated. These market facilities provide a liquid market for promoting price discovery for valuing the Fund’s assets and for disposing of bitcoin to satisfy redemption requests.
The Panel also heard considerable evidence regarding allegations of manipulative or abusive conduct in markets for bitcoin. After considering the evidence, the Panel found:
While there is evidence of market manipulation and the associated risks, there is also sufficient evidence of a real market in bitcoin, with real trading. Though that real trading may be somewhat impacted by fake trading and though other crypto-asset trading and unregistered market trading may have some knock-on effect, Staff has not proven that true price discovery in the bitcoin market is prevented by insufficient ‘true trading’ or price manipulation, at least on the regulated exchanges.
In addition, the Panel noted the steps taken by 3iQ to mitigate the risk of market manipulation:
While the risks of price manipulation in the bitcoin spot market still exist, 3iQ has mitigated the potential impact on the Fund’s valuation through several steps: its selection of MVIBTC as the index, the use of a professional investment manager experienced in bitcoin markets, and the Fund’s use of the non-redeemable investment fund structure.
Staff also raised concerns about the safeguards for the Fund’s bitcoin. To comply with the custodial requirements under NI 81-102, 3iQ proposed to engage a qualified custodian, Cidel Trust Company, and a qualified sub-custodian, Gemini Trust Company, to hold the Fund’s bitcoin. 3iQ also led evidence regarding the technical and other safeguards that would be taken by 3iQ and these custodians to protect the Fund’s bitcoin. The Panel concluded:
Like any valuable commodity, I accept that bitcoin can be stolen or lost. The Applicants also concede that point. But Staff did not establish that Cidel or Gemini, specifically, do not follow sufficient practices for safeguarding bitcoin. Rather, Staff relies on evidence of examples of losses incurred by crypto-asset trading platforms, all but one of which were unregulated and most of which involved hacks of hot wallets. I am not persuaded that there was sufficient evidence that professional, regulated crypto-asset custodians, like Gemini, have suffered losses of customer assets.
Finally, Staff raised concerns regarding the ability of the Fund to obtain audited financial statements, as required by NI 81-106, because of limited audit guidance for cryptoassets and the absence of a SOC 2 Type 2 Report from Gemini, 3iQ’s proposed sub-custodian. The Panel accepted 3iQ's evidence that “a qualified and reputable auditor says it can conduct the audit, even without [a SOC 2 Type 2] report, and still comply with generally accepted auditing standards (GAAS).”
In light of the evidence, the OSC Panel found that the issuance of a receipt for a final prospectus for the Fund was not contrary to the public interest. In considering the public interest, the Panel commented on the promotion of fair and efficient capital markets and confidence in capital markets:
Denying investors the opportunity to invest in bitcoin through a public fund would not promote fair and efficient capital markets and confidence in capital markets. Instead, it would suggest that investors should acquire bitcoin through unregulated vehicles, and capital market participants should be encouraged to create those vehicles.
The Panel also observed that the Fund was innovative and could mitigate risks for investors:
The notion of professionalizing investing in risky assets to mitigate risks should be encouraged, not discouraged. Ontario capital market participants should be encouraged to engage with the Commission, and not incentivized to avoid doing so. Pooling of investor funds under a professional management structure to address and mitigate risks in an underlying asset market is innovative and should be encouraged, especially when it provides an alternative to investors acquiring bitcoin through unregulated vehicles.
The Panel’s decision contrasts with various decisions by the SEC concerning proposed bitcoin ETFs. Multiple applications to list bitcoin ETFs have been refused by the SEC, primarily because of concerns about market manipulation. In making its decision, the OSC Panel distinguished these SEC decisions, where the burden of proof was on the applicants proposing the bitcoin ETFs to demonstrate that their proposals were consistent with the federal Exchange Act and other requirements under U.S. law:
In reaching a determination, I distinguish the Bitcoin decisions issued by the SEC to date. These decisions concerned applications by exchanges for proposed rule changes to allow the listing and trading of shares of bitcoin-based ETFs. All but one of the seven submitted SEC decisions were issued by the Division of Trading and Markets of the SEC under delegated authority, and not issued by the SEC Commissioners themselves. The SEC decisions applied a different legal test to different evidence, with a different burden of proof, which burden was not placed on agency staff…
The SEC decisions related to different products, with different structures. There are key material differences between ETFs and the Fund, including the amount of exposure to bitcoin and the frequency at which bitcoin is required to be purchased, sold and valued. Accordingly, I give little if any weight to the SEC’s consideration of proposed rule changes to allow the listing and trading of shares of bitcoin-based ETFs.
As a result of the decision, the Panel has directed the Director of the IFSP Branch to issue a receipt for a final prospectus of the Fund. Subject to the issuance of a receipt for the final prospectus and acceptance for listing on a Canadian securities exchange, The Bitcoin Fund will be the first publicly traded bitcoin investment fund in the world.
Chris Naudie, Lori Stein, Evan Thomas and Louis Tsilivis represented 3iQ and The Bitcoin Fund at the hearing and review before the OSC Panel. Andrew Aziz and Lori Stein advised 3iQ in connection with the prospectus for The Bitcoin Fund.