CSA Proposes Amendments To Regulation Of Crypto Asset Investment Funds - Fin Tech

The Canadian Securities Administrators (CSA) recently published for a 90-day comment period proposed amendments to National Instrument 81-102 - Investment Funds (NI 81-102) its companion policy (Proposed Amendments) pertaining to reporting issuer investment funds that seek to invest directly or indirectly in crypto assets (Public Crypto Asset Funds).

As of June 30, 2023, there were 21 Public Crypto Asset Funds in Canada with aggregate net assets of approximately C$3.03 billion. Ten of such funds provide exposure to Bitcoin (BTC), nine funds provide exposure to Ether (ETH) and two provide exposure to both BTC and ETH. The CSA describe the Proposed Amendments as a codification of existing practices of, and exemptive relief obtained by, Public Crypto Asset Funds over the past several years.

The Proposed Amendments are intended to provide greater regulatory clarity with respect to certain key operational matters regarding investments in crypto assets, including by imposing:

criteria regarding the types of crypto assets in which Public Crypto Asset Funds are permitted to invest;
restrictions on investing in crypto assets by Public Crypto Asset Funds or other types of reporting issuer investment funds;
requirements concerning custody of crypto assets held on behalf of a Public Crypto Asset Fund.

The CSA suggest that this regulatory clarity can facilitate new product development in the space.

The CSA's project to implement a regulatory framework for Public Crypto Asset Funds started with the publication in July 2023 of CSA Staff Notice 81-336 - Guidance on Crypto Asset Investment Funds that are Reporting Issuers (SN 81-336). The Proposed Amendments are the second phase of this regulatory project. A third future phase will involve a public consultation concerning a broader and more comprehensive regulatory framework for funds investing in crypto assets.

Summary of Proposed Amendments

Alternative mutual funds and non-redeemable investment funds only. Only alternative mutual funds and non-redeemable investment funds would be permitted to: (i) buy, sell, hold or use crypto assets directly; and (ii) invest indirectly in crypto assets through specified derivatives. Mutual funds that are not alternative mutual funds or non-redeemable investment funds would only be permitted to invest in crypto assets by investing in underlying alternative mutual funds or non-redeemable investment funds that invest in crypto assets, subject to existing fund of fund restrictions.¹

Recognized exchange requirement. Public Crypto Asset Funds would only be permitted to invest in crypto assets that are listed for trading on, or are the underlying interest for a specified derivative that trades on, an exchange that has been recognized by a securities regulatory authority in Canada (the Recognized Exchange Requirement). The Recognized Exchange Requirement would not prohibit Public Crypto Asset Funds from acquiring crypto assets from sources other than recognized exchanges, such as crypto asset trading platforms (CTPs).

Prohibitions on using crypto assets for securities lending, repos and reverse repos. Public Crypto Asset Funds would be prohibited from using crypto assets in securities lending, repurchase transactions or reverse transactions, as the loaned securities, transferred securities or collateral posted in connection with these transactions, as applicable.

Prohibition on crypto assets in money market funds. Money market funds would not be permitted to buy or hold crypto assets.

Prohibition on non-fungible crypto assets. Public Crypto Asset Funds would be prohibited from buying or holding crypto assets that are not fungible. The CSA explains that non-fungible assets, such as collectibles, may have characteristics that are incompatible with investment fund products offered to retail investors for reasons related to liquidity and valuation risks.

Specific requirements for Crypto Custodians. Custodians and sub-custodians that hold crypto assets on behalf of an investment fund (a Crypto Custodian) would be subject to requirements for the Crypto Custodian to:

keep crypto assets in offline storage ("cold wallet" storage), except as needed to facilitate purchases and sales or other portfolio transactions in the fund;
maintain insurance regarding crypto assets it custodies for an investment fund that a "reasonably prudent person would maintain". The Proposed Amendments would not require a specific type of insurance or minimum dollar amount to meet this standard, but would require Crypto Custodians to use their best judgment to determine whether the insurance is sufficient, including taking into account industry standards. Investment fund managers would also be expected to understand the material terms of such insurance, consistent with their fiduciary obligations to the fund;
obtain, on an annual basis, a report prepared by a public accountant assessing the Crypto Custodian's internal management and controls relating to security, availability, processing integrity, confidentiality and privacy (Annual Internal Controls Audit Report). The CSA does not specify the exact report that must be obtained, but would accept a Service Organization Control (SOC)-2 Type 2 Report prepared in accordance with the framework developed by the applicable professional accounting standard-setting body, or another comparable report;
deliver the Annual Internal Controls Audit Report to the fund, and confirm that it has done so in its annual compliance report;
satisfy a standard of carewhich would include policies and procedures that address the unique risks concerning safeguarding of crypto assets, including (as set out in proposed companion policy guidance) :
- having specialist expertise and infrastructure relating to custody of crypto assets;
- maintaining unique public and private keys for crypto assets held on behalf of the Public Crypto Asset Fund, including storing keys in segregated wallets or in an omnibus wallet visible on the blockchain, so long as the books and records of the Crypto Custodian confirm the fund's ownership of the crypto assets;
- using hardware devices to hold private keys that are subject to robust physical security practices, including private key backup and recovery;
- using signing approaches, such as multi-signature technology, that minimize single point of failure risk;
- maintaining robust systems and practices for the receipt, validation, review, reporting and execution of instructions from the fund;
- maintaining website security measures including two-factor authentication, strong, encrypted passwords, encryption of user information and other state-of-the-art measures to secure client information and protect against hacking attempts; and
- maintaining robust cyber and physical security practices, including appropriate internal governances and controls, risk management and business continuity practices.

Permission for in-kind subscriptions. Public Crypto Asset Funds that are alternative mutual funds would be permitted to accept crypto assets that are not securities as subscription proceeds, provided that:

the mutual fund is permitted to purchase the applicable crypto asset, the crypto asset is acceptable to the fund's portfolio adviser and consistent with the fund's investment objectives, and
the value of the crypto asset accepted as subscription proceeds is at least equal to the issue price of the securities of the mutual fund for which they are payment, calculated as if the crypto asset was a portfolio asset of the fund.

This clarification would codify exemptive relief that has been granted to existing Public Crypto Asset Funds, primarily to allow designated brokers and other market makers to exchange crypto assets they hold for "creation units" of Public Crypto Asset Funds that are ETFs.

Observations

Recognized Exchange Requirement

The Recognized Exchange Requirement builds upon the CSA's observation in SN 81-336 that "the presence of a regulated futures market for a crypto asset provides support for the proper valuation of a Public Crypto Asset Fund that invests in that crypto asset, along with other operational benefits". The Recognized Exchange Requirement would restrict the investible crypto assets of Public Crypto Asset Funds to BTC and ETH and specified derivatives, the underlying interests of which are BTC and ETH. This is consistent with the investment portfolios of Canada's 21 existing Public Crypto Asset Funds.

Generally, an exchange must be recognized, or exempt from recognition, in a province or territory of Canada in order to provide access to participants in that jurisdiction. The Chicago Mercantile Exchange (CME) is the primary regulated exchange for BTC futures and the only regulated exchange for ETH futures. While the CME is exempt from recognition as an exchange in Ontario, Quebec and other CSA jurisdictions, it is recognized as an exchange by the Alberta Securities Commission, ensuring that ETH would continue to be a permitted investible asset for Public Crypto Asset Funds.

Prohibitions on using Crypto Assets for Securities Lending, Repos and Reverse Repos

The CSA's commentary that accompanied the Proposed Amendments explains the CSA's belief that, "the market characteristics of most crypto assets make them impractical" for being used as transferred securities in securities lending transactions or being posted as collateral for repurchase agreements and reverse repurchase agreements. The CSA describe these restrictions as being included "to remove any regulatory ambiguity".

However, as market participants continue to innovate, and market structures for crypto asset trading continue to evolve, the CSA's belief may not be accurate for very long. The Proposed Amendments would have the effect of preventing a Public Crypto Asset Fund from using crypto assets for securities lending, repurchase and reverse repurchase transactions, even if it were possible to do so in a manner that complies with the existing NI 81-102 framework for these types of transactions.

Specific Requirements for Crypto Custodians

While the Proposed Amendments relating to Crypto Custodians could be criticized for being overly prescriptive, another perspective is that the Proposed Amendments provide a helpful checklist for investment fund managers and custodians seeking to ensure satisfactory discharge of their standards of care when engaging, supervising and monitoring Crypto Custodians. It is helpful that the highly technical details regarding Crypto Custodian polices and procedures are set out in the companion policy, rather than NI 81-102 itself, to allow for flexibility as cryptography and related crypto asset security technology continue to evolve.

The Proposed Amendments reflect similar flexibility regarding the requirement for a Crypto Custodian to maintain insurance for the crypto assets it custodies, by adopting a "reasonably prudent person" standard which seeks to ensure that the Crypto Custodian's insurance program is consistent with industry practice, yet another evolving area of the crypto asset industry.

Permission for In-Kind Subscriptions

By providing express permission for Public Crypto Asset Funds to accept in-kind subscriptions, the Proposed Amendments would address a technical issue which only allows a mutual fund to accept securities as subscription proceeds in lieu of cash.

Notably, this clarification codifies the distinction between the CSA's approach and the restrictive approach taken by the U.S. Securities and Exchange Commission (SEC) when regulating the 11 spot bitcoin ETFs that were approved on January 10, 2024. In December 2023, all of these ETFs amended their registration statements to remove the possibility of in-kind subscriptions and redemptions, adopting the cash-only model that appeared to be a condition of the SEC's subsequent approvals².

Proposed Amendments are Silent on Staking

While SN 81-336 includes detailed comments regarding the CSA's observations and expectations for Public Crypto Asset Funds that propose to engage in staking activities, the Proposed Amendments do not include any provisions or guidance relating to staking. SN 81-336 describes staking as "the act of committing of 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". Staked crypto assets earn rewards for participating in the validation of transactions, generally in the form of the staked asset.

In October 2023, Canadian crypto asset investment manager 3iQ Corp. commenced staking activities within two of its Public Crypto Asset Funds following unitholder and regulatory approval. Although there is no minimum or maximum amount of the portfolio assets that may be staked, 3iQ Corp. stated its intention, "to adopt a measured approach to [s]taking, taking into account the liquidity needs of the Fund and the novelty of the investment strategy"³. 3iQ Corp. has initially targeted staking up to 50% of the ETH held by The 3iQ Staked Ether ETF, and up to 90% of the ETH held by the Ether Fund, a non-redeemable investment fund, due to its infrequent liquidity requirements⁴.

Exclusion of staking from the Proposed Amendments suggests that the CSA would continue to give discretion to investment fund managers and portfolio advisers to develop staking practices for Public Crypto Asset Funds that adequately address the policy concerns and expectations regarding staking set out in SN 81-336, including to:

independently analyze the staking activities and consider statements made by any regulator or securities regulatory authority about whether staking conducted in the contemplated manner involves the issuance of a security and/or a derivative;
conduct appropriate due diligence with respect to the effect on the crypto asset's liquidity within the fund's portfolio as a result of the fund's participation in staking and in turn how this impacts the Public Crypto Asset Fund's compliance with the illiquid asset restrictions in section 2.4 of NI 81-102;
be mindful of the restrictions on securities lending transactions detailed in section 2.12 of NI 81-102, since depending on how it is proposed to be conducted, staking could be viewed as akin to lending portfolio assets to or even guaranteeing obligations of a person or company engaged to act as validator;
engage a third party to act as validator, since a validator actively participates in consensus of a proof of stake network protocol by broadcasting votes and committing new blocks to the blockchain, which could be viewed as exerting control over or being involved in the management of the proof of stake protocol; and
engage in staking activities within a framework similar to the terms and conditions imposed on registered crypto asset trading platforms that offer "staking as a service" pursuant to terms and conditions of registration acceptable to the CSA⁵.

The CSA's approach toward the regulation of staking activities by Public Crypto Asset Funds is markedly different from the SEC's approach toward the regulation of staking. The SEC's current lawsuit against Coinbase, Inc. includes allegations that its staking-as-a-service program is an unregistered securities offering⁶, and the SEC entered into a US$30 million settlement with Kraken in February 2023 relating to its staking-as-a-service program⁷. Unlike the CSA, the SEC has not offered an acceptable path for CTPs or public investment funds to offer staking services to holders of ETH and other crypto assets in compliance with securities laws.

While the SEC approved public listings of several ETFs that provide exposure to ETH using futures in October 2023⁸, it has delayed decisions regarding numerous spot ETH ETF applications until May 2024. Industry commenters anticipate SEC approval of ETH spot ETFs in 2024 on the basis that there is no meaningful way for the SEC to distinguish its position on BTC and ETH spot ETFs⁹. However, when the SEC approved the spot BTC ETFs earlier this month, Chair Gary Gensler stated that its action was, "cabined to ETPs holding one non-security commodity, bitcoin, [and should] in no way signal the Commission's willingness to approve listing standards for crypto asset securities"¹⁰. Having regard to the SEC's position on staking activities, it would appear that the likelihood for any SEC-approved ETH ETF to be able to stake its ETH in the near future is extremely low.

Next Steps

Public comments on the Proposed Amendments may be submitted until April 17, 2024. For further information on how these proposals may affect your business, we invite you to contact the authors or a member of our Securities Regulation and Investment Products Group or Fintech Group.

Footnotes

1. The CSA is also proposing to amend the definition of "alternative mutual fund" to include a mutual fund that invests in crypto assets.

2. https://cointelegraph.com/news/ark-blackrock-bitcoin-etf-sec-cash-create.

3. https://ca.finance.yahoo.com/news/3iq-launches-staking-3iq-ether-125200163.html

4. Notice of Special Meetings and Joint Management Information Circular, Special Meetings of Unitholders of The Ether Fund and 3IQ Ether ETF, 14 Sept 2023.

5. See, for example, the staking terms and conditions set out in In the Matter of Wealthsimple Investments Inc. and In the Matter of Bitbuy Technologies Inc.

6. https://www.sec.gov/news/press-release/2023-102.

7. https://www.sec.gov/news/press-release/2023-25.

8. https://www.reuters.com/technology/vaneck-launches-etf-tied-ether-futures-2023-10-02/.

9. https://cointelegraph.com/news/spot-ethereum-etf-next-for-sec-approval-analysts/

10. https://www.sec.gov/news/statement/gensler-statement-spot-bitcoin-011023.

To view the original article click here

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.