In a ground-breaking decision, the Ontario Securities Commission ("OSC") overturned the decision of the Acting Director of the Investment Funds & Structured Products Branch of the OSC ("IFSP") to refuse to issue a receipt for the establishment of the Bitcoin Fund (the "Fund") – which is a proposed investment fund based on the cryptocurrency Bitcoin.
3iQ Corp. ("3iQ") is the investment fund manager and had been working on the Fund for three years with the goal of allowing retail investors the benefits of investing in bitcoin through a regulated, listed fund. Following multiple discussions with the IFSP, the Acting Director of the IFSP refused to issue a receipt for the Fund's prospectus. In declining to issue a receipt, the Director questioned the suitability of cryptocurrency as an investment, citing the lack of regulation for cryptocurrencies and the various associated risks.
By way of background, the proposed Fund is a non-redeemable investment fund ("NRIF") established as a trust. The objectives of the Fund are to provide investors with:
- exposure to bitcoin; and
- the opportunity for long-term capital appreciation.
On February 15, 2019, the Acting Director for the IFSP refused to issue a receipt for the Fund's prospectus citing that it was not in the public interest to do so1 and that the Fund's prospectus did not comply in a substantial respect with a requirement of the Securities Act2.
In arriving at this decision, the Acting Director put forward the following arguments:
- The Fund's lack of ability to accurately value its assets due to the "fragmented and unregulated environment in which bitcoin generally trades";
- The risk associated with safeguarding the Fund's assets and the ability of the sub-custodian to provide Customary SOC Reports;
- The risk of the Fund not being able to file audited annual financial statements in accordance with National Instrument ("NI") 81-106;
- The operational risks associated with the lack of established regulation in the bitcoin market; and
- Bitcoin being an illiquid asset and the Fund not complying in a substantial respect with the restriction NI 81-102 against the holding of illiquid assets.
OSC Panel Decision
In establishing and structuring the Fund, 3iQ engaged industry participants and the regulators. 3iQ requested to be heard before a panel of the OSC in which it submitted that a regulated Fund is a necessity given the recent collapses of various other platforms globally whereby individuals invest in crypto-assets without regulatory oversight.
Upon review, the OSC panel found that the Fund was structurally different in nature than certain Exchange Traded Funds ("ETFs") related to cryptocurrencies that have been rejected by the U.S. Securities and Exchange Commission. This was due to the Fund placing restrictions by monthly reporting and only allowing redemptions annually by using the NRIF structure, which would significantly reduce the impact of market manipulation by daily trading. The Fund would also be using MVIBTC (as defined below) as the index and would only be purchasing bitcoin from dealers that hold a license or are otherwise regulated. All of these considerations distinguished the Fund from an ETF which requires constant trading and is more vulnerable to market manipulation.
In arriving at its decision, the OSC panel also looked at the reasoning of the Acting Director as well as arguments put forth by Staff:
Staff argued that bitcoin is illiquid because it is not currently traded on market facilities comparable to the Toronto Stock Exchange ("TSX") and there is no central source for trading data concerning bitcoin. The OSC panel found that there is sufficient evidence of real volume and real trading in bitcoin on registered exchanges in large dollar size. Furthermore, the regulation does not define the term "market facility" that is found in the definition of "illiquid asset" and the term should not be narrowly construed to imply some form of established and mature trading facility or network.
2. Valuation and Market Manipulation
The OSC panel stated that under NI 81-106, the Fund would be required to calculate its net asset value using the fair value of its assets and liabilities. 3iQ proposed to value the Fund's bitcoin by reference to an index called the MVIS CryptoCompare Institutional Bitcoin Index ("MVIBTC") which is regulated by the German Federal Financial Supervisory Authority. MVIBTC uses transaction data from 22 trading platforms to calculate the value of bitcoin and complies with the European Union benchmark regulations and the International Organization of Securities Commissions regulations. As such, the OSC panel was not satisfied by the Staff's argument that valuation would not be possible. The OSC panel further noted that the issue with market manipulation having an impact would also be minimal since: (i) the fund will only invest in bitcoin; (ii) would pursue a buy and hold strategy; and (iii) only buy and sell bitcoin on regulated exchanges.
3. Safeguarding of the Fund's Assets
The Fund would use Cidel Trust Company, which is regulated by the federal Office of the Superintendent of Financial Institutions as a custodian and use Gemini Trust Company, LLC as a sub-custodian, which is regulated by New York State as a qualified custodian under NI 81-102. Staff made two arguments: (1) risk of loss; and (2) lack of insurance. The OSC panel commented that bitcoin can be lost or stolen like any valuable commodity but Staff did not provide sufficient evidence that Gemini, a regulated crypto-asset custodian, has suffered losses of customer assets.
4. Auditability of the Fund's Financial Statements
Staff submitted that it would be against the public interest to issue a receipt due to concerns over the Fund's ability to file audited annual financial statements. In making this argument, Staff pointed to the lack of Gemini's SOC 2 type 2 report and the fact that Gemini may deny the auditor for the Fund access to test the operating effectiveness of Gemini's controls. However, the OSC panel relied on the Fund's submission that a qualified auditor can conduct the audit, even without the report, and still comply with generally accepted auditing standards.
In reaching its decision, the OSC panel commented that by denying the Fund a receipt would not promote fair and efficient capital markets and confidence because it would leave investors with no choice but to invest without the protections of a public fund. The OSC panel also found that there was no issue of unfair, improper or fraudulent practices as far as the structure of the Fund was concerned or the operation of it.
In conclusion, the OSC panel decided that Staff had not demonstrated that bitcoin is an illiquid asset and that the Fund will not be compliant with NI 81-102 or that it was not in the public interest to issue a receipt for the Fund's prospectus. Accordingly, the panel ordered that the Acting Director's decision be set aside, and that the Acting Director was directed to issue a receipt for the Fund's prospectus.
While the findings of the OSC in this decision is not an endorsement of investment funds based on a cryptocurrency model, it does provide guidelines for the regulation of these funds. This is an important step as it will support innovative investment opportunities while also protect investors who will be able to invest in funds with regulatory oversight.
1 Securities Act, RSO 1990, c S.5, s 61(1)
2 Ibid, s 61(2)(a)(i)
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