This summer, the Canadian Securities Administrators (“CSA”) published CSA Staff Notice 81-336 Guidance on Crypto Asset Investment Funds that are Reporting Issuers (the “Notice”) concerning funds that seek to invest in crypto assets, either directly or indirectly, under National Instrument 81-102 Investment Funds (“NI 81-102”) (“Public Crypto Asset Funds”). The Notice describes the market for Canadian Public Crypto Asset Funds and key findings from CSA Staff reviews of such funds. It also provides guidance on the CSA’s expectations for stakeholders on certain operational matters but does not otherwise create any new or modify any existing legal requirements.
Background
A number of Public Crypto Asset Funds have launched since the first prospectus receipt for a Canadian Public Crypto Asset Fund was issued on April 1, 2020. According to the Notice, there were 22 Public Crypto Asset Funds in Canada as of April 30, 2023, with approximately $2.86 billion in collective net assets. At present, these funds invest only in bitcoin and/or ether primarily through direct holdings of these crypto assets. Public Crypto Asset Funds are subject to the same regulatory framework as other publicly distributed investment funds in Canada.
Key Findings
The Notice states that, as part of their general oversight mandate, and in response to issues that have arisen in crypto asset markets, CSA Staff reviewed Public Crypto Asset Funds that directly hold crypto assets and are primarily structured as exchange-traded funds (“ETFs”). Focusing on liquidity, ETF structure and custody, CSA Staff observed the following in respect of funds reviewed:
- the funds had not experienced any material difficulties in meeting redemption requests, and investment fund managers (“IFMs”) reported using various approaches to manage liquidity risk (e.g., ongoing portfolio management; continuous liquidity assessments of the underlying crypto assets; ongoing monitoring of relationships with liquidity providers; ensuring the availability of alternative liquidity sources);
- most of the ETFs traded very closely to their net asset value (“NAV”);
- the ETFs were able to meet large redemption requests as part of their normal operating procedures and without needing to borrow cash; all redeemed securities were paid in cash at NAV based on their valuation index, with settlement on the next business day; and
- various custody requirements were being met (e.g., requirements related to segregation, storage, recordkeeping, controls and procedures and insurance).
Further Guidance
CSA Staff also identified several areas that may warrant further guidance. These include: (i) crypto asset and crypto asset market characteristics; (ii) custody requirements; (iii) the staking of crypto assets; and (iv) know-your-product (“KYP”), know-your-client (“KYC”) and suitability obligations.
Crypto asset and crypto asset market characteristics
The CSA note that the characteristics of a crypto asset and its market are essential to determining whether the crypto asset is a suitable investment for a publicly distributed investment fund. The most important considerations include but are not limited to: (i) the ability to determine a fair value of the crypto asset; (ii) the crypto asset’s liquidity; and (iii) the crypto asset’s classification and related implications.
Valuation
The CSA also observe that crypto asset markets now span a wide spectrum in terms of maturity. The more efficient and transparent a market’s facilities, the more it will be able to support the operations of a Public Crypto Asset Fund. To this end, a market for any crypto asset in which a fund seeks to invest should support the fund’s ability to calculate its NAV in accordance with National Instrument 81-106 Investment Fund Continuous Disclosure. When analyzing whether a prospectus receipt for such fund should be issued, CSA Staff will consider the market and 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;
- there is a regulated futures market for that crypto asset; and
- there are publicly available indices administered by a regulated index provider for the crypto asset.
In light of these criteria, the CSA believe that the markets for bitcoin and ether best support the operations of Public Crypto Asset Funds at this time. They note, however, that, with greater institutional support and mainstream adoption, other crypto assets may become suitable investments for publicly distributed investment funds in the future.
Liquidity
When contemplating an investment in a crypto asset, funds must conduct due diligence to determine whether the crypto asset is of sufficient liquidity to comply with NI 81-102. Given the general volatility in the markets for crypto assets and recent market failures, the CSA emphasize the need for effective liquidity risk management programs that include stress testing, ongoing monitoring and regular program review.
Classification
The CSA also expect funds to conduct due diligence to determine whether a crypto asset in which they propose to invest is a security or derivative and may be subject to additional securities law requirements and restrictions. As the properties of a crypto asset may change materially over time, Public Crypto Asset Funds must update their due diligence regularly for continued compliance.
Custody requirements
Public Crypto Asset Funds are subject to the custody requirements in NI 81-102. Their portfolio assets must be held by qualifying custodians or sub-custodians, and crypto assets raise unique custodial considerations, including expertise and infrastructure tailored to the safekeeping of this asset type.
In the Notice, the CSA list several practices that reflect their minimum expectations for the custody of crypto assets of a Public Crypto Asset Fund. These practices include: (i) the selection of a crypto custodian with the necessary experience and expertise; (ii) the primary storage of crypto assets offline, in “cold wallets”; (iii) the segregation of assets, visible on the blockchain; (iv) website security measures; (v) the maintenance of insurance for corporate crime and theft related to the storage of crypto assets; and (vi) the provision of the crypto custodian’s System and Organization Control reports (i.e., SOC-2 Type-2 Reports) to the fund’s auditors. These practices and expectations are substantially similar to the proposed terms and conditions for entities that seek to act as custodians for crypto asset trading platforms in Canada, which we discussed in a previous post.
Staking crypto assets
In the Notice, “staking” refers to the act of committing or locking crypto assets in smart contracts to permit the owner or their agent to act as a validator for a particular proof-of-stake consensus algorithm blockchain. The CSA continue to monitor the presence and role of staking in the crypto asset industry but are of the view that staking may in some cases involve the issuance of a security or derivative. They expect Public Crypto Asset Funds interested in staking to have established policies and procedures to assess whether their activities involve the issuance of a security and/or derivative. These policies and procedures should include a process for independent analysis of the staking activities and consideration of any statements made by a regulator on whether the staking as contemplated involves the issuance of a security and/or derivative.
The CSA highlight that staking may also implicate other securities law requirements and restrictions, such as those related to liquidity, lending and a fund’s characterization as a “non-redeemable investment fund” under NI 81-102. While this and more specific expectations on staking are discussed in the Notice, IFMs are ultimately expected to conduct their own due diligence to determine whether any proposed staking activity will impact the fund’s compliance with illiquid asset restrictions in NI 81-102. The CSA encourage Public Crypto Asset Funds interested in staking to contact their principal regulator to discuss the applicability of securities legislation and possible approaches to compliance.
KYP, KYC and suitability obligations
Registrants must comply with securities law requirements related to KYP, KYC and suitability determinations in connection with purchases or sales of securities of Public Crypto Asset Funds for, or recommendations of Public Crypto Asset Funds to, their clients. The CSA caution that when fulfilling these obligations, registrants should be aware that holding crypto assets, including securities of Public Crypto Asset Funds, comes with elevated levels of risk that may not be suitable for many investors.
What’s Next?
The Notice should be reviewed for further guidance as certain matters discussed in the Notice may become the subject of future CSA policy work.
Separately, the Office of the Superintendent of Financial Institutions (“OSFI”) has also launched a consultation on the regulatory capital and liquidity treatment of crypto-asset exposures, in response to the new banking standards for crypto-asset exposures released by the Basel Committee on Banking Supervision in December 2022. OSFI published two draft guidelines, for federally regulated deposit-taking institutions and insurers, and comments were open until September 20, 2023. These guidelines will replace the interim advisory on the regulatory treatment of crypto-asset exposures, published in August 2022, when they come into effect in early 2025.
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