Canadian securities regulators recently published a staff notice that sets out their views and expectations regarding the operations of public investment funds that invest in novel forms of digital (cryptographic) assets such as bitcoin and ether.
The first public crypto asset fund (PCAF) was approved in Canada by prospectus receipt issued in 2020.This led to the establishment of the world's first exchange-traded funds (ETFs) that invest directly in crypto assets. In the staff notice, the Canadian securities regulators report that as of April 30, 2023 there are 22 PCAFs in Canada that collectively have approximately $2.86 billion in net assets, achieved primarily through direct holdings in crypto assets.
The staff notice provides an overview of the PCAF market in Canada and is aimed at clarifing the current securities regulatory requirements applicable to PCAFs. It also sets out expectations for practices by PCAFs and stakeholders with respect to custody of crypto assets, as well as how PCAFs may be able to "stake", or generate a return on, crypto assets through engagement with the assets' underlying blockchain network. The staff notice further discusses key findings from staff's review of PCAFs with respect to liquidity, valuation, and investments in crypto assets other than bitcoin and ether, as well as implications for know-your-product (KYP), know-your-client (KYC) and suitability obligations.
Regulatory framework for PCAFs
PCAFs are subject to the same regulatory framework as other publicly distributed investment funds in Canada. This current framework requires PCAFs to:
- Have an investment fund manager (IFM) and portfolio manager(s) that are registered pursuant to National Instrument 31-103 Registration Requirements, Exemption and Ongoing Registrant Obligations.
- Distribute securities by way of a prospectus prepared in accordance with National Instrument 41-101 General Prospectus Requirements, National Instrument 81-101 Mutual Fund Prospectus Requirements and National Instrument 81-102 Investment Funds (NI 81-102).
- Calculate net asset value (NAV) on a daily basis in accordance with National Instrument 81-106 Investment Fund Continuous Disclosure (NI 81-106).
Existing PCAFs that are structured as ETFs or conventional mutual funds are classified as "alternate mutual funds" under NI 81-102, providing for an enhanced ability to borrow cash or provide security interests over assets, engage in short-selling and/or use specified derivatives, subject to certain restrictions. Existing PCAFs have appointed custodians and sub-custodians to hold their portfolio crypto assets, each of which is required to meet the applicable qualification criteria set out in NI 81-102.
Staff observations of existing PCAFs
As a function of their general oversight role, and in response to recent market events impacting the digital asset market, Canadian securities regulators have conducted reviews of PCAFs that directly hold crypto assets, focusing primarily on liquidity, fund structure and custody. They note that PCAFs have not experienced material difficulties in meeting redemption requests, and ETFs with investments in crypto assets were able to meet those requests as part of normal operating procedures with redeemed securities paid in cash at NAV based on respective valuation indices, with next day settlement.
With respect to custody, the Canadian securities regulators found PCAFs exhibited the following practices, in line with prior staff guidance with respect to the operation of registered crypto asset trading platforms:
- PCAFs segregate their own crypto assets from those of their crypto asset custodian.
- Crypto custodians deploy "cold wallets", or more secure "off-line" storage for crypto assets.
- PCAFs are listed as the beneficial owner of crypto assets in their custodian's records.
- Crypto asset custodians maintain insurance over custodied assets of PCAFs.
Stakeholder considerations regarding PCAFs
The staff notice enumerates key stakeholder considerations and challenges regarding PCAFs, and provides enhanced guidance to funds, substantively as follows:
Valuation of crypto asset investments
The staff notice states that the market for any crypto asset in which a PCAF seeks to invest should support the fund's ability to calculate its NAV in accordance with NI 81-106. Staff will consider a crypto asset's market in an analysis of whether to recommend the issuance of a receipt for a prospectus of a PCAF that seeks to invest in particular types of crypto assets. Information requirements are expected to include evidence of an "active market" for the crypto asset, 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.
IFMs should consider whether the market for a crypto asset has real and substantial trading volume to promote accurate price discovery, both in absolute terms as well as when compared to other markets for commodities and equities. A significant volume of crypto asset transactions on regulated exchanges (as opposed to unregulated exchanges) will promote more reliable price discovery due to the lower risk of market manipulation. Canadian securities regulators consider that the presence of a regulated futures market for a particular crypto asset further promotes greater price discovery, where anti-manipulation rules allow for a fair and transparent value of that crypto asset to be more accurately determined therefore raising fewer investor protection concerns. The staff notice also points out that a regulated futures market can support the ability of authorized dealers and market makers to properly carry out their market making duties, including the use of derivatives to hedge against price fluctuations with respect to PCAFs that are ETFs.
In light of the above, Canadian securities regulators are of the view that the markets for bitcoin and ether best support the operations of PCAFs at this time without compromising investor protection, noting that in the future greater institutional support and mainstream adoption of other types of crypto assets may result in those assets becoming suitable investments for publicly distributed investment funds.
Classification of crypto asset investments
The staff notice sets out staff's expectation that PCAFs perform due diligence with respect to whether a crypto asset investment is a security or a derivative. As a result of how a given crypto asset is characterized, various provisions of NI 81-102, including concentration and issuer control restrictions, may limit an investment fund's ability to buy and hold crypto assets. The staff notice goes on to recognize that the properties of a crypto asset may materially change over time, such as through technology updates. As such, staff expect PCAFs to regularly update their due diligence on crypto assets to ensure investments align with applicable securities laws.
Crypto asset custody
PCAFs are subject to the custody requirements applicable to investment funds generally as set out in NI 81-102. Portfolio assets including crypto assets must be held by custodians that are qualified to act, as prescribed. In addition to the usual considerations of trust law principles that apply to all types of assets held on behalf of clients, crypto assets present unique custodial considerations, including expertise and infrastructure specifically tailored to the safekeeping of these types of assets. The minimum expectations of Canadian securities regulators for practices pertaining to the custody of crypto assets of a PCAF by a crypto custodian include: primary storage of crypto assets in "cold wallets", use of segregated wallets (including an omnibus wallet) visible on the blockchain, strong website security measures, maintenance of insurance for corporate crime/theft relating to the storage of crypto assets, and annual System and Organization Control (SOC-2 Type-2) reports prepared on the crypto custodian's behalf by a public accountant.
Crypto asset staking
Staking is referred to in the staff notice 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. The staff notice provides that PCAFs interested in staking crypto assets held in their portfolios should have established policies and procedures to assess whether their staking involves the issuance of a security and/or a derivative. These policies and procedures should include a process for independent analysis of the staking activities and consideration of statements made by any regulatory authority about whether staking conducted in the contemplated manner involves the issuance of a security and/or a derivative, including review by legal counsel.
Further, crypto assets that may otherwise have been liquid, once staked, may become "illiquid assets" within the meaning of NI 81-102. For example, if crypto assets become subject to a lock-up, unbonding, unstaking, or similar periods imposed by a particular blockchain protocol, they may no longer be liquid. The staff notice recommends that appropriate due diligence be conducted with respect to the crypto asset's liquidity within the fund's portfolio as a result of the fund's participation in staking and how this impacts the PCAF's compliance with the illiquid asset restrictions contained in NI 81-102.
Staff clarified they would expect that neither a fund nor its IFM would act as its own validator. Instead, PCAFs looking to stake crypto assets should engage a third party to act as validator (i.e. staking as a service). This is to mitigate concerns that, consistent with the definition of "non-redeemable investment fund" in NI 81-102, staff consider an investment fund, as an issuer, should not seek to exercise control over, or become involved in the management of, investee companies. In any event, staff's expectation is that IFMs of PCAFs engage in their own due diligence to determine whether proposed staking complies with applicable and current securities legislation. Further, IFMs must be proficient and knowledgeable about staking crypto assets, enter written agreements with third parties to stake crypto assets, monitor validators for downtime, jailing and slashing events, and appropriately manage liquidity and other risks to protect crypto assets staked by the fund.
KYP, KYC and suitability obligations respecting PCAFs
Registrants such as advisors are required to comply with existing securities law obligations with respect to PCAFs related to KYC, KYP and suitability determinations in connection with purchases and sales of securities of PCAFs, including:
- taking reasonable steps to asses and understand any securities of PCAFs that are made available to clients, and assessing and monitoring all relevant aspects of the securities on an ongoing basis, including the securities' structure, features, risks, initial and ongoing costs and impact of those costs.
- collecting certain information from clients, keeping the information current and taking reasonable steps to confirm the accuracy of the information.
- when recommending PCAFs to clients, remaining cognizant that holding crypto assets comes with higher levels of risk that may not be suitable for all investors.
The digital asset industry continues to evolve in a productive manner through clear statements of guidance and expectations from regulators such as those provided by Canadian securities regulators in this recent staff notice. The staff notice provides additional clarity for PCAFs operating in Canada, while identifying areas for prudent legal review and potential further development. The staff notice also reiterates many of staff's existing positions with respect to staking and custody, applying these principles in the investment fund context.
For contrast, institutional market participants in the United States have recently begun re-engaging with the Securities and Exchange Commission (SEC) with respect to obtaining approvals for inaugural spot bitcoin ETFs in the United States. The SEC has also recently charged certain significant crypto asset trading platforms operating in the United States with engaging in unregistered securities offerings through staking programs.
Through this lens, the recent staff notice can be read as an incremental confirmation of the existence of public crypto asset funds in Canada and the associated standards for custody of crypto assets, as well as validation as to the manner in which crypto assets may be "staked" to generate a return. The staff notice is further evidence of the means by which the Canadian market can leverage its regulatory framework in accordance with Canadian securities regulators' expectations to develop global leadership in the blockchain and digital asset space including with respect to publicly traded funds.
For questions or further information on the matters discussed in this article, please reach out to a member of Gowling WLG's Blockchain and Smart Contracts Group.