CSA Propose Guidance on Crypto Asset Investment Funds

On July 6, 2023, the Canadian Securities Administrators (“CSA”) issued CSA Staff Notice 81-336 Guidance on Crypto Asset Investment Funds That Are Reporting Issuers (the “Notice”) to provide guidance to stakeholders regarding the operations of investment funds seeking to invest in crypto assets, either directly or indirectly, within the National Instrument 81-102 Investment Funds (“NI 81-102”) framework (“Public Crypto Asset Funds”).

Key Takeaways

The Notice seeks to clarify CSA expectations of those who hold crypto assets and asset fund managers, including:

• the regulatory framework applicable to Public Crypto Asset Funds;
• considerations in evaluating and determining suitability for a Public Crypto Asset Fund;
• expectations relating to the custody of portfolio assets held by Public Crypto Asset Funds; and
• related Know-Your-Client (“KYC”), Know-Your-Product (“KYP”) and suitability obligations.

Regulatory Framework for Public Crypto Asset Funds

The Notice highlights that Public Crypto Asset Funds are subject to the same regulatory framework as other publicly distributed investment funds in Canada, which includes but is not limited to:

• retaining a registered investment fund manager (“IFM”) and portfolio manager(s) under National Instrument 31-103 Registration Requirements, Exemptions and Ongoing Registrant Obligations (“NI 31-103”);
• distributing securities of the fund by way of a prospectus prepared in accordance with National Instrument 41-101 General Prospectus Requirements (“NI 41-101”) or National Instrument 81-101 Mutual Fund Prospectus Requirements (“NI 81-101”);
• remaining subject to the operational framework of NI 81-102, including issuer concentration and control restrictions, restrictions on holding illiquid assets, and other investment restrictions set out in Part 2 of NI 81-102;
• providing daily calculations of a net asset value (“NAV”) in accordance with National Instrument 81-106 Investment Fund Continuous Disclosure (“NI 81-106”); and
• appointing custodians and sub-custodians (“Crypto Custodians”) to hold their portfolio assets of Public Crypto Asset Funds as set out in Part 6 of NI 81-102.

Review Findings by CSA Staff

CSA staff conducted reviews of Public Crypto Asset Funds that directly hold crypto assets, focusing on liquidity, ETF structure, and custody and noted the following:

Liquidity: Public Crypto Asset Funds did not experience any material difficulties in meeting redemption requests. Various approaches were reported by IFMs for liquidity risk management of Public Crypto Asset Funds, such as ongoing portfolio management and continuous liquidity assessments of underlying crypto assets, in addition to ongoing monitoring of relationships with liquidity providers and ensuring that alternative sources of liquidity are available.

ETF Structure: ETFs were found to trade very closely to their NAV. ETFs were able to meet large redemption requests as part of their normal operating procedures, with all redeemed securities paid in cash at NAV based on their respective valuation index, with settlement the next business day. No ETFs required borrowing of cash to meet redemption requests.

Custody: The CSA confirmed there was (i) segregation of Public Crypto Asset Fund’s crypto assets from those of the Crypto Custodian and other clients of the Crypto Custodian; (ii) use of offline or “cold wallets” storage of crypto assets held by the Crypto Custodian; (iii) listing of the Public Crypto Asset Fund as the beneficial owner of its crypto assets in the Crypto Custodian’s books and records; (iv) existence of controls and procedures that validate security, segregation and ownership of the crypto assets including verification on the blockchain; and (v) maintenance by the Crypto Custodian of insurance over custodied crypto assets.

Considerations Regarding Public Crypto Asset Funds and Suitability

The Notice highlights areas for which greater guidance regarding CSA staff expectations may be warranted and could become subject to future policy work.

Crypto Asset and Crypto Asset Market Characteristics:

In determining whether a crypto asset is a suitable investment for a Public Crypto Asset Fund, CSA staff will take into consideration (i) the ability to determine the fair value of the crypto asset; (ii) the liquidity of the market for the crypto asset; and (iii) the classification of the crypto asset and the implications arising from such classification.

The three considerations include:

(i) Fair Value

The CSA’s view is that market manipulation in some unregulated segments of existing crypto asset markets could impair or limit an IFM’s ability to determine a fair value for the crypto asset in question for the purpose of calculating NAV. When determining whether to recommend the issuance of a receipt for the prospectus for an investment fund that seeks to directly invest in the crypto asset, CSA staff will review the details of a given crypto asset’s market in their analysis which includes:

• sufficient evidence of an active market for the crypto asset comprising actual and regularly occurring market transactions on an arm’s length basis;
• 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.

(a) What is an Active Market?

As outlined in the Notice, a market is typically deemed an active market when the “quoted prices are readily and regularly available from an exchange, dealer, broker, industry group, pricing service or regulatory agency and those prices reflect actual and regularly occurring market transactions on an arm’s length basis.”

To accurately value a crypto asset, an IFM should review whether the market for that crypto asset has real and substantial trading volume, in large size, both in absolute terms and when compared to other markets for commodities and equities.

(b) Regulated Futures

CSA staff have taken the position that the presence of a regulated futures market for a crypto asset can provide support for the proper valuation of a Public Crypto Asset Fund which invests that crypto asset concurrently with other operational benefits. This presence promotes greater price discovery and prevents market manipulation that may be seen in unregulated future markets. Regulated future markets for a given crypto asset have been found to correlate with institutional support for that crypto asset.

(c) Use of Pricing Indices

The CSA note that existing Public Crypto Asset Funds have based their valuations on spot pricing from available crypto asset indices. To help mitigate the risks of inaccurate pricing of a particular crypto asset, a selection of publicly available indices that aggregate pricing from a variety of sources to determine a spot price can be used.

(ii) Liquidity of Underlying Assets and Factors to Consider in Assessing Liquidity

Under NI 81-102, restrictions may be placed on proportion of “illiquid assets” held in investment funds. A fund is required to conduct the necessary due diligence to determine if a crypto asset is of sufficient liquidity in order to comply with NI 81-102 requirements. If a crypto asset is a portfolio asset that cannot be readily disposed of through market facilities on which public quotations in common use are widely available at an amount that at least approximates the amount at which the portfolio asset is valued in calculating the NAV of the investment fund, it may be an “illiquid asset” within the meaning of NI 81-102.

Due to the general volatility and price movements of the markets for many crypto assets, IFMs are expected to regularly measure, monitor, and manage the liquidity of the investment fund’s underlying portfolio assets. There must also be consideration to the time to liquidate each underlying portfolio asset, the price the asset may be sold at, and the pattern of redemption requests.

(iii) Classification of Crypto Asset

The CSA reiterate in the Notice that certain crypto assets may be considered securities or derivatives. It is an expectation of Public Crypto Asset Funds to conduct appropriate due diligence in determining whether the crypto assets they seek to invest in are securities or derivatives. General securities law requirements apply to crypto assets that are securities or derivatives, including prospectus requirements and/or restrictions on secondary trades.

Public Crypto Asset Funds that propose to engage in “crypto lending” are expected to conduct appropriate due diligence to ensure compliance with applicable securities laws. The CSA reiterate that Public Crypto Asset Funds are generally prohibited from lending portfolio assets that are not securities.

Custody Requirements

As set out in Part 6 of NI 81-102, Public Crypto Asset Funds are subject to custody requirements that outline portfolio assets are to be held by Crypto Custodians that qualify under sections 6.2 and 6.3 of NI 81-102 as applicable. The CSA set out minimum expectations of practice requirements consistent with existing legal obligations under Part 6 of NI 81-102. These practices include:

• the IFM satisfying itself that a proposed Crypto Custodian possesses the required expertise and experience to safely custody the crypto assets to be held on behalf of the Public Crypto Asset Fund;
• storage of crypto assets in “cold wallets” maintained by the Crypto Custodian, unless otherwise required for purchases and redemptions by the fund;
• segregation of assets, visible on the blockchain that confirm the fund’s ownership of the applicable crypto assets, and records clearly reflecting such ownership;
• the use of website security measures to protect against hacking attempts;
• maintenance of insurance for corporate crime/theft relating to the storage of crypto assets; and
• preparation of audit materials for the Public Crypto Asset Fund, system and organization control reports prepared on the Crypto Custodian’s behalf by a public accountant.

Staking Crypto Assets

The CSA define the term staking 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.” It is the CSA’s view that staking may involve the issuance of a security or derivative. Accordingly, Public Crypto Asset Funds interested in staking crypto assets must have established policies and procedures to assess whether any staking activities involve the issuance of a security and/or a derivative in compliance with applicable securities legislation. The CSA also expect that these policies include a component of independent analysis and consideration of statements made by a securities regulatory authority or regulator regarding whether any staking conducted involves the issuance of a security and/or a derivative.

Staking requires that a validator play an active role in the consensus of a proof of stake network protocol by broadcasting votes and committing new blocks to the blockchain. Such action could be viewed as exerting control over or being involved in the management of the proof of stake protocol. It is expected that Public Crypto Asset Funds engage a third party to act as a validator to mitigate any concerns related to control consistent with the definition of “non-redeemable investment fund” in NI 81-102.

Public Crypto Asset Funds are expected to conduct appropriate due diligence with respect to the effect on the crypto asset’s liquidity within the fund’s portfolio due to any staking and in turn any impact to the Public Crypto Asset Fund’s compliance with the illiquid asset restrictions in section 2.4 of NI 81-102.

It is the CSA’s view that staking may be akin to lending portfolio assets to or even guaranteeing obligations of a person or company engaged to act as a validator. Therefore, other considerations include the prohibitions in section 2.6 of NI 81-102 related to lending and other investment practices by an investment fund should be reviewed by the Public Crypto Asset Fund.

Knowing the Client, Knowing the Product and Suitability Obligations

The Notice reiterates the obligations under securities legislation related to KYC, KYP and suitability determinations by registrants for purchases or sales of securities of Public Crypto Asset Funds for, or recommendations by Public Crypto Asset Funds to, their clients. The obligations of KYC include (i) collection of certain information from clients; and (ii) taking appropriate steps to have clients confirm the accuracy of information and maintenance of such information. KYP obligations include firms taking reasonable steps to assess and understand any securities that are made available to clients and are required to monitor on an ongoing basis all relevant aspects of the securities including structure, features, risks and costs.

Conclusion

The Notice outlines CSA expectations of Public Crypto Asset Funds stakeholders and clarifies applicable securities regulatory requirements. The Notice also summarizes potential risks associated with the holding of crypto assets via Public Crypto Asset Funds while providing guidance to various stakeholders operating within the NI 81-102 framework. The issuance of this Notice will assist in overall development of existing and emerging crypto asset markets as it promotes transparency, risk management and regulation.

If you have any questions with respect to CSA Staff Notice 81-336 Guidance on Crypto Asset Investment Funds That Are Reporting, please contact Geoffrey Cher ([email protected]) or Jeff Arnold ([email protected]). The authors gratefully acknowledge the assistance of summer student Preet Ranu in the preparation of this update.

This update is intended as a summary only and should not be regarded or relied upon as advice to any specific client or regarding any specific situation.

If you would like further information regarding the Notice discussed in this update or if you wish to discuss any aspect of this commentary, please feel free to contact us.