On January 18, 2024, the Canadian Securities Administrators ("CSA") issued proposed amendments to National Instrument 81-102 Investment Funds ("NI 81-102") and Companion Policy 81-102 Investment Funds ("81-102CP") (collectively, the "Proposed Amendments"). The Proposed Amendments are intended to provide greater clarity within the regulatory framework for prospectus-offered investment funds investing in crypto assets ("Public Crypto Asset Funds" or "PCAFs"). In particular, the Proposed Amendments provide criteria relating to permitted investments, investment restrictions and custody requirements for PCAFs by seeking to codify practices of existing PCAFs arising from the review of their prospectus offerings and certain exemptive relief. The Proposed Amendments are available for a 90-day comment period.
Background
The Proposed Amendments form the second phase of the CSA's three-phased project to implement a regulatory framework for Public Crypto Asset Funds (the "Project")1. The objectives of the Project are to review existing requirements, provide guidance and to ultimately implement a regulatory framework for Public Crypto Asset Funds that provides sufficient investor protection, mitigates risks and results in greater clarity for product development and management.
Proposed Amendments to NI 81-102
Part 1 – Definitions
The CSA propose to expand the definition of "alternative mutual fund" to include mutual funds that invest in crypto assets. The rationale behind this change is that it is consistent with the current framework allowing alternative mutual funds to have greater exposure to alternative assets classes or investment strategies than is permitted for conventional mutual funds.
Part 2 – Investments
A. Restrictions on investing in crypto assets
The CSA seek to amend section 2.3 of NI 81-102 to introduce three restrictions on Public Crypto Asset Funds investing directly or indirectly in crypto assets.
First, the Proposed Amendments would permit only alternative mutual funds and non-redeemable investment funds to buy, sell, hold or use crypto assets directly. Indirect investments in crypto assets through specified derivatives would also be prohibited. Conventional mutual funds may only invest in crypto assets by investing in alternative mutual funds or non-redeemable funds that are permitted to invest in crypto assets. Any such investments are subject to the "fund of fund" rules in section 2.5 of NI 81-102 which could, among other things, restrict investment into such underlying fund to 10% of the net asset value of the PCAF.
Second, investment funds subject to NI 81-102 would be restricted to investing only in crypto assets that are listed for trading on, or are the underlying interest for a specified derivative where that specified derivative trades on, an exchange recognized by a Canadian securities regulatory authority. The CSA suggest that this restriction is an attempt to address the market integrity and price discovery concerns identified in the Staff Notice (as defined in footnote 1).
Third, Public Crypto Asset Funds would be prohibited from buying or holding non-fungible crypto assets. A "non-fungible" crypto asset refers to a crypto asset whose individual units are inherently unique, and therefore, not interchangeable for one another. The CSA recognize that this prohibition could unnecessarily narrow the universe of investable crypto assets, so this is one of the Proposed Amendments for which the CSA are specifically seeking submissions.
B. Securities loans, repurchase transactions, reverse repurchase transactions and money market funds
The CSA propose changes to sections 2.12, 2.13 and 2.14 of NI 81-102 to prohibit the use of crypto assets in securities lending, repurchase transactions and reverse repurchase transactions, as the loaned securities, transferred securities and posted collateral in such transactions. The Proposed Amendments also clarify that a "money market fund," as defined in section 2.18 of NI 81-102, is prohibited from buying or holding crypto assets, since money market funds are precluded from being alternative mutual funds. The CSA suggest that these changes eliminate regulatory ambiguity but, in reality, the limitations codify the terms of current offerings and address regulatory concerns with the potential use of crypto assets in the securities lending and repo markets.
Part 6 – Custodianship of Portfolio Assets
A portion of the Proposed Amendments is dedicated to codifying various practices and policies governing the behaviour of custodians and sub-custodians holding crypto assets on behalf of investment funds (a "Crypto Custodian"). Many of these practices and policies are currently being employed by Crypto Custodians of existing Public Crypto Asset Funds, and include:
- a requirement for Crypto Custodians to hold crypto assets of PCAFs in cold (offline) storage, unless the crypto assets are needed to facilitate other portfolio transactions in the PCAF;
- a requirement for Crypto Custodians to obtain insurance that a "reasonably prudent person" would maintain with respect to crypto assets they hold on behalf of PCAFs; and
- a requirement for Crypto Custodians to obtain an annual report assessing the Crypto Custodian's internal controls relating to security, availability, processing integrity, confidentiality and privacy. The Proposed Amendments require that such report must be prepared by a public accountant and delivered to the investment fund being offered related custody services.
Part 9 – Sale of Securities of a Mutual Fund
The Proposed Amendments also seek to codify exemptive relief that has been historically granted to existing PCAFs such as the ability for designated brokers and other market makers of exchange-traded mutual funds (ETFs) to exchange crypto assets they hold for "creation units" of the Public Crypto Asset Funds.
More specifically, the CSA propose to amend subsection 9.4(2) of NI 81-102 to allow PCAFs to accept crypto assets as subscription proceeds so long as:
- it is permissible for the fund to purchase the applicable crypto asset and that the specified crypto asset is not only acceptable to the fund's portfolio advisor but is also consistent with the fund's investment objectives; and
- the value of the crypto asset being received by the fund is not less than the issue price of the securities of the fund.
Proposed Amendments to 81-102CP
Guidance on "Crypto Assets"
The term "crypto assets" is not currently defined in any instruments relating to investment fund regulation. The CSA propose an amendment to section 2.01 of 81-102CP to provide guidance as to what the CSA generally consider to be a crypto asset in regulating investment funds. According to the Proposed Amendments, Canadian securities regulators will consider crypto assets to "include any digital representation of value that uses cryptography and distributed ledger technology, or a combination of similar technology, to create, verify and secure transactions."
Investing in Crypto Assets
The Proposed Amendments include section 3.3.01 of 81-102CP to clarify that the requirement for funds to invest only in listed crypto assets does not mean that the crypto assets must be acquired through a recognized exchange. The Proposed Amendments do not prohibit funds from acquiring crypto assets from other sources (e.g., a crypto asset trading platform) so long as the crypto asset is also listed for trading on an exchange recognized by a Canadian securities regulatory authority.
Custody Standard of Care
The CSA's proposed changes to 81-102CP aim to introduce additional guidance as to best practices for Crypto Custodians so that they can successfully fulfill the standard of care requirements owed to investment funds. If introduced, such additional guidance will be included in subsection 8.1(2) of 81-102CP and will involve:
- ensuring that the Crypto Custodian has the necessary skill and expertise to provide custody services relating to crypto assets;
- the use of segregated or omnibus wallets visible on the blockchain for storing private cryptographic keys so long as the Crypto Custodian is able to confirm the fund's ownership of the crypto assets being held;
- the use of physical hardware devices to store private cryptographic keys as well as the use of multi-signature technology to reduce single point failure risk;
- maintaining updated online security, including two-factor authentication and strong password requirements with encryption, to secure client information held by the Crypto Custodian; and
- maintaining state-of-the-art cyber and physical security practices, including regulated internal controls, risk management and business continuity practices.
Request for Comments
In addition to soliciting comments on the Proposed Amendments generally, the CSA are seeking specific feedback on the following proposed changes to NI 81-102 and 81-102CP:
- the proposed changes to 81-102CP that seek to clarify the type of assets that will be considered "crypto assets" by Canadian securities regulators;
- the proposed restrictions preventing investment funds from holding non-fungible crypto assets;
- the proposed restrictions preventing investment funds from holding crypto assets that are not listed for trading on a recognized exchange; and
- the proposal to require Crypto Custodians to obtain annual assurance reports and the types of reports that should be accepted by the CSA as fulfilling these new requirements.
Conclusion
The CSA's Proposed Amendments aim to provide greater regulatory clarity with respect to important operational aspects of Public Crypto Asset Funds. If adopted, the CSA believe that by codifying practices of existing Public Crypto Asset Funds and exemptive relief previously granted to such funds, the Proposed Amendments will facilitate new product development and improve risk mitigation measures within the investment fund regulatory framework.
The CSA are accepting comments in writing from stakeholders on the Proposed Amendments until April 17, 2024.
Footnote
1. Phase I – CSA Staff Notice 81-336 Guidance on Crypto Asset Investment Funds that are Reporting Issuers (the "Staff Notice"), published on July 6, 2023, represented phase one of the Project. For more information, please review our commentary on the Staff Notice here.
Phase II – The Proposed Amendments build on the guidance in the Staff Notice to form phase two of the Project by introducing targeted amendments that aim to resolve priority issues for regulators regarding Public Crypto Asset Funds.
Phase III – The Third Phase of the Project will consist of public consultation regarding a broad and comprehensive regulatory framework for Public Crypto Asset Funds.
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.
