Crypto: Only for alt funds?

The proposals would restrict investing in crypto to alternative mutual funds. They would also limit the crypto investments that funds can make to assets that are traded on a recognized exchange, and to assets that are fungible — in other words, no non-fungible tokens (NFTs). The proposals would also prohibit cryptoassets from being used in securities-lending transactions, repos and similar transactions.

The CSA wants to codify the sorts of requirements set for fund managers in regulators’ approvals for some of the world’s first crypto funds, while also incorporating policy positions set out in industry guidance.

“We think this can facilitate new product development in the space while also ensuring that appropriate risk mitigation measures are built directly into the investment fund regulatory framework,” the CSA’s notice regarding the proposals stated.

The proposed changes have been well received by investor advocates but not by industry.

The Ontario Securities Commission’s (OSC) Investor Advisory Panel (IAP) said in its submission that it supports curbing the kinds of assets within crypto funds.

“[I]nvestments in non-exchange traded crypto assets present too much risk to make such investments suitable for broad availability to retail investors,” the IAP said. “The potential benefits to investors of holding non-fungible crypto assets are limited, while the risk of investor harm is high.”

The IAP also called on the CSA to address the risks posed by investors accumulating exposure to cryptoassets through traditional investment funds.

“The panel is concerned about the potential concentration in cryptoassets within a traditional fund-of-funds structure, particularly those that employ a tactical asset allocation approach and are made available to retail investors,” the IAP’s comment stated.

However, many in both the traditional financial industry and the crypto sector believe the limitations sought by regulators are too restrictive — and represent a worrying step in the wrong direction.

The Alternative Investment Management Association’s (AIMA) submission stated that limiting funds’ holdings to cryptoassets (or crypto-based derivatives) that are traded on regulated exchanges effectively limits the choices to Bitcoin and Ether. At this point, no other cryptoassets trade directly, or have derivatives that trade, on a regulated exchange.

“We are concerned that these stringent provisions may stifle market and product development and potentially drive investors toward less-regulated markets and products with inadequate investor protections,” AIMA said.

The Investment Industry Association of Canada (IIAC) echoed this concern.

“While we appreciate the CSA’s suitability concerns, we respectfully submit that investors may be better protected if they are able to gain exposure to cryptoassets through a regulated investment product, such as a public cryptoasset fund, rather than purchasing cryptoassets directly,” the IIAC said.

AIMA recommended regulators require funds to invest in assets traded on recognized crypto trading platforms. The group also cautioned against completely ruling out NFTs.

AIMA al so weighed in against the CSA’s proposed ban on cryptoassets as collateral in securities-lending transactions.

“While challenges may exist currently, it is conceivable that safeguards could be implemented over time, rendering the use of cryptoassets for securities lending … a viable option,” AIMA said.

Industry groups also warned the proposed approach risks short-circuiting progress in an area where Canadian regulators once led the way.

While the U.S. Securities and Exchange Commission only approved the launch of crypto-based investment funds earlier this year, the OSC did so in 2019. That’s when Toronto-based fund manager 3iQ Corp.sought the regulator’s approval for one of the world’s first crypto mutual funds.

The OSC’s staff initially opposed the fund, but ultimately approved it following a hearing before the OSC’s tribunal. The hearing panel concluded 3iQ had adequately addressed the regulator’s investor protection concerns about allowing investment funds to hold crypto, such as novel liquidity, valuation and custody issues.

Since then, a handful of other fund managers have secured approval for a variety of crypto-based mutual funds and ETFs. The terms of these initial prospectus approvals and subsequent regulatory guidance now form the basis for the CSA’s proposed rules.

Those proposals contradict the CSA’s objective of allowing product development to flourish, 3iQ said.

“We believe that providing a regulated and efficient product is essential for investor protection,” the firm said in its submission, arguing that strict limits on regulated funds will drive investors to unregulated markets or suboptimal investment alternatives.

And restricting crypto’s use in lending transactions will limit competitiveness, the firm warned.

“The outright prohibition of lending activities is a brute force approach that removes the ability for asset managers to innovate in Canada,” 3iQ said.

The firm acknowledged that while tightly restricting access to crypto may be an obvious response to the high-profile frauds and failures that have beleaguered the sector over the past few years, “leaning in to providing regulated products will actually better protect consumers.”

3iQ suggested the availability of its first crypto funds probably prevented at least some Canadian investors from using offshore platforms, such as that of FTX Trading Ltd., to gain exposure to crypto.

“The existence of crypto regulated products likely reduced the harm for Canadian investors by making it easier to access the asset class in a safe way. That is why we believe now in light of the recent FTX collapse, the CSA (and the OSC) should … continue to foster innovation to protect investors,” 3iQ said.

The Canadian Blockchain Consortium’s policy and advocacy committee, meanwhile, suggested the emerging crypto sector needs a bespoke regulatory regime.

“The Canadian cryptoasset industry requires separate statutory oversight (and potentially an independent regulator) instead of integrating trading platform requirements into existing securities legislation,” its submission argued. “Without this separation, confusion relating to securities regulation will continue to plague industry concerns.”

Setting up a new regime to oversee the crypto sector would require legislation, however, and there’s no sign of policymakers at any level pursuing this objective.

This article appears in the May issue of Investment Executive. Subscribe to the print edition, read the digital edition or read the articles online.