Crypto: only for alternative funds?

The proposals would limit crypto investments to alternative mutual funds. They would also limit the cryptocurrency investments that funds can make to assets traded on a recognized exchange and fungible assets — in other words, no non-fungible tokens (NFTs). The proposals would also prohibit the use of cryptoassets in securities lending, repurchase agreements and similar transactions.

The CSA wants to codify the requirements imposed on fund managers in the authorizations granted by regulators to some of the world’s first crypto funds, while incorporating the principled positions set out in industry guidance.

“We believe this can facilitate the development of new products in the space while ensuring that appropriate risk mitigation measures are integrated directly into the regulatory framework for investment funds,” states the CSA notice regarding proposals.

The proposed changes were welcomed by investor advocates, but not by the industry.

The Ontario Securities Commission’s (OSC) Investor Advisory Group says in its submissions that it supports limiting the types of assets contained in crypto funds.

“Investments in non-exchange-traded cryptoassets present too much risk for these investments to be widely accessible to retail investors,” says the Investor Advisory Committee. The potential benefits to investors of holding non-fungible cryptoassets are limited, while the risk of harm to investors is high. »

The Investor Advisory Group also called on the CSA to address the risks posed by investors gaining exposure to cryptoassets through traditional investment funds.

“The group is concerned about the potential concentration of cryptoassets in a traditional fund structure, particularly those that use a tactical asset allocation approach and are made available to retail investors,” the investor advisory group says .

However, many in the traditional financial industry and the cryptocurrency sector believe that the limits imposed by regulators are too restrictive and represent a worrying step in the wrong direction.

The Alternative Investment Management Association (AIMA) believes that limiting fund holdings to cryptoassets (or derivatives based on cryptocurrencies) that are traded on regulated exchanges effectively limits choices to Bitcoin and Ether. Currently, no other cryptoasset trades directly, or has derivatives that trade, on a regulated exchange.

“We fear that these strict provisions will stifle the development of markets and products and encourage investors to turn to less regulated markets and products offering inadequate protection to investors,” summarizes AIMA.

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

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

AIMA recommends that regulators require funds to invest in assets traded on recognized cryptocurrency exchanges. The group also warns against excluding NFTs altogether.

AIMA also spoke out against the CSA’s proposal to ban cryptoassets as collateral in securities lending transactions.

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

Industry groups have also signaled that the proposed approach risks short-circuiting progress in an area where Canadian regulators have already led the way.

While the U.S. Securities and Exchange Commission only approved the launch of cryptocurrency-based investment funds earlier this year, the OSC did so in 2019. It was at that time that Toronto-based fund manager 3iQ has sought regulator approval for one of the world’s first cryptocurrency mutual funds.

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

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

These proposals go against the objective of the CSA which is to allow the development of new products, raises 3iQ.

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

And restricting the use of cryptocurrencies in lending transactions will limit competitiveness, the company warns.

“The outright ban on lending activities is a brutal approach that deprives asset managers of the opportunity to innovate in Canada,” summarizes 3iQ.

The company acknowledges that while strictly restricting access to cryptocurrency may be an obvious response to the high-profile frauds and failures that have plagued the industry in recent years, “looking at the offering of regulated products will actually better protect consumers. »

3iQ believes the availability of its early crypto funds likely prevented at least some Canadian investors from using offshore platforms, such as FTX Trading, to gain exposure to cryptocurrency.

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

The Canadian Blockchain Consortium’s policy and advocacy committee suggests that the emerging cryptocurrency sector needs a tailored regulatory regime.

“The Canadian cryptoasset industry requires separate statutory oversight (and potentially an independent regulator) rather than integrating trading platform requirements into existing securities legislation,” the report states. Without this separation, confusion over securities regulation will continue to undermine industry concerns. »

Establishing a new regime to oversee the cryptocurrency sector would require legislation, however, and there is no sign that policymakers at any level are pursuing this goal.