So far so good for crypto funds, but CSA flags risks

Canada’s crypto-focused investment funds have so far remained in regulators’ good books, but new guidance from the Canadian Securities Administrators (CSA) highlights areas where fund mangers must remain careful — including when it comes to their valuation and liquidity practices.

The CSA published a notice Thursday outlining the regulators’ experience with crypto-focused funds and setting out some added guidance for fund managers in the fledgling sector.

According to the notice, since the Ontario Securities Commission began approving some of the world’s first crypto-focused mutual funds and ETFs in early 2020, the sector has grown to 22 funds with about $2.9 billion in assets under management (as of April 30).

Regulators reviewed these funds in response to recent turmoil in the crypto sector and found no real issues in terms of managers fulfilling redemption requests or ensuring sound custody arrangements.

The CSA’s review of crypto ETFs found that they “had not experienced any material difficulties in meeting redemption requests” and that even large redemption demands have been met without funds taking extraordinary measures to fulfil those requests.

The regulators also found that fund managers in the sector are using a variety of tools to ensure adequate liquidity, and the review confirmed that the funds’ assets are being appropriately segregated, custodied and insured.

Nevertheless, the CSA also flagged certain areas that could raise concerns.

For instance, the regulators’ guidance stressed the importance of fund managers relying on active, regulated markets for valuation data. It warned that evidence of manipulation in certain crypto markets — such as widespread fake trading or wash trading — means these markets can’t be relied on for valid pricing data.

“CSA staff think that this would impair or limit [a fund manager’s] ability to determine a fair value for the crypto asset in question for the purpose of calculating a [net asset value],” it said.

To that end, the notice set out considerations for managers in determining whether a market provides useful pricing data.

“To accurately value a crypto asset, [fund managers] should consider 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,” it said.

Additionally, pricing data from regulated futures markets can also support accurate valuations, the notice suggested — although concerns about manipulation in unregulated markets exist here too.

“CSA staff consider that the presence of a regulated futures market for a particular crypto asset promotes greater price discovery, a view that is supported by recent research,” it said.

Given these concerns, at this point, the only cryptoassets where there’s likely to be adequate, reliable pricing data are Bitcoin and Ether, the report noted.

“In the future, greater institutional support and mainstream adoption of other crypto assets may result in those crypto assets becoming suitable investments for publicly distributed investment funds,” it said.

At the same time, given the volatility in crypto markets and the sudden failure of certain large crypto-trading platforms, the regulators called on fund managers to ensure they have effective liquidity management procedures in place, including stress-testing and ongoing monitoring of the underlying crypto market liquidity.

The guidance also warned fund managers to ensure they are assessing whether specific cryptoassets could be considered securities or derivatives, which may trigger concentration limits or restrictions on securities lending, among other regulatory considerations.

To that end, the guidance also addressed the practice of “staking” in the crypto sector — locking certain assets into smart contracts — which the regulators said could amount to issuing securities (or derivatives), could result in an asset that would otherwise be considered liquid becoming an “illiquid asset” under securities regulations, and could also trigger securities lending restrictions.

“We encourage stakeholders to review this guidance to better understand our expectations of public crypto asset funds,” said Stan Magidson, chair of the CSA and chair and CEO of the Alberta Securities Commission (ASC), in a release.

“It is important for such funds to clearly understand their existing regulatory obligations given recent events in the crypto market.”