VIA EMAIL AND SEDAR
February 15, 2019
Attention: Lori Stein
Re: 3iQ Corp. (the Manager) and The Bitcoin Fund (the Fund)
Non-Offering Preliminary Prospectus dated October 30, 2018 (the Prospectus) -- SEDAR Project No. 2835709
This letter sets out my decision as Director to refuse to issue a receipt for the Fund's prospectus
• under subsection 61(1) of the Securities Act (Ontario) (the Act) because it appears that it is not in the public interest to do so; and
• under subsection 61(2)(a)(i) of the Act because the Fund's prospectus does not comply in a substantial respect with a requirement of the Act or the regulations.
I understand that the Manager filed the Prospectus as a non-offering prospectus with a view to resolving some of the issues discussed herein through the exercise of its right to be heard before the Commission, if necessary. The Manager would then convert or refile the Prospectus as an offering prospectus to raise proceeds once these issues are resolved.
The Prospectus raises the novel issue of whether an investment fund that invests substantially all of its assets in bitcoin should be offered to the public, including to retail investors.
In arriving at my decision, I reviewed:
• the correspondence between staff of the Investment Funds and Structured Products Branch of the Commission (Staff) and the Manager in connection with a pre-filing of the Prospectus;
• submissions provided by the Manager at a meeting I attended on October 9, 2018;
• the Prospectus; and
• the correspondence between Staff and the Manager in connection with Staff's review of the Prospectus, including Staff's negative recommendation letter dated January 25, 2019.
I provided the Manager the opportunity to make further submissions prior to making my decision, which it declined. The Manager also waived any further opportunity to be heard in front of the Director under subsection 61(3) of the Act.
The facts, Staff's submissions, the Manager's submissions, and my reasons for refusing to receipt the Fund's prospectus are set out below. Terms defined in the Prospectus have the same meaning if used in this decision, unless otherwise defined.
The Fund is a non-redeemable investment fund (NRIF) established as a trust under the laws of the Province of Ontario. The Manager is the investment fund manager of the Fund. The Manager filed the Prospectus on behalf of the Fund.
As stated in the Prospectus, the Fund's investment objectives are to seek to provide its investors with:
(a) exposure to digital currency bitcoin and the daily price movements of the U.S. dollar price of bitcoin; and
(b) the opportunity for long-term capital appreciation.
To achieve its investment objectives, the Fund will invest in long-term holdings of bitcoin purchased from sources including bitcoin exchanges.
Bitcoin is a digital asset that is not issued by any government, bank or central organization. Bitcoin, commonly referred to as a cryptocurrency or cryptoasset, is based on the decentralized, open source protocol of the peer-to-peer bitcoin computer network, which creates the decentralized public transaction ledger, known as the "blockchain", on which all bitcoin transactions are recorded.
NRIFs may engage in certain investment strategies and invest in asset classes not typically permitted for mutual funds. There are not yet, however, any publicly offered (i.e., prospectus qualified) investment funds in Canada and the United States that invest substantially all of their assets in bitcoin. There are several funds that are not publicly offered in Canada that invest substantially all of their assets in bitcoin, including one managed by the Manager (the 3iQ Pooled Fund). The 3iQ Pooled Fund only offers its securities under exemptions from the prospectus requirement. The Manager has operated the 3iQ Pooled Fund since April 2018.
As an NRIF, the Fund will not be in continuous distribution like a mutual fund or an exchange-traded mutual fund (ETF). It will also have more limited redemption rights relative to a mutual fund. Investors of the Fund will not have the right to redeem their Fund units on demand at the net asset value (NAV). They will have the right to redeem annually at NAV, or monthly at a discount to NAV. NRIFs generally complete public offerings in the same manner as traditional corporate issuers. If a receipt were to be issued for its prospectus, the Fund will engage underwriters to complete an offering and it will list its securities on an exchange to provide its investors with secondary market liquidity.
Cidel Trust Company (the Custodian) will be appointed as the custodian of the assets of the Fund. The Custodian is a federally regulated trust company based in Calgary, Alberta and is a wholly-owned subsidiary of Cidel Bank Canada, a Schedule II Bank regulated by the Office of the Superintendent of Financial Institutions.
The Custodian, however, has advised the Manager that it does not have the capacity to hold bitcoin on behalf of the Fund. Consequently, the Custodian intends to appoint a sub-custodian to hold bitcoin on behalf of the Fund. The Manager is in discussions with several bitcoin sub-custodians, some of which may be qualified to act as a sub-custodian under Part 6 of National Instrument 81-102 Investment Funds (NI 81-102).
Staff's view is that bitcoin is a novel asset currently in its nascent state. Given this, Staff's overlying concern is that more time is required for the development and maturing of regulatory infrastructure for this asset before it can be considered an appropriate underlying asset for an investment fund available to the public.
Staff submissions regarding why it is not in the public interest to issue a receipt for the Fund's prospectus under subsection 61(1) of the Act include the following:
(a) Nature of bitcoin
(i) Due to bitcoin's nascent stage of development, there is a lack of consistent regulation and uncertainty over its treatment by banks and other financial institutions and as a means of payment by retail and commercial outlets. The regulatory framework for cryptoassets, including bitcoin, in many jurisdictions is incomplete and, given the ability to move bitcoin globally, gaps between regulatory regimes is an emerging problem.
(ii) There are significant market integrity concerns regarding the trading of bitcoin that make it an unsuitable asset for a retail investment fund. The cryptoasset market, which includes the bitcoin market, is particularly vulnerable to market abuse and manipulative behaviour because of a number of factors, including the immature stage of development of the market and its actors, a lack of information about the identity of market participants and their activity, and the possibility of new abusive behaviours that may not be captured by current monitoring tools due to the novel nature of the market.
(iii) The nature of bitcoin makes it inherently vulnerable to cybercrime and fraudulent activity. Cryptoassets such as bitcoin are high-value targets for cybercrime, including hacks and thefts.
(b) Trading of bitcoin
Bitcoin trading is fragmented across several platforms and many of these platforms raise significant investor protection issues, including protection of client funds and assets, confidentiality safeguards for personal information, and reliable processes for pricing and trading in bitcoin. The lack of maturity of the bitcoin spot market raises concerns relating to the price discovery for bitcoin, including the risk of manipulation. Manipulation that occurs on less reputable bitcoin exchanges has a direct impact on the price of bitcoin on more reputable exchanges or the price provided by OTC counterparties.
(c) Custody of bitcoin
The Manager has not provided sufficient comfort regarding the security and safety of the bitcoin to be held on behalf of the Fund by its sub-custodian. Since custodians hold assets for various clients, they typically engage an external auditor to perform an audit of their internal controls so they can provide a copy of such assurance reports to any client who requests internal control information in connection with the audit of the client's financial statements. There are different types of assurance reports that have been developed, however, it is common for custodians to engage their auditor to issue Service Organizational Controls 1 (SOC 1) and Service Organizational Controls 2 (SOC 2) reports or their equivalent. In each instance, the custodian's auditor would issue a report pertaining to the design of its controls (Type 1 Report), and a report assessing whether such controls were operating as intended over a defined period (Type 2 Report). It would be very unusual for a fund to rely on the services of a custodian that cannot provide SOC 1 and SOC 2 reports (both Type 1 and Type 2) upon request.
While some bitcoin sub-custodians have prepared SOC 1 (Type 1) and/or SOC 2 (Type 1) reports, the Fund has not yet received from any sub-custodian a copy of all the SOC reports typically provided by fund custodians, i.e., SOC 1 (Type 1 and Type 2) and SOC 2 (Type 1 and Type 2) reports (this set of SOC reports are referred to as the Customary SOC Reports).
(d) Filing of annual financial statements
The Fund may not be able to file annual audited financial statements in accordance with National Instrument 81-106 Investment Fund Continuous Disclosure (NI 81-106) if the sub-custodian is unable to provide the Fund with the Customary SOC Reports.
NI 81-106 requires investment funds that are reporting issuers to file audited annual financial statements on an on-going basis. An investment fund relies on a custodian to safeguard its assets and process transactions with respect to those assets upon direction of the fund. Since a fund's assets are held by a third party, in order to complete an audit of the fund's financial statements, the fund's auditor must ensure that it has sufficient appropriate audit evidence to support that the assets being held by the custodian are properly secured and segregated, and that the custodian has appropriate controls in place to process transactions when requested to do so by the fund. In the case of the Fund, to form an unqualified opinion on the Fund's annual audited financial statements, the Fund's auditor will likely need the Customary SOC Reports from the sub-custodian to confirm the existence and ownership of bitcoin held, and the adequacy of internal controls at the sub-custodian.
(e) Loss of bitcoin
The Fund has not taken sufficient steps to protect its investors against the potential loss of bitcoin. The Custodian will not assume liability for the sub-custodian in the event of loss of the Fund's bitcoin. Neither the Custodian nor sub-custodian will have insurance for the Fund's bitcoin held off-line in cold storage.
The Fund's prospectus does not comply in a substantial respect with a requirement of the regulations
Staff submit that the prospectus of the Fund does not comply in a substantial respect with a requirement of the regulations because the Fund will not comply with the restrictions on illiquid assets under NI 81-102. Under NI 81-102, an NRIF is limited to investing no more than 20% of its NAV in illiquid assets. The Fund intends to invest substantially all of its assets in bitcoin. In Staff's view, bitcoin is an "illiquid asset" as defined in NI 81-102 as it does not trade on market facilities on which public quotations in common use are widely available. Therefore, Staff's view is that the Director should refuse a receipt for the prospectus under subsection 61(2)(a)(i) of the Act.
The Manager's submissions regarding why it would not be contrary to the public interest to issue a receipt for the Fund's prospectus include the following:
(a) Access to bitcoin through a regulated and professionally managed investment fund
Retail investors in Canada can obtain direct exposure to bitcoin and other cryptocurrencies by investing in securities of reporting issuers which have bitcoin, ether or other cryptocurrencies as their primary asset and have obtained stock exchange listings by completing reverse take-overs of shell issuers on the TSXV (the RTO Vehicles). Canadian retail investors can also invest in bitcoin directly on unregulated exchanges and through automatic teller machines, and such bitcoin is generally held online in "hot wallets" where it is susceptible to hackers and fraud. The Fund will provide Canadian retail investors with a safer way to buy and sell bitcoin with the benefit of the investment expertise of a professional portfolio manager and the security of cold storage. The Fund addresses some of the risks associated with investing in bitcoin by providing investors with a safer way to acquire and dispose of bitcoin on a pooled basis and on a prospectus qualified basis. In addition, the units of the Fund will be sold only through a syndicate of IIROC dealers. Because units of the Fund may only be purchased through IIROC members, all Canadian investors will be subject to the KYC requirements of IIROC members under Canadian AML/ATF rules as well as applicable securities laws.
(b) The risks associated with trading bitcoin on unregulated platforms will be mitigated
The Manager expects that bitcoin will be purchased for the Fund from a Bitcoin Source, including from its sub-custodian and other bitcoin exchanges. The Manager conducts due diligence on each proposed Bitcoin Source prior to transacting with such Bitcoin Source in order to confirm its reputation and stability, including by conducting research on the executive officers and significant shareholders of the Bitcoin Source and the regulatory regime, if any, applicable to the Bitcoin Source. The Manager also confirms that each Bitcoin Source maintains appropriate KYC policies and procedures and refuses to transact with any person or entity that is on a list of designated persons or entities established and maintained under applicable AML Regulation in the jurisdiction of the Bitcoin Source. The Manager ensures that each Bitcoin Source has its head office in a jurisdiction which is a member of the International Financial Action Task Force (FATF) or its global network of FATF-Style Regional Bodies.
The Manager will determine where to place the Fund's bitcoin orders based on the prices and volumes available through each Bitcoin Source with a view to achieving best execution for the Fund. Once a bitcoin order has been executed and allocated to the Fund, the Manager reviews and approves the transaction. Upon approval, the sub-custodian is notified and payment for the trade is settled. Once the sub-custodian receives the bitcoin on behalf of the Fund, the sub-custodian immediately places the bitcoin in cold storage, ensuring that such bitcoin is allocated to the Fund's account on a segregated basis.
The Fund's Bitcoin Sources offer trading limits which will seek to ensure that no bitcoin sold to the Fund comes from a wallet associated with illicit activity or from dark web sites or money laundering sites (known as "mixing" sites, such as BitBlender and DreamMarket). Leading cryptoasset exchanges, including some of the Fund's proposed Bitcoin Sources, are licensing exchange surveillance systems which are used by regulated exchanges.
In addition, the Manager will use forensic software to analyze each bitcoin which may be purchased by the Fund in order to identify any ledger entries which are known to be linked to illicit or illegal activity.
Unlike ETFs which accept in specie transfers of securities from designated brokers in exchange for newly-created units, the Manager will control all purchases of bitcoin for the Fund and will know where all its bitcoin is coming from.
(c) The pseudonymous (not anonymous) nature of bitcoin makes it easier to trace than cash
Although criminals may have been early adopters of bitcoin and other cryptocurrencies, law enforcement agencies are now working with cryptoasset forensics firms to track criminal activity on the blockchain. Some forensics firms also offer financial compliance software to cryptocurrency exchanges and others. The Manager will purchase financial compliance software to review coin sources at the Bitcoin Sources, as well as their underlying sources, and block bitcoin transactions from countries which are subject to AML/ATF sanctions or other economic sanctions.
(d) No restrictions on investments in volatile assets
The volatility of bitcoin is not higher than other asset classes and there are no restrictions against investment funds investing in volatile assets.
(e) Valuation of bitcoin
The Fund will be able to value its bitcoin investments. The Fund's bitcoin will be valued based on the MVIS CryptoCompare Bitcoin Index (MVBTC) maintained by MV Index Solutions GmbH (MVIS). MVBTC is intended to be an index of the U.S. dollar price of one bitcoin. It is representative of the bids and offers of market participants to buy or sell bitcoin on those exchanges elected by the MVBTC to serve as pricing sources for the calculation of the MVBTC. The MVBTC is geared towards timeliness and represents an unbiased estimator of the bitcoin price. MVIS is an index provider based in Frankfurt, Germany and regulated as an index administrator by the German Federal Financial Supervisory Authority. MVIS had adopted indexing practices and operations for its digital assets indices, including MVBTC, which comply with EU benchmark regulations. MVIS's pricing benchmarks are also compliant with International Organisation of Securities Commissions regulations.
(f) The Fund's assets will be held appropriately
The Custodian meets the requirements of Part 6 of NI 81-102 and the Manager is currently in discussions with various entities to act as sub-custodian for the Fund's bitcoin holdings, including entities that may be qualified to act as sub-custodian under Part 6 of NI 81-102. There is no requirement for a custodian or sub-custodian to provide a fund with SOC reports. Neither the Custodian nor the sub-custodian will maintain insurance against risk of loss of bitcoin held on behalf of the Fund off-line in cold storage, as such insurance is not currently available on commercially reasonable terms and obtaining such insurance is not consistent with industry practice for custodians of bitcoin. The Prospectus contains clear disclosure regarding the risk of loss and the lack of insurance.
(g) Filing of audited financial statements
The Fund will file the required audited financial statements for the Prospectus and intends to file audited annual financial statements required under NI 81-106.
The auditor of the Fund is MNP LLP. The Fund will provide an audited opening balance sheet that meets the financial statement requirements for a prospectus for a new investment fund. This opening balance sheet will report on the Fund's initial holding of one bitcoin. The Manager expects that it will be able to file audited financial statements for the Fund required under NI 81-106, accompanied by an unqualified audit report on those statements, for the year ending December 31, 2019 (the 2019 Financial Statements). The auditor's delivery of an unqualified audit report will be subject to completion of its audit tests relating to the 2019 Financial Statements. The Manager expects that the auditor will be able to provide an unqualified audit report upon receipt of all documentation from the sub-custodian that the auditor considers necessary to complete its audit procedures.
The Fund's prospectus does not comply in a substantial respect with a requirement of the regulations
The Manager submits that the Director should not refuse to issue a receipt for the Fund's prospectus under subsection 61(2)(a)(i) of the Act because bitcoin is not an "illiquid asset" as defined in NI 81-102. Consequently, the Fund will comply with the restrictions regarding illiquid assets under NI 81-102.
The Manager provided data regarding the high daily trading volumes and liquidity expectations for bitcoin reported by some of its Bitcoin Sources, as well as data regarding the relatively large market capitalization of bitcoin compared to many other publicly traded asset classes. The Manager submits that public quotations for bitcoin are in common use and are widely available. MVBTC and the CME CF Bitcoin Real-Time Index are examples of two bitcoin indices administered and calculated by regulated index administrators which provide market prices for bitcoin. A consolidated market price is also available on Bloomberg under the ticker XBT.
The Manager submits that the definition of "illiquid asset" in NI 81-102 does not specify that the "market facilities" through which liquid portfolio assets are readily disposable must be regulated
"marketplaces" as defined in National Instrument 21-101 Marketplace Operation, and there is no general definition of "market" or "market facilities" in National Instrument 14-101 Definitions or in NI 81-102.
Director's Decision and Reasons
As set out at the start of this letter, I have decided not to issue a receipt for the Fund's prospectus under subsections 61(1) and 61(2)(a)(i) of the Act.
As set out in section 1.1 of the Act, the purposes of the Act are: (a) to provide protection to investors from unfair, improper or fraudulent practices; (b) to foster fair and efficient capital markets and confidence in capital markets; and (c) to contribute to the stability of the financial system and the reduction of systemic risk.
Bitcoin and other cryptoassets create novel challenges in striking a balance between product innovation that may promote fair and efficient capital markets and the protection of investors. In my view, because of the lack of established regulation for the bitcoin market at this time, an investment in the Fund raises a number of investor protection issues, notably, issues concerning the valuation, safeguarding and liquidity of bitcoin. Currently, the types of assets that publicly offered investment funds invest in are more mature traditional assets (such as equities and bonds) for which established regulation already exists.
Investing in bitcoin involves investment risk, that is, the risk of losing money as a result of market price decline, as does any investment. In fair and efficient capital markets, investors assess and take investment risks. The securities regulatory regime generally seeks to manage these risks for investors through the provision of full, true and plain disclosure and through sales of investment products by registered dealers. Unlike corporate issuers, publicly offered investment funds are subject to additional regulatory requirements to provide protection for investors against the risks associated with operating an investment fund. Requirements that promote the accurate valuation of fund assets, the liquidity of a fund and the safeguarding of fund assets seek to mitigate operational risks that are not appropriate for investment funds available to the public. I am of the view that in deciding whether it is not contrary to the public interest to issue a receipt for a prospectus of an investment fund, I am required to consider whether fund operational risks are adequately managed by measures other than providing disclosure of such risks to investors. The section below outlines my concerns with specific operational risks arising from the Fund's investment of substantially all of its assets in bitcoin.
I agree with Staff's concerns regarding the impact on the Fund's ability to accurately value its assets for investors due to the fragmented and unregulated environment in which bitcoin generally trades. Appropriate valuation is important as the Fund's NAV generally serves as a benchmark for the trading price of its units on the exchange, determines the price at which investors can redeem their investment, and is an input in significant aspects of the Fund (such as the Manager's management fee).
The Manager has considered this issue and attempted to address it with constraints around its Bitcoin Sources and valuing the Fund's bitcoin based on the MVBTC. I accept Staff's submission, however, that trading activities on other less reputable platforms can impact pricing of bitcoin on more reputable platforms. In my view, this risk to the Fund's ability to accurately value its holdings is not typically present for traditional portfolio assets that either trade on a regulated marketplace or through more developed industry standard dealer trading networks.
Safeguarding of Assets
I accept Staff's submission that an investment in the Fund presents a novel risk regarding the safeguarding of the fund assets to the extent that the bitcoin sub-custodian is not yet able to provide the Customary SOC Reports. I acknowledge that Staff does not normally require Customary SOC Reports for publicly offered investment funds. Bitcoin, however, is a novel digital asset that requires novel custodial arrangements. Without the Customary SOC Reports (which I understand a custodian of traditional portfolio assets provides to its clients in accordance with industry practice) or insurance maintained by the Custodian or sub-custodian against the risk of loss of bitcoin held on behalf of the Fund in cold storage, I am concerned that an investment in the Fund presents a novel risk that is unacceptable for a prospectus qualified fund offering. I note also that some entities seeking to act as sub-custodian for bitcoin holdings may not qualify to act as a sub-custodian under Part 6 of NI 81-102. If the Custodian and Manager wish to retain an entity that does not meet the requirements to act as the bitcoin sub-custodian under Part 6 of NI 81-102, I would also need to consider whether the risks of using this type of entity as sub-custodian for the Fund's bitcoin holdings can be sufficiently mitigated.
Audited Annual Financial Statements
Accurate and timely financial reporting is a fundamental requirement of publicly offered investment funds to ensure transparency and on-going information to investors. I accept Staff's submission that an investment in the Fund presents a novel risk of the audited financial statements required under NI 81-106 not being filed. As discussed above, Staff does not normally request the Customary SOC Reports from a custodian or sub-custodian for a prospectus review. Bitcoin, however, is a novel asset. It is unclear how the Fund's auditor will be able to provide an unqualified opinion on the Fund's annual financial statements in accordance with NI 81-106 without receiving the Customary SOC Reports from the sub-custodian.
I note that there are investment funds that are not reporting issuers, such as the 3iQ Pooled Fund managed by the Manager, that are subject to audited annual financial statement requirements under NI 81-106. These products are sufficiently new that they have not yet passed the initial date for filing their first set of audited annual financial statements. The audit experience with these products may provide useful information regarding challenges or standards for the audit profession. At present, however, I believe there is a material risk that the Fund will not be able to file audited annual financial statements.
The Manager provided detailed submissions to address the operational risks set out above and the Prospectus provides disclosure of the risks of an investment in the Fund. The Manager has clearly invested significant resources in designing the Fund with a view to mitigating and disclosing the relevant risks for retail investors. However, due to the nascent state of bitcoin and the lack of established regulation for bitcoin market, there is currently no compelling evidence that the Manager's processes and controls for the operation of the Fund (as set out in its submissions) will be effective in mitigating my concerns regarding the valuation and safeguarding of fund assets and the risk of the Fund's audited financial statements not being filed. I am not convinced that these investor protection issues will be adequately addressed. Therefore, I am of the view that it would be contrary to the public interest for a receipt to be issued for the Fund's prospectus.
The Fund's prospectus does not comply in a substantial respect with a requirement of the regulations
I further agree with Staff that bitcoin is an illiquid asset and, consequently, that I am obligated to refuse a receipt for the Fund's prospectus under subsection 61(2)(a)(i) of the Act as the Fund does not comply in a substantial respect with the restriction in NI 81-102 against the holding of illiquid assets.
Under NI 81-102, "illiquid asset" means 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 net asset value per security of the mutual fund.
The Manager rightly submits that "market facilities" is an undefined term and that the definition of "illiquid asset" does not, on its face, require that the asset can be readily disposed of through a regulated exchange or marketplace. I agree with Staff, however, that the term "market facilities" implies some form of established and mature trading facility or network in order to promote a robust valuation of a fund's assets. In my view, Staff's interpretation provides the definition of "illiquid asset" with meaning. Such a market facility does not exist yet for bitcoin.
I also note that subsection 61(2)(a)(i) of the Act states that a receipt for a prospectus shall not be issued if it appears to the Director that "the prospectus or any document required to be filed with it" does not comply in any substantial respect with any of the requirements of the Act or the regulations. While it may appear that this subsection applies only to the disclosure in the prospectus, given that publicly offered investment funds are subject to fund operational
requirements in NI 81-102 (which is a "regulation" as defined in subsection 1(1) of the Act), I believe that I should consider any non-compliance with NI 81-102 when considering the application of subsection 61(2)(a)(i) of the Act.
I also find that it would be contrary to the public interest under subsection 61(1) of the Act to issue a receipt for a prospectus for a fund that proposes to operate in violation of NI 81-102.
The Manager submitted that the Fund could potentially provide retail investors with better protection relative to how bitcoin can be accessed by investors either directly or by investing in other publicly traded vehicles such as the RTO Vehicles. I understand that the RTO Vehicles are not investment funds. Further, they did not file a prospectus and therefore a decision under section 61 of the Act was not required. While I appreciate the importance of innovation in publicly offered investment funds, as discussed above, it does not appear to me at this time that the operational risks presented by the Fund are sufficiently mitigated such that the Fund can make a public offering.
In conclusion, I am of the view that a receipt for the prospectus of the Fund should not be issued. The Manager has the right under subsection 8(2) of the Act to request a hearing before the Commission to review my decision. Should the Manager wish to exercise that right, it may file an application with the Registrar in the Commission Secretary's Office.