On February 15, 2019, the Ontario Securities Commission issued a decision in which it refused to issue a receipt for a prospectus filing made by 3iQ Corp. (3iQ) in respect of The Bitcoin Fund (the Fund). The decision highlights the challenges faced by issuers seeking to do business in cryptocurrency markets, which regulators continue to view as highly problematic.
3iQ designed the Fund as a non-redeemable investment fund (NRIF) that would expose investors to bitcoin and daily price movements of bitcoin relative to the US dollar. 3iQ filed a non-offering prospectus on behalf of the Fund in order to resolve the concerns of the OSC in advance of issuing units in the Fund. It intended to convert and refile its prospectus as an offering prospectus to raise proceeds if and when those issues were resolved.
The prospectus indicated that the Fund would appoint Cidel Trust Company to act as custodian of the assets of the fund. However, as Cidel did not have the capacity to hold bitcoin on behalf of the Fund, it would appoint a sub-custodian.
Position of OSC staff
OSC staff submitted that it was simply too early for bitcoin to be considered an appropriate asset for an investment fund available to the public. Staff expressed concern about the gaps between regulatory regimes in other jurisdictions and the high potential for abuse in a cryptocurrency market that is still very difficult to monitor. Staff also expressed concern about the fact the Fund had not yet received from any sub-custodian a copy of a customary Service Organizational Control (SOC) audit report and submitted that it would be very unusual to rely on a custodian that could not provide such a report on request.
Notably, staff argued that the Fund had not taken sufficient steps to protect investors against the risk of loss of bitcoin, such as by obtaining insurance. Staff also took the position that the prospectus was not compliant with NI 81-102, which limits a NRIF to investing no more than 20% of its net asset value in illiquid assets. Staff took the position that bitcoin is an illiquid asset, because it is not traded on market facilities on which public quotations in common use are widely available.
Fund manager responses
Among other things, 3iQ argued that Canadian investors are already able to gain exposure to bitcoin through: (i) the securities of issuers holding cryptoassets that went public via reverse takeovers (ii) unregulated exchanges; and (iii) ATMs. Compared to those alternatives, the Fund would be a safer way to invest in cryptoassets with the benefit of the expertise of a professional portfolio manager. It also argued that it would be able to perform diligence to establish the source of the bitcoin acquired by the Fund to minimize exposure to fraud or other illicit activities. 3iQ also disputed that bitcoin is illiquid with trading volume evidence.
OSC refuses receipt in the public interest
The OSC founded its decision on a concern about the lack of established regulation for the bitcoin market, which raises investor protection issues. In deciding whether it is contrary to the public interest to issue a receipt for the Fund’s prospectus, the OSC is required to consider whether fund operational risks are adequately managed by measures other than providing disclosure of such risks to investors. It therefore focused its review on operational concerns.
The OSC expressed concern about accurate valuation due to the fragmented and unregulated bitcoin market. Despite the fact that 3iQ had taken steps to ensure reliable, reputable sources of valuation information, the OSC accepted staff’s submission that trading on less reputable platforms can impact pricing on more reputable platforms. This exposure differentiates bitcoin assets from conventional investments assets.
While the OSC acknowledged that SOC reports are not normally required by staff for publicly-offered investment funds, it stated that “bitcoin is a novel digital asset that requires novel custodial arrangements”. It found that, without customary SOC reports or insurance to protect against the risk of loss of bitcoin held in cold storage, an investment in the Fund presents a novel risk that is unacceptable for a prospectus qualified fund offering.
The OSC also found that bitcoin is an illiquid asset, and as a result, 3iQ’s prospectus was not compliant with NI 81-102.
Decision expresses regulatory unease about cryptoassets
The OSC’s decision makes clear that cryptoassets are still a long way from being considered trustworthy asset classes.
It also emphasizes the unease created by the recent death of Quadriga’s founder Gerald Cotton and related inaccessibility of nearly USD $150 million in cryptoassets. The OSC’s concerns regarding financial reporting and insurance for coins in cold storage appear to be focused at least in part on making sure that the peculiar circumstances that led to the Quadriga situation are not repeated.