Is Crypto the Next Asset Class for Irish funds?
While the onset of the Covid-19 pandemic in early 2020 led to a bear market in global equities and similar negative performance for fixed income and real estate funds around the globe, one asset class that was able to avoid a similar fate was the developing crypto-asset market. In fact, in contrast to equity, fixed income and real estate markets, crypto-assets including Bitcoin, lesser-known “alt-coins” and other digital coins, tokens and assets experienced significant increases in value during the initial months of the pandemic which continued throughout 2021.
Such increases have led to estimates that the global crypto-asset market is currently worth approximately US$2.5 trillion, a more than tenfold increase on estimates from 2019. Naturally, this has led to investors and asset managers increasing their focus on such assets, and an increasing acceptance within the financial industry that crypto-assets can be an appropriate part of a balanced portfolio. In light of the increasing value and acceptance of such assets, there have been a number of recent developments of interest.
Recent Global Developments
Many hedge fund managers in North America have included crypto-assets within their portfolios for some time, with the most well-known being the Grayscale Bitcoin Trust. In addition, European managers’ focus on crypto-assets has increased in recent years with a number making crypto-focused exchange-traded products available to institutional investors. However, developments in Canada and the United States during 2021 suggest that there is a move to provide non-institutional investors with greater opportunities to access crypto exposures via crypto-asset funds. In particular, the launch of the world’s first Bitcoin ETF (managed by Purpose Investments Inc.) on the Toronto Stock Exchange (“TSX”) in February 2021, shortly followed by two further Bitcoin ETFs (managed by Evolve Funds Group Inc. and CI Global Asset Management respectively) also listed on TSX, have provided North American investors with greater opportunities to access Bitcoin exposure through such vehicles.
In addition to developments in Canada, over the course of 2021, the Securities and Exchange Commission (“SEC”) received a significant volume of applications from managers, including a number with a European presence, seeking to establish similar ETFs in the United States. To date, the SEC has refused all applications seeking approval of a spot Bitcoin ETF, outlining that it has a number of outstanding concerns for such products. However, in October 2021, the SEC approved the first futures-based bitcoin ETF (managed by ProShares) with many managers now offering such ETFs to their clients. It is also expected that the SEC will continue to receive applications for the first spot-based ETF over the course of 2022.
Current Irish Position
Similar to the approach taken by its peer regulators in North America, the Central Bank of Ireland (the “Central Bank”) has increased its focus on crypto-assets in recent times and has noted that it is “cognisant of both the important opportunities and material risks associated with crypto-assets”. The Central Bank also outlined in February 2022 that it had seen an increase in queries from managers seeking to take both direct and indirect exposure to crypto-assets. While the Central Bank has currently ruled out allowing UCITS to invest in crypto-assets, it has confirmed that it will accept applications from managers of Irish QIAIFs proposing to take such exposure and in this respect, the Central Bank granted its first approval for an Irish QIAIF to take indirect exposure to crypto-assets (by acquiring cash-settled Bitcoin futures which are traded on the Chicago Mercantile Exchange) in March 2022. Any submissions to the Central Bank in relation to taking exposure to crypto-assets will need to demonstrate how the manager of a QIAIF can appropriately manage the risks associated with crypto-assets. Managers seeking to take crypto exposure, should be aware that as part of any submission to the Central Bank, the following information should be provided:
- details and evidence of the experience of the manager in managing crypto-assets;
- the types of crypto-assets that the relevant fund proposes to take;
- liquidity and scenario analysis including hypothetical analysis on how the relevant fund would have performed if historically exposed to crypto-assets;
- details of the risk management systems and procedures that the manager has in place to ensure that the risks associated with crypto-asset exposures are properly managed, measured and monitored on an ongoing basis; and
- details of the counterparties with which the relevant fund will trade
Considerations for Depositaries
In order to allow Irish funds to take exposure to crypto-assets, it will be necessary for the depositaries of such funds to ensure that they can comply with their custody obligations in respect of such assets. It is expected that any such funds may seek to take exposure to crypto-assets by directly investing in such assets or by entering into derivative instruments which reference underlying crypto-assets. While depositaries may be confident that they can support their obligations in respect of crypto-asset derivatives, some depositaries may need to put revised processes in place where a fund takes direct exposure to crypto-assets.
It is interesting to note that in the case of the three Canadian ETFs, the custodian of each ETF appointed Gemini Trust Company, LLC (“Gemini”), a leading provider of custody services in respect of crypto-assets, as a sub-custodian of each ETF. In its capacity as sub-custodian, Gemini will generally hold the Bitcoin purchased by each ETF in “cold storage”, whereby the Bitcoin will be held in a wallet that is offline and is not connected to the internet, thus minimising the possibility of theft in the event of a security breach. The Bitcoin purchased by each ETF will generally only be held in “hot storage” (i.e. where there is a connection to the internet) in order to facilitate investor redemptions.
In addition to the considerations outlined above, managers seeking to establish an Irish fund which takes exposure to crypto-assets will need to be cognisant of the European Commission’s draft regulation on markets in crypto-assets (“MiCA”), which forms part of its wider Digital Finance Package. Many crypto-assets currently fall outside the scope of European financial services regulation and, although some individual EU Member States have implemented national frameworks to try to address this gap, the divergence in these frameworks has hindered the ability of crypto-asset issuers and service providers to scale up their business activity to an EU level. MiCA is the European response to this – a dedicated and harmonised regulatory framework intended to ensure that the EU makes the most of the opportunities created by crypto-assets whilst also mitigating the risks that they pose, with many viewing MiCA as a “mini-MiFID” regime.
Similar to MiFID and other European financial services legislation, MiCA would enable firms to use their pan-European passport to provide crypto-asset services throughout Europe and provide better protection to investors, which should lead to increased user confidence in the crypto-asset market.
In order to be able to avail of the pan-European passport, crypto-asset service providers will, amongst other things, be required to:
- have an EU presence and obtain a licence. MiCA requires crypto-asset service providers to have a registered office in the EU and to be authorised by an EU national competent authority;
- comply with prudential requirements. The firm will be required to meet minimum and ongoing capital requirements and have an insurance policy in place – the amount of which will depend on the nature of service provided;
- comply with organisational and disclosure requirements, including rules on safekeeping of client’s funds and outsourcing; and
- put appropriate policies and procedures in place. MiCA requires firms to have a complaints handling procedures in place and to maintain and operate an effective policy to prevent conflicts of interest.
MiCA is currently a proposal, and will have to go through the EU legislative process (which could mean significant changes to the initial proposal). It is estimated that MiCA will enter into force during 2023, however, there will also be a transitional period after it comes into force to give firms time to comply with the new requirements.
The future opportunities for Irish funds
With the increasing volume, value and acceptance of crypto-assets, it is clear that European investors will continue to seek greater access to this asset class. With the increased focus of the Central Bank on this area, Irish funds are well placed to be at the forefront of future developments in this area, provided that managers are able to comply with the requirements of the Central Bank and any future regulatory developments in this area.