Circular Letter CVM/SIN 11/2018

SECURITY AND EXCHANGE COMMISSION OF BRAZIL
Rua Sete de Setembro, 111/2-5th and 23-34th Floors – Center – Rio de Janeiro - RJ – ZIP Code: 20050-901 – Brazil Tel.: (21) 3554-8686 - www.cvm.gov.br Circular Letter No. 11/2018/CVM/SIN Rio de Janeiro, September 19, 2018

To the administrators and managers of investment funds regulated by CVM Instruction No. 555/14

Subject: Indirect investment in cryptoassets by investment funds

Dear Sirs,

This Circular Letter aims to complement Circular Letter CVM/SIN No. 1/2018, which addressed the possibility and conditions for investment in cryptoassets by investment funds regulated by CVM Instruction No. 555.

CVM Instruction No. 555, in its Articles 98 and following, when addressing investment abroad, authorizes indirect investment in cryptoassets through, for example, the acquisition of shares in funds and derivatives, among other assets traded in third jurisdictions, provided they are admitted and regulated in those markets. However, in compliance with the duties imposed on them by regulation, it is incumbent upon administrators, managers, and independent auditors to observe certain due diligence measures in the acquisition of these assets.

A first point that stands out is that already raised by various regulatory and supervisory bodies worldwide 1 regarding the possibility of direct or indirect financing of illegal operations in this market, such as money laundering, unfair practices, fraudulent operations, or price manipulation, among other similar practices.

In this context, and also taking into account the requirement to combat and prevent money laundering imposed by CVM Instruction No. 301, we understand that an adequate way to address such concerns is to make such investments through trading platforms ("exchanges") that are subject, in those jurisdictions, to supervision by regulatory bodies that have, recognizably, powers to curb such illegal practices, through, inter alia, the establishment of regulatory requirements.

Although it is recommended that investments be made through these exchanges, as there is no explicit prohibition against investments being made in other ways, due to their fiduciary duties, administrators and managers must ensure that the chosen structure is capable of fully meeting the legal and regulatory requirements mentioned above.

Also regarding the theme of the normal functioning of markets in which cryptoassets and their derivatives are traded, it is important that the manager verify whether a given cryptoasset does not represent a fraud, as has been seen with great recurrence, for example, in recent ICO operations 2 worldwide. Thus, it is important that the manager adopt due diligence measures to minimize the risk of fostering the offering of a fraudulent cryptoasset, by verifying the relevant variables associated with the issuance, management, governance, and other characteristics of the cryptoasset.

Important examples in this evaluation are (i) whether the base software is free and open source or closed; (ii) whether the technology is public, transparent, accessible, and verifiable by any user; (iii) whether there are arrangements that give rise to conflicts of interest or excessive concentration of power in the issuer or promoter of the cryptoasset 3, or the use of aggressive sales techniques; (iv) the trading liquidity of the cryptoasset; (v) the nature of the network, consensus and validation protocols, and the software used; or (vi) the profile of the development team, as well as their degree of involvement with the project.

In the case of representative cryptoassets, here qualified as those that represent another underlying asset, right, or contract, it is incumbent upon the fund manager to also evaluate other aspects arising from the concentration of risk seen in the figure of the issuer of the cryptoasset in such hypotheses, which requires especially rigorous due diligence on this issuer; the risk analyses naturally associated with the underlying asset, right, or contract to which the cryptoasset refers; and finally, whether such a cryptoasset should or should not be considered a security, and if so, whether it has any prior registration required.

It is natural that, in the case of indirect investment made through investment funds constituted abroad and managed by third parties, it is incumbent upon the administrator and manager to evaluate, under the conditions required by the circumstances, whether the manager of the invested fund adopts risk mitigation practices and measures equivalent to those that the manager of the investing fund would adopt in its position.

It is worth also remembering the role of the independent auditors hired by the fund, as, in line with the expected attributes of this professional, they must be capable of conducting adequate and proportional due diligence regarding any cryptoassets held by the fund. And to the fund administrator, in exercising the role provided for in Article 79, § 1st, of CVM Instruction No. 555, to ensure that the fund hires an auditor qualified and structured for such function.

On the other hand, another risk factor associated with cryptoassets is that positions in custody of these assets are subject to frequent attacks by specialists in information system intrusions, the well-known "hackers".

It is true that the course of such operations through regulated platforms would also mitigate such risks, but, in any case, it is good evidence of due diligence for the fund managers and administrators to seek robust custody solutions already available in this market.

Another quite relevant characteristic in this market, which differs from what is commonly observed in other conventional segments of the capital market, is the governance associated with these cryptoassets. It is of special importance that the fund manager pay attention to the governance rules provided for the acquired cryptoasset, in order to become aware, price, and monitor any additional risks, such as the possibility of unfair distributions, manipulations, or even limitations on trading liquidity.

For certain cryptoassets, such rules allow for operations known as forks or airdrops, which impose on their holders the risk of coming to have other cryptoassets, resulting from these operations, that differ in nature and characteristics from the original one until then held directly or indirectly by the investment fund.

Naturally, as such operations fall outside the more traditional scope seen in other financial assets comprising the portfolios of investment funds regulated by CVM Instruction No. 555, it is prudent that administrators and managers of funds with such strategies make clear, in the fund documents, which policies they will adopt regarding such events.

Also regarding disclosure, the transparency of the particular types of risks to which an investor exposed to cryptoassets in general is subject must be exposed in the fund documents by the administrator and manager who pursue such investment strategy. A current and pertinent indicator of what these risks are can be consulted, for example, in the statement released on 3/7/2018 by the CVM titled "Initial Coin Offerings (ICOs)", insofar as applicable.

A last point of concern regarding the application in such cryptoassets is related to the structural difficulty of pricing, at fair value, of these investments, especially when they are less liquid alternatives.

As is known, there is still no consensus or internationally accepted model for calculating the fair value of this type of investment. Thus, it is evidence of adequate due diligence that the invested cryptoasset has liquidity compatible with the needs for periodic pricing of the fund, as determined for funds regulated by CVM Instruction No. 555, to avoid an undue transfer of wealth between fund unitholders, a risk that is especially relevant in funds constituted in the form of an open condominium.

A possible parameter, in this sense, is investment in cryptoassets that contain the permanent disclosure of globally recognized price indices, prepared by independent third parties, and which in turn are calculated based on actual transactions carried out by investors in such cryptoassets.

Sincerely,

Digitally signed by
DANIEL WALTER MAEDA BERNARDO
Superintendent of Institutional Investor Relations

1 http://www.valor.com.br/financas/5205725/bc-nao-pode-permitir-bolhas-nem-uso-ilicito-de-criptomoedas-dizilan; https://publications.banque-france.fr/sites/default/files/medias/documents/focus-16_2018_03_05_en.pdf; https://www.reuters.com/article/us-g20-imf-cryptocurrencies/imfs-lagarde-says-cooperation-needed-to-keepcrypto-assets-safe-idUSKCN1GP1SX; 2 https://medium.com/satis-group/cryptoasset-market-update-b678aeda4c5e

3 Examples are the commissioning of chain entities, the existence of promises of yield or returns of any kind, or the existence of a centralized operator.