Ripe or rotten? Cryptocurrencies and pension plans in 2023

Clearly the last six months or so have not been the greatest for enticing pension plans or any other institutional investor to make any sort of leap to invest in, or adjacent to, cryptocurrencies. We have seen the bankruptcy of several crypto lending businesses, including some caught up in the bankruptcy of the crypto exchange FTX. These events have put a chill on the market and motivated governments and regulators to examine market participants more closely and tighten certain regulatory requirements or impose new disclosure obligations.1  

Despite the negative sentiments arising from current events, the presence of digital assets, including cryptocurrencies, in the commercial world, and investments in them, are unlikely to go away. The current chill on the market could also be seen as an opportunity for the public sector and larger private sector pension plans to take the time to learn more about digital assets, assess areas that present risk, and develop standards and techniques to manage these risks in order to be ready should opportunities in the digital asset space present themselves in the future. Moreover, familiarity with crypto and developing policies and practices with respect to same may prove useful in contexts distinct from the investment function. 

What is crypto? 

The greatest mystery of crypto is what it actually is. This seems to be a great barrier to undertaking a consideration of it as a possible asset class for pension plans. While a proper explanation can be highly technical and, therefore, daunting, basically cryptocurrencies are based on the blockchain theory of a decentralized network. In a decentralized/distributed network, every “node” keeps a copy of the transaction ledger, and the entire network must agree on all transactions. Key elements of this are:  

• Each entry on a blockchain ledger is an “address” where value can be stored. 
• Each address has a public key known to all, and a private key known only to its owner. 
• The private key is required to transfer value from one address to another. 

A blockchain-based digital asset, also known as a coin or token, is the software code that states the value held at a blockchain address. 

 General risks associated with cryptocurrencies 

Whether you are a pension plan or not, there are a number of commercial risks to be aware of as one considers using or investing in cryptocurrencies. The main risks are: 

• custody risk – loss of assets due to theft, hacks, or loss of private keys2 

• anti-money laundering/anti-terrorist financing and sanctions risk (i.e., due to the ability of parties to hide or fabricate their identities in cyberspace and the absence of an intermediary overseeing transactions) 
• securities regulatory risk 
• for non-tax-exempt entities, tax risk – how to track and tax crypto asset transactions 
• investment risk  

This article is primarily focused on consideration of investment risk as it applies to registered pension plans. However, even for plans that are not likely to consider investments in the crypto space for a good many years, some level of understanding of these other risks can be useful in responding in a responsible, informed matter to a request for payment in cryptocurrencies from service providers or plan members. 

 General investment risk 

Similar to other novel asset classes, crypto presents issues in determining value, dealing with volatility of a nascent asset class, etc. These may be succinctly described thus: 

• unlike a conventional security, cryptocurrencies do not represent a payment obligation or participating interest in net assets of an issuer  
• difficult to value using traditional techniques and metrics 

• highly speculative 
• extremely volatile 

Turning the focus to registered pension plans 

Pension plan administrators (including pension committees) owe duties to the plan membership to properly administer and invest the pension fund. As part of the investment function, it can certainly be argued that outright ignoring certain asset classes without any consideration for them is as imprudent as investing in an asset class of which the administrator has no understanding. Accordingly – and with an exception for smaller pension plans in which one can likely say that expending resources on asset classes that there is virtually no chance the pension fund will hold either directly or indirectly is discouraged – it may be time for larger private pension plans and the public-sector pension plans to make increasing efforts to better understand cryptocurrencies. Indeed, it may be that a pension plan may find itself investing in some form of pooled fund that itself has some dealings in crypto (e.g., one of that fund’s investments pays dividends in crypto); a service provider may desire payment in crypto; or even a plan member may request payment in crypto. The more one knows and appreciates before these issues come to light, the better prepared the administrator will be to address them with a cool head, either by making interim or preliminary policy calls or making one-off decisions in the heat of the moment. 

As noted at the beginning of this article, news of substantial failures garners many headlines and presents especially cautionary tales. The recent failures of crypto lenders and exchanges are reminders of the investment risk inherent in new asset classes for even the most expert of investors. Still, if one sees good opportunities and takes care in decision-making, failures in some instances do not erase opportunities in others. After all, some companies in the auto, forestry, and steel industries make good investments despite high-profile failures in these industries. Ultimately, it comes down to understanding and managing risks appropriately in each individual circumstance. 

Options for investing in the crypto “space” 

There are three broad ways to invest in cryptocurrencies or in the crypto space: directly, by investment in crypto itself or in ETFs that themselves deal in crypto; or indirectly, by investing in crypto-linked businesses, businesses that serve crypto, or businesses that accept crypto as payment. 

There are also techniques for managing crypto risks. Investors can invest through a fund or managed account so as to avoid direct investment and all of the complications that can present (e.g., through publicly traded ETFs for Bitcoin, Ether, and soon, perhaps, other currencies or some hedge funds). Investors still need to carry out their due diligence and determine which, if any, regulatory regime (US registered RIA/CPO, EU AIFM, MiFID-compliant, Canadian-registered PM/IFM) applies, and whether the applicable requirements are being met. Determining how the manager mitigates crypto-specific risks, diversifies across counterparties and exchanges, and values crypto assets also needs to be assessed. 

If you are contemplating direct investments in crypto, ensure you are aware of the relevant custody policies and procedures and have, or have access to, technical expertise to monitor the relevant blockchain networks and protocols. 

Pension plan-specific matters 

As plan administrators are investing a pension fund for the benefit of others (i.e., the plan members), it is incumbent on those undertaking the administration generally, and fund investment more specifically, to have an appreciation of how any proposed crypto or crypto-adjacent investments fit within the context of the total portfolio and relate to the liabilities of the plan. These considerations are relevant not just for crypto investments, of course, but for all pension plan investments. It is, however, a more complex and at least novel exercise with a new asset class. 

Set out below is a road map for the sequence of steps a plan administrator may consider when investing in crypto or the crypto space. 

The first step is to organize some expertise to understand crypto, the range of investment options, and how they might fit within the overall portfolio of the pension fund. In many cases, this would entail outsourcing to acquire the expertise, including obtaining legal advice on the key mitigation steps and developing related policies. This level of due diligence would include developing thoughts around the volatility and liquidity of the proposed investment. It may also entail an investigation into the possibility of investment funds or corporations in which the pension fund already invests (or may invest in future) using or investing in cryptocurrency themselves, and determining what commercial and other issues that may present to the pension plan. This means policies or approaches in connection with arising issues (e.g., whether distributions could be made to the plan in cryptocurrency and how the fund would deal with that) need to be developed. 

If a “go” decision follows this, then turn to an examination of the plans’ statement of investment policies and procedures (SIPP). It is necessary for all fund investments to be made in compliance with the SIPP, and depending on whether a decision is made to invest directly in crypto, in an ETF, or in an adjacent business, there may be a need to modify the SIPP to permit or more clearly permit investments in this space. Investments in ETFs or in an ownership interest in an entity that services the crypto space may well not require any changes, but it would probably be a good idea to at least tweak a SIPP to the extent that direct investments in crypto are contemplated. In that vein, the administrator may also need to come to its own view as to how to characterize crypto for purposes of the SIPP (e.g., is it a commodity, a security, or, despite other characterizations, a currency?). Finally, as every SIPP requires the inclusion of parameters for valuing assets, it will be necessary to assess whether the current language in the SIPP adequately covers the proposed crypto investment or that language needs to be revised. 

At the time of making any actual investments, plan administrators need to ensure that there are clear minutes or other written memoranda outlining the decision-making process, due diligence, and reason for making the decision, as well as some idea of conditions that would lead to a decision to sell the investment. In a perfect world, the materials would indicate how each of the risk areas identified in the first part of this article have been addressed. Prudence is a process, not a result, and thus it is important to have a clear record of the decision-making in connection with investments, in particular those in any novel investment class for the plan. A further practical step may be to make any initial investment fairly modest relative to the size of the pension plan to see how that progresses and to take advantage of the inevitable learning that will occur in real time rather than in the theoretical due diligence phase, which is rarely capable of revealing all elements that will arise when an actual investment is made. 

As with all plan investments, undertake constant review from time to time to assess whether the investment continues to make sense in the context of all of the pension fund’s assets and the plan’s liabilities. 

 Miscellaneous thoughts in an increasingly digital world 

As noted earlier, beyond the new investment space, there may be other areas of pension plan administration where an administrator may encounter cryptocurrencies. While it may not be the most pressing issue, it may be worthwhile to ensure that, as new service contracts are entered into or refreshed or new investments in funds are made, some attention is paid to ensuring that by the terms of the contract or subscription agreement (or side letter), cryptocurrency issues are addressed, whether in a positive or a negative way. For example, it may be wise to place a little more focus on currency or payment clauses to make it clear, where desirable, that payment or distribution may only occur in the lawful currency of Canada or another jurisdiction. Do investment fund provisions that allow managers to make some distributions in-kind give rise to the possibility that this may include cryptocurrency? What would a plan do if it found itself on the receiving end of Bitcoin? 

Finally, it may be worthwhile thinking about how the plan would react to individual plan members seeking payment in cryptocurrency or, where transfers of assets in are permitted, seeking to transfer cryptocurrency into the plan. Presumably, without the architecture to properly take custody of cryptocurrency, or simply because it would impose disproportionate costs on the plan, most plans would not entertain these requests. However, a little thought in this area would not hurt. Indeed, on the question of payment of pensions, absent unorthodox plan terms, it is far more likely than not that most plan administrators could safely take the position that the plan terms do not require it to pay pensions in anything other than Canadian dollars. 

Greg Winfield is a counsel in the pensions, benefits, and executive compensation group at McCarthy Tetrault LLP.