Daniel Haeberli and Benjamin Leisinger, partners at Homburger, look at how the cryptoasset class has been thrown open to institutional investors
On November 20, 2018, the Swiss special purpose vehicle (SPV) Amun AG, owned by fintech group Amun, issued the first series of exchange traded products (ETPs) linked to an index tracking the performance of the top five cryptocurrencies. Amun was the name of the sun god in ancient Egypt. The listing of the Amun ETP under the ticker symbol HODL – a popular backronym for 'hold on for dear life' but originally a typo that has become very popular in the cryptocurrency world – on the SIX Swiss Exchange (SIX) on November 22, 2018 was a novelty in Switzerland – if not a world premiere – and brought some sunlight to Switzerland!
The Amun ETPs are fully collateralised by the underlying cryptocurrencies being deposited with an independent third-party custodian. The idea behind the Amun ETP is to give institutional investors that are restricted to investing only in securities, or do not want to set up custody for digital assets, exposure to cryptocurrencies. It makes investing in cryptocurrencies as easy as buying a stock.
The founders of Amun have explored 27 different jurisdictions and exchanges around the world and settled for Switzerland and the SIX Swiss Exchange for its liberal but stable regulatory regime and financial excellence.
This article summarises the requirements that the issuer of such products and the products themselves must meet in order to be permissible under Swiss law and regulations and eligible for listing and trading on the SIX Swiss Exchange.
Legal qualification of exchange traded products
As per the regulations of the SIX, ETPs are collateralised, non-interest-paying, bearer debt securities (debentures), which are issued as securities, sold and redeemed in the same structure and denominations on a continuous basis and replicate the price trend of an underlying instrument, either unchanged or leveraged (tracker certificate). These products are not subject to the Swiss Collective Investment Schemes Act (CISA) and, as such, are not supervised or subject to approval by the Swiss Financial Market Supervisory Authority (FINMA). When structuring the specific product, it is very important to avoid the product being potentially qualified as a collective investment scheme if this is not intended. Otherwise, regulatory requirements, including approval by the FINMA, will fully apply.
Yet, ETPs qualify as structured products. While the CISA does not specifically define what a structured product is, it lists capital-protected products, capped return products and certificates as examples. Swiss legal doctrine, the Swiss Bankers Association and the Swiss Structured Products Association (SVSP) also broadly define structured products as a separate category of investment products, the return or redemption value of which depend on the development of one or several underlyings. Products where the primary focus is financing, such as collateralised debt obligations (CLO), asset backed securities (ABS), convertible bonds and bonds (as per article 1156 of the Swiss Code of Obligations), are not considered structured products. Credit-linked notes issued for the purposes of financing the reference debtor or forward and options transactions (for example futures, warrants, traded options, etc.), do not qualify as structured products either, irrespective of their legal set-up. Legally, structured products are debt instruments (claims), so that the default risk of these securities (the same as for bond issues) depends on the creditworthiness of the issuer or provider of security respectively. As such, a product tracking the development of an underlying one-to-one (ie, a delta one tracker certificate) and not intended to finance the issuer, such as exchange traded products exactly tracking the performance of one or more cryptoassets, qualify as structured products under Swiss law.
Under the Rules of the SIX, specific rules have to be complied with for the listing and admission to trading of structured products in the form of ETPs. In this context, the Additional Rules for the Listing of Exchange Traded Products (ARETP) are of specific relevance.
According to Article 5 CISA and Article 4 of the Swiss Collective Investment Schemes Ordinance (CISO), only Swiss banks, Swiss insurers, Swiss broker dealers and foreign institutions subject to equivalent prudential supervision may publicly sell, issue, guarantee or distribute structured products in Switzerland or out of Switzerland. To publicly issue, guarantee or distribute structured products in Switzerland, foreign institutes must generally have a branch in Switzerland.
Alternatively, structured products may be issued by SPVs and distributed to non-qualified investors in or from Switzerland if the products are guaranteed or secured in an equivalent manner by a financial intermediary (mentioned in the preceding paragraph) or secured by equivalent collateral (see next section below on collateralisation). According to Article 2 of the Swiss Stock Exchange and Securities Trading Act, however, persons or entities that on a commercial basis create derivatives and offer them publicly qualify as broker dealers (in the form of a derivatives house). As such, issuers of derivatives normally require a licence from FINMA and must, therefore, meet various requirements as to organisation, capital etc. Notwithstanding this, the licence requirement does not apply for the issuance of structured products by an SPV. The CISA, as the more specific and more recent piece of legislation, provides specific requirements for the issuance of structured product by an SPV. If an SPV indeed requires a licence from FINMA as a broker-dealer, the option of an issuance of structured products by an SPV would never apply. This view also is held in Swiss legal doctrine.
For ETPs to be listed on the SIX, the issuer must generally meet further requirements. These requirements include a reported equity capital of at least CHF25 million (about $25 million), in accordance with the financial reporting standard used in the listing prospectus, an active track record of at least three years, unless the ETPs are exclusively collateralised with certain underlyings and in a specified way, and the existence of annual financial statements pursuant to the accounting standard that applies to the issuer. According to the rules of the SIX, however, exemptions from these requirements may be granted in justified cases.
The CISO regulates what is considered to be "equivalent collateral" by specifically mentioning the provision of legally enforceable physical security held in Switzerland in favour of the investors. According to Swiss legal doctrine, as recently confirmed by the explanatory report of the Swiss Federal Council dated October 24, 2018, in relation to the draft Financial Services Ordinance, the collateral does not necessarily have to be located within Switzerland. Rather, the legal enforceability of the collateral to protect the investors is the decisive element.
The ARETP of the SIX further requires that ETPs are collateralised in one of the following ways: by presenting the underlying instrument for deposit either physically or in the form of a futures contract; by means of liquid equities, participation certificates, profit-sharing certificates, collective investment schemes, bonds or commodities that are listed or admitted to trading on SIX or a foreign exchange with equivalent regulation; or by means of cash balances or precious metals.
The collateral must at least cover the outstanding amount of the ETPs, ie the structure of the products and the collateralisation and issuance must ensure that the ETPs are always fully collateralised.
According to the ARETP of the SIX the underlyings of the ETPs must be "eligible underlyings".
If no exception is granted, such eligible underlyings must consist of specified assets listed in the ARETP or baskets of such eligible underlyings. These assets include equity securities, bonds and collective investment schemes listed or admitted to trading on the SIX or on a foreign securities exchange with equivalent regulation. When collective investment schemes are used as the underlyings, they must also fulfil the conditions of the CISA and its implementing provisions. Further, all derivatives that are listed or admitted to trading on SIX are permitted as underlying instruments. Standardised options and futures contracts that are traded on an exchange with equivalent regulation are also permitted. Indices may also be used as underlying instruments, provided they meet certain criteria, including that they are composed of permitted underlying instruments and the index regulations of the sponsor are available online free of charge. Foreign currencies, reference rates, precious metals and commodities may also be used as underlying instruments if they meet certain criteria.
The SIX's Regulatory Board may permit further underlying instruments. Specifically, according to Circular No. 3 of the SIX, cryptocurrencies are permitted as underlying assets for derivatives, provided that certain criteria are met. These criteria are also applied by the SIX for the permissibility of underlyings for ETPs. Before each application for admission of a product, the respective issuer must check whether the following criteria are (still) fulfilled:
- The permissible cryptoasset underlyings are cryptocurrencies in the form of coins (tokens, ie, shares in a project, which are frequently issued as part of an initial coin offering (ICO), are not permissible as underlying instruments). This criterion mainly serves the function to avoid an indirect circumvention of the rules in order to use ETPs for indirect ICOs.
- Further, such coins must be based on open source software that functions on the principles of blockchain technology. A consensus protocol must be used and transactions must be verified by the network participants using a clearly defined process. The issuance of further cryptocurrency agreements must be clearly regulated and must not systematically favour individuals.
- At the time of application for provisional admission to trading, the relevant cryptocurrency must be one of the 15 largest cryptocurrencies in terms of market capitalisation in USD.
- In order for the respective cryptocurrency to be eligible as an underlying, it has to be ensured that the prices for the cryptocurrency used are regularly quoted and are readily publicly accessible via the internet. In addition, it must be ensured that the cryptocurrency can be traded directly against a common fiat currency such as USD or EUR and that a price feed is available via a common information system such as SIX Financial Information, Bloomberg or Reuters.
- There must be at least one trading venue for the relevant cryptocurrency that meets the following criteria: (1) it offers trading against a common fiat currency; (2) it creates transparency through the publication of prices; (3) the trading venue provides an API interface; and (4) the website of the trading venue must at least be written in English.
If a specific cryptocurrency is used (or intended to be used as underlying) for the first time, the applicant must clearly show to SIX Exchange Regulation how the aforementioned requirements are met.
In the event of a fork in a cryptocurrency used as the underlying during the term of a derivative traded on the SIX, the derivative that relates to the new cryptocurrency and is allocated to existing investors free of charge may also be admitted to trading. Another permissible way to settle such a fork is to add the new cryptocurrency as an extra underlying instrument to the existing product. This may be done if the new cryptocurrency meets all the above requirements but for the requirement of being one of the 15 largest cryptocurrencies.
The admission of new derivatives to the new cryptocurrency is only possible when all requirements including the requirement to belong to the 15 largest cryptocurrencies are met.
ETPs listed on the SIX must have a minimum capitalisation of CHF1 million at the time the listing application is submitted. In the case of ETPs relating to cryptocurrencies, a certain safety buffer it is advisable due to the possibility of significant fluctuations in the value of the underlying.
For ETPs listed on the SIX, the issuer must make an undertaking to the SIX to ensure that a market exists for the ETPs in question, ie, that there is a market maker for the specific ETPs. The market maker agreement for the relevant ETPs between the specified market maker and the SIX also forms part of the listing application.
The SIX is authorised to issue implementing provisions with regard to market making; however, it has not to date done so for ETPs.
Applicable law and venue
In general, ETPs listed on the SIX are governed by Swiss law. ETPs that are governed by foreign law may be listed only if a foreign legal system is a recognised legal system by the Regulatory Board of the SIX. Upon application, the Regulatory Board of the SIX may still recognise further foreign legal systems, provided the applicant can demonstrate that the legal system in question meets international standards in respect of investor protection and transparency regulations.
In order to give the investors a realistic chance to enforce their rights under the ETPs or in connection with the structure, investors must be able to take their case before a state court to assert their rights against those involved in the structure (for example against the issuer, the custodian of the collateral, etc.). The place of jurisdiction must ensure, as at least one alternative, that the courts in the country whose legal system is applicable to the terms of the issue in question are competent to hear such cases. In the case of Swiss law governed ETPs, the jurisdiction of the courts of the City of Zurich may, for example, be perfectly chosen as the venue.
One important document to be submitted as part of the listing application (and prepared for the offering of the ETPs), is the prospectus. The prospectus can either take the form of a base prospectus (which includes a form of final terms) and completed final terms for the specific issuance to be offered and listed, or of a stand-alone prospectus for an individual series of ETPs.
The listing prospectus must meet the requirements of Scheme G of the SIX's listing rules. In addition to the risk factors, the information about the issuer and the information about the securities that are always required for listing prospectuses, specific further information must be provided. This information also includes the description of the way of collateralisation and the procedure of enforcement of the collateral in the event of an event of default. Further, detailed information about the parties involved in the structure is required. In order to again clarify that the ETPs do not qualify as collective investment schemes, a declaration in bold is required highlighting that the ETPs are not collective investment schemes in the sense of the CISA and that they are subject to neither approval from nor supervision by the FINMA.
Additionally, for ETPs relating to cryptoassets, the listing prospectus must include the additional risk factors and information required by Circular No. 3 of the SIX. As per this Circular, in the case of cryptocurrencies, information on the following points must also be provided in the listing prospectus:
- The most important differences and the resulting risks between conventional (fiat) currencies and the cryptocurrency must be explained. These are in particular non-existent intrinsic value, trading of the cryptocurrency on unregulated online exchanges, lower trading volume, and greater volatility; and
- the specific risks in connection with products in cryptocurrencies, in particular fraud risks and risks arising from possible hacker attacks.
SIX Exchange Regulation reserves the right to require the inclusion of further information in the listing prospectus if the cryptocurrency or the product structure so require.
No simplified prospectus
When ETPs are listed on the SIX, or any other Swiss exchange, the requirement to produce a simplified prospectus – which would normally apply in the case of offering/distributing structured products to non-qualified investors in or from Switzerland does not apply. This exemption already applies if the plan is to list the ETPs but is offered to investors prior to such listing on the basis of the (draft of the) prospectus.
Rules for maintaining the listing
Interim financial reporting requirements do not apply in the case of a mere listing of ETPs on the SIX. This means that the issuer of ETPs does not have to prepare and publish semi-annual financial statements. Neither is the issuer obliged to produce a corporate calendar covering at least the current financial year, and to keep it up to date. Rather, the ARETP contain an annex stating the regular reporting obligations and the deadlines thereof, for example regarding annual financial statements or regarding the increase or reduction in number of ETPs. Of course, the notice requirements stated in the terms and conditions apply and must be made as disclosed in the given listing prospectus and terms and conditions of the specific ETPs.
With the possibility of issuing cryptoasset-linked ETPs in Switzerland and to list them on the SIX, investors, in particular institutional investors, get a good chance to participate in the new asset class of cryptocurrencies, or in the case of index products even in part of the whole market of these new asset classes, through a traditional listed product rather than registering with a crypto exchange or wallet provider.
The interest expressed in the financial press with respect to these types of products suggests that there will be further issuances of similar cryptoasset-linked instruments in Switzerland listed on the SIX.
|About the author|
Daniel Haeberli is a partner in the Banking and Finance and Capital Markets teams. He is a banking and finance as well as a structured products and derivatives specialist. His practice focuses on secured lending, syndicated debt and structured financing as well as derivatives, retail structured products, investment funds and bond offerings. He is the co-head of the Homburger TechGroup and head of 'Legal & Regulation' at the Swiss Structured Products Association.
|About the author|
Benjamin Leisinger is a partner in the Banking and Finance and Capital Markets teams. His practice focuses on banking, finance and capital markets law. His areas of expertise also include corporate and commercial law.
Benjamin Leisinger regularly advises Swiss and international financial institutions in financing transactions, in particular in the capital markets, and regarding regulatory matters, including questions related to licensing and regulatory capital.
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