The CSA and IIROC are seeking to take a thoughtful approach to regulating crypto asset platforms, one that balances regulatory imperatives while fostering innovation and flexibility in the nascent crypto asset industry.
On March 14, 2019, the Canadian Securities Administrators ("CSA") and the Investment Industry Regulatory Organization of Canada ("IIROC") published a joint Consultation Paper 21-402 – Proposed Framework for Crypto-Asset Trading Platforms ("Consultation Paper"). The Consultation Paper seeks input from the fintech community, market participants, investors and other stakeholders on how securities regulatory requirements may be tailored for platforms that facilitate the buying and selling or transferring of crypto assets ("Platforms") operating in Canada. The intention is to use this feedback to establish a framework ("Proposed Platform Framework") that provides regulatory clarity to Platforms, addresses risks to investors and creates greater market integrity.
In formulating the issues for consideration in developing a Proposed Platform Framework, the CSA and IIROC considered the approaches taken by securities and financial regulators in other jurisdictions such as the United States, the E.U., Singapore, Hong Kong and Malaysia. The CSA have stated that, in many jurisdictions, the existing regulatory requirements extended to Platforms within those jurisdictions. Similarly, it would appear from the content and tone for the Discussion Paper that the CSA also are looking to develop a type of Proposed Platform Framework that would largely rely on or be inspired by the existing regulatory framework applicable to marketplaces, while addressing more appropriately the specific factors and nuances relevant to the trading of crypto assets in a largely digital environment.
Balancing Regulation and Innovation: A Hybrid Approach
Given that Platforms perform a myriad of functions traditionally provided solely by either alternative trading systems, exchanges, dealers, custodians and clearing agencies, the CSA and IIROC have suggested a "hybrid" approach to the Proposed Platform Framework – one that encapsulates requirements for each of those traditional market participants while facilitating innovation that will benefit investors and the Canadian capital markets.
Existing securities legislation: when and how will it apply?
As we wrote about in our paper (available here), a crypto asset may be subject to Canadian provincial securities laws to the extent that such crypto asset is considered a security or a derivative for the purposes of such laws. For example, the Securities Act (Ontario) defines a security to include, among other things, an investment contract. The seminal case in Canada for determining whether an investment contract exists is Pacific Coast Coin Exchange v. Ontario (Securities Commission), where the Supreme Court of Canada identified the four central attributes of an investment contract, namely:
- an investment of money;
- in a common enterprise;
- with the expectation of profit; and
- which profit is to be derived in significant measure from the efforts of others.
If an instrument satisfies the Pacific Coin test, the instrument will be considered an investment contract and, therefore, a security under Canadian securities laws. The CSA and IIROC acknowledge it is widely accepted that some of the well-established crypto assets that function as a form of payment or means of exchange on a decentralized network, such as bitcoin, are not currently in and of themselves, securities or derivatives. In their view, however, securities legislation may apply to Platforms that offer trading of crypto assets that are commodities because the investor's contractual right to the crypto asset may constitute a security or derivative.
In addition to applying the Pacific Coin test to individual crypto assets, the CSA and IIROC are proposing to evaluate the specific factors and circumstances of how trading occurs on various Platforms in order to assess whether a security or derivative may be involved. Where that is the case, the Platform would generally be subject to Canadian securities and derivatives legislation. The factors under consideration include:
- Whether the Platform is structured so that there is intended to be and is delivery of crypto assets to investors,
- If there is delivery, when that occurs, and whether it is to an investor's wallet over which the Platform does not have control or custody,
- Whether investors' crypto assets are pooled together with those of other investors and with the assets of the Platform,
- Whether the Platform or a related party holds or controls the investors' assets,
- If the Platform holds or stores assets for its participants, how the Platform makes use of those assets,
- Whether the investor can trade or roll over positions held by the Platform, and
- Having regard to the legal
arrangements between the Platform and its participants, the actual
functions of the Platform and the manner in which transactions
occur on it:
- who has control or custody of crypto assets,
- who the legal owner of such crypto assets is, and
- what rights investors will have in the event of the Platform's insolvency.
As a marketplace, a Platform would be subject to requirements set out in National Instrument 21-101 Marketplace Operation, National Instrument 23-101 Trading Rules and National Instrument 23-103 Electronic Trading and Direct Access to Marketplaces. The Consultation Paper queries whether it would be appropriate for Platforms to become registered as investment dealers and IIROC dealers and marketplace members. In the case of marketplaces that trade over-the-counter derivatives, including platforms that offer derivatives with exposure to a crypto asset, the CSA and IIROC anticipate that requirements may need to be specifically tailored to reflect the requirements that currently apply to derivatives.
How are specific types of risk addressed?
While the foundations of the Proposed Platform Framework are based on existing regulatory frameworks, the CSA have indicated that in formulating applicable requirements, they will need to address risks that are particularly significant in the crypto asset context, as outlined below:
- Custody. The CSA and IIROC propose to assess whether a Platform's risk management policies and procedures are appropriate to manage and mitigate the custodial risks. Expectations may be guided by the operational model of the Platform. Specifically, the Consultation Paper raises for discussion the possibility of requiring that Platforms obtain SOC 2, Type I and II Reports for their custody system and, if they use third-party custodians, to ensure that they have SOC 2, Type I and II Reports. Type II Reports will be particularly difficult for many Platforms and may well not be appropriate for new Platforms, as they involve reviews over an extended time period, which may be impossible for a start-up;
- Price determination. Platforms may also be required to foster price discovery for the crypto assets they offer for trading. Where the Platform or an affiliate acts as a market maker and provides quotes, the mechanisms for determining those quotes may be expected to be available to participants. When trading as a market maker against its participants, a Platform may also be required to provide participants with a fair price;
- Surveillance of trading activities. The Consultation Paper considers whether Platforms should permit dark trading, short selling activities, or extending margin to their participants. A similar dark market was recently proposed in Bermuda;
- Systems and business continuity. Platforms may be required to comply with the systems and business continuity planning requirements applicable to existing marketplaces in NI 21-101;
- Conflicts of interest. Platforms may be required to identify and manage potential conflicts of interest and will be required to disclose whether they trade against their participants, including acting as a market maker, and the associated conflicts of interest. To the extent Platforms are required to become IIROC Members, they may also be subject to requirements in the Universal Market Integrity Rules (UMIR) aimed at mitigating the risks associated with trading against their participant;
- Insurance. Although the type of insurance coverage is yet unknown, the Proposed Platform Framework may require that Platforms obtain and maintain sufficient insurance coverage to protect against cyber-attacks and theft from insiders, which may be very difficult in the case of "hot" crypto asset wallets; and
- Clearing and Settlement. The CSA and IIROC are considering whether an exemption from the requirement to report and settle trades through a clearing agency is appropriate for Platforms. In these circumstances, Platforms would still be subject to certain requirements applicable to clearing agencies and would therefore be required to have policies, procedures and controls to address certain risks including operational, custody, liquidity, investment and credit risk. Platforms operating on a decentralized model may be required to have controls in place to address the specific technology and operational risks of the Platform. Currently, there are no regulated clearing agencies for crypto assets that are securities or derivatives.
Targeted and risk-appropriate exemptions will be required to address the specific characteristics of crypto assets and related Platforms that make the application of the conventional securities and derivatives regulatory framework to this asset class very challenging. Exemptive relief should be used to create a regulatory outcome in Canada that is as closely as possible aligned with the regulatory solutions developed in the leading IOSCO jurisdictions.
The CSA and IIROC are inviting interested parties to make written submissions on certain consultation questions identified in the Consultation Paper by May 15, 2019. For information on how to make a submission, please see Part 6 of the Joint Consultation Paper.
For more information on Canada's regulatory approach to crypto assets, including with respect to cryptocurrency offerings and funds, see CSA Staff Notice 46-307 – Cryptocurrency Offerings (along with our corresponding commentary here) and CSA Staff Notice 46-308 – Securities Law Implications for Offerings of Tokens.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.