Canadian securities regulators have released for comment a consultation paper on a proposed framework for the regulation of crypto asset trading platforms. In developing the framework they engaged with and considered the approaches taken by securities regulators in other jurisdictions around the world. As a follow-up to previously published guidance, the proposed framework is intended to provide regulatory clarity, address risks to investors and create greater market integrity in crypto asset trading.
According to the consultation paper, there are over 2000 crypto assets being traded on over 200 exchange platforms, with many of these platforms operating globally and without regulatory oversight. The regulators note that crypto assets with a value of almost US$1 billion were stolen from globally operated platforms in 2018. As a result, regulators around the world are grappling with how to appropriately regulate these platforms. In Canada, there are no platforms recognized as an exchange or otherwise authorized to operate as a marketplace or dealer of crypto assets. The consultation paper is requesting input from the FinTech community and other interested parties in formulating an appropriate regulatory framework for crypto asset trading platforms in Canada.
The novel and disparate nature of crypto assets
The regulators have noted that all crypto assets do not fit consistently within traditional definitions of securities or derivatives under Canadian securities laws, as they have disparate functions, structures, governance and rights. Offerings of "utility tokens" for example, which allow holders to access or purchase goods developed by the creators of the token have been generally determined to involve a distribution of securities in the form of investment contracts, while other crypto assets are tokenized forms of traditional securities. Still others, such as bitcoin, function as a form of payment or means of exchangeable currency with features akin to commodities rather than a security. With such diversity in the assets being traded on platforms, regulators indicate that an evaluation of how trading occurs is required to assess whether or not a security or derivative is involved. In addition, the trading platforms themselves may perform functions similar to one or more of an exchange, marketplace, alternative trading system, custodian, dealer or clearing agency, making it difficult to appropriately characterize these platforms under existing regulations. As a result, the factors currently under consideration by the regulators in making these assessments 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 rollover 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 is the legal owner of such crypto assets; and
- what rights investors will have in the event of the platform's insolvency.
The proposed regulatory framework
The proposed framework is based on the existing regulatory framework applicable to marketplaces in Canada. It incorporates relevant requirements for dealers facilitating trading or dealing in securities and is intended to take into account the disparate functions that may be performed by each platform. It will apply to platforms that operate in Canada or that have Canadian participants that are subject to securities legislation, but do not currently fit within the existing regulatory framework.
The proposed framework contemplates the following:
- "As a marketplace, a Platform will be subject to requirements that will address many of the risks […] 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".
- Requirements that address the risks relating to dealer functions, such as providing custody of crypto assets and permitting direct access to trading by retail investors, consistent with those already in existence within regulatory frameworks applicable to dealers will be applied to crypto asset trading platforms.
- Firms that are currently registered in the category of exempt market dealer and are currently permitted under securities legislation to facilitate the sale of securities, including crypto assets, in reliance on available prospectus exemptions will be permitted to continue to offer this service as long as they do not fall within the definition of "marketplace".
- Platforms will become registered as investment dealers and become IIROC dealer and marketplace members.
- A platform that intends to carry on business as an exchange will be required to discuss with regulators whether recognition as an exchange is appropriate or if the proposed platform framework is more appropriate.
- If a platform is trading or dealing in crypto assets that may be classified as derivatives, it may be appropriate to apply requirements that are similar to the requirements of the proposed platform framework.
Challenges and Proposed Solutions
Custody and verification of assets. Many crypto assets are kept on the platform itself with the platform controlling the participants' private keys, versus being held in private wallets, controlled by users. Further, insufficient segregation between investors' assets and the platform creates risk if the platform becomes insolvent. Appropriate custody controls, therefore, are an important part of managing risk. As we have recently seen happen to the investors with assets held on Quadriga CX, the loss of a private key, for whatever reason, can have devastating consequences. The regulators propose the requirement of a robust system of risk management policies and procedures, internal controls and record-keeping that ensures participants' assets are accounted for and that they are separated from the platform's assets. Standards specific to the custody of crypto assets are expected to be determined and implemented. Compliance is to be maintained through independent audits. Regulators are seeking input on the standards to be adopted with respect to safeguarding assets and controls assurance.
Cybersecurity and risk to platform integrity. Cybersecurity breaches are one of the largest risks facing crypto asset platforms. To address this, platforms will be required to have adequate internal and information technology controls over their trading, surveillance and clearing systems in the same way marketplaces currently do. They will also be required to enlist an experienced entity to conduct independent systems reviews of their internal controls and security protocols. Regulators are seeking input to determine under what circumstances, if any, an exemption from the independent systems review requirement should be considered.
Insurance. Most platforms are currently operating without insurance. The regulators acknowledge the significant difficulty and costs involved in acquiring insurance when many banks and insurers continue to avoid anything 'crypto,' and the risk of cyber-attacks remains high. Regulators are seeking input on alternative measures equivalent to insurance, to address investor protections.
Lack of transparency regarding price, volume, orders and trades. Every crypto asset is different and comes with its own risks. There is currently no standard of quality or threshold for a crypto asset to meet before it is made available for trading on a given platform. There is little information regarding the liquidity of particular crypto assets available to participants. It is important for all participants to understand how prices are determined, and whether or not that price is fair. As with traditional marketplaces, the proposed framework will require platforms to facilitate price discovery for the assets available for trading and any platform trading as a market maker against its participants will be required to provide participants with a fair price. Regulators are seeking input as to the factors that should be considered in determining a fair price for crypto assets and whether there are reliable pricing sources available to assist in assessing compliance with these requirements.
Surveillance of trading activities. Different types of marketplaces are required to monitor trading activities and enforce market integrity in different ways. Exchanges, for example, are required to monitor trading activities on the exchange. An alternative trading system is required to engage a regulation services provider to conduct surveillance and enforcement activities. On crypto asset platforms, all trading is not currently monitored, which provides opportunity for manipulative and dark trading. The regulators have proposed that an agency such as IIROC could perform surveillance and enforcement on such platforms. However, they recognize that there are unique challenges associated with market surveillance on crypto trading platforms, including the lack of a central source for pricing, dealing with 24-hour trading on a global basis, and the volatile nature of crypto assets, making effective surveillance difficult. To reduce the risks, they propose to implement restrictions on the trading of crypto assets to exclude dark trading, short selling or the extension of margin to participants. Regulators are seeking input on appropriate market surveillance tools and market integrity requirements to be established in the proposed framework.
Clearing and settlement. Currently there are no regulated clearing agencies for crypto assets. Regulators are considering whether an exemption from the requirement to report and settle trades through a clearing agency is appropriate, noting that platforms will be required to have policies, procedures and controls to address risks relating to the settlement of trades. Where transfers of crypto assets occur on a decentralized blockchain protocol, the platform will be required to have controls in place to address technological and operational risks. Regulators are seeking input on available models for clearing and settling crypto assets and the risks associated with the decentralized model.
Conflicts of interest. The regulators contemplate disclosure protocols that will require platforms to identify and manage potential conflicts of interest, including disclosing whether or not the platform trades for its own account against their participants and the associated conflicts of interest. This will allow potential participants to be better informed when deciding whether to participate on a platform. Regulators are seeking input regarding specific disclosure requirements relating to trades between a platform and its participants and whether current business models are able to appropriately manage conflicts of interest.
The consultation paper outlines a list of 22 specific questions for consideration by the FinTech community and other interested parties.
On March 28, 2019, representatives from the OSC LaunchPad participated in our Blockchain Leadership Series exploring recent trends in blockchain and the important role key stakeholders are playing in shaping the technology's future, including in the area of crypto asset trading platforms. On April 4, 2019, representatives from the Ontario Securities Commission (OSC) and additional Canadian Securities Administrators jurisdictions participated in the FFCON19 Fearless FinTech and Funding Conference in Toronto to further explain the regulatory proposals and to reiterate their willingness to hear comments from various stakeholders.
Given the importance of the proposed regulatory framework in this evolving market, stakeholders are strongly encouraged to provide innovative commentary before the deadline of May 15, 2019 to assist the regulators in the creation of a framework that is tailored for platforms operating or intending to operate in Canada.
For questions or further information on the proposed regulation of crypto asset platforms, please reach out to a member of Gowling WLG's Capital Markets/Crypto team:
Vancouver - Brett Kagetsu, Stefan McConnell, Denis Silva
Calgary - Gord Chmilar
Toronto - Ian Palm, Andre Poles, Kathleen Ritchie, Jason Saltzman, Usman Sheikh
Waterloo - Bryce Kraeker
Ottawa - Lorraine Mastersmith
Montreal - Naïm Antaki, Michael Garellek, Jean-François Pelland