Parties interested in the crypto asset trading industry have been given an opportunity to provide their views on the appropriate regulatory oversight in Canada for crypto asset trading platforms.
On March 14, 2019, the Canadian Securities Administrators (CSA) and the Investment Industry Regulatory Organization of Canada (IIROC and, together with the CSA, the Regulators) jointly published Consultation Paper 21-402 Proposed Framework for Crypto-Asset Trading Platforms (Consultation Paper), in which the Regulators recognize the need for regulation of platforms that facilitate the buying, selling or transferring of crypto assets (Platforms).
The Regulators propose to address the novel features and risks associated with such Platforms through a set of tailored regulatory requirements (Proposed Platform Framework) to be further developed through consultation with the financial technology community, market participants, investors and other stakeholders. The Proposed Platform Framework is intended to apply both to Platforms that operate in Canada and to those that have Canadian participants.
In their two previously published Staff Notices (Staff Notice 46-307 Cryptocurrency Offerings and Staff Notice 46-308 Securities Law Implications for Offerings of Tokens), the CSA Staff had posted their interpretations and guidance without first seeking comments. For more information about the Staff Notices, please see our previous Blakes Bulletins: Industry Responds to CSA Guidance on Cryptocurrency Offerings and How Securities Law Applies to Offerings of Blockchain-Based Tokens and Coins: More Examples and CSA Comments.
The new Consultation Paper takes a different approach and seeks input from interested parties and stakeholders, who may share their views and recommendations with the Regulators until May 15, 2019. The Proposed Regulatory Framework outlined in the Consultation Paper indicates some preliminary thinking by the Regulators. Readers should carefully consider and respond in detail to the consultation questions posed by the Regulators as they take this positive step towards clarifying the regulatory framework applicable to Platforms.
The Consultation Paper covers many aspects of a complicated system and poses a total of 22 questions on various topics. The Regulators seek comments not only on those specific questions but also any other comments on the appropriate regulation of Platforms. Certain of these consultation questions are outlined below.
1. What factors should the Regulators consider in determining whether a security or derivative is being traded on a Platform?
The Consultation Paper states, “If crypto assets that are securities and/or derivatives are traded on a Platform, the Platform would be subject to securities and/or derivatives regulatory requirements.”
The Regulators go on to state, “We note that it is widely accepted that at least 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.” Nevertheless, the Regulators state that securities legislation may still apply to such Platforms, “because the investor’s contractual right to the crypto asset may constitute a security or derivative”, but do not indicate what such contractual rights may entail.
The Regulators are evaluating how trading occurs on Platforms to assess whether a security or derivative may be involved. Some factors under consideration include whether the Platform is structured so that there is delivery of crypto assets to investors, whether investors assets are pooled together, whether the Platform holds or controls participants’ assets, and what rights investors will have in the event of the Platform’s insolvency, among others.
While we understand that the role of the Consultation Paper is not to provide further guidance at this stage, we hope that the Regulators will provide further clarity through the continued development of the Proposed Platform Framework.
The focus upon the preliminary “is it a security?” question is natural, given the jurisdiction of the Regulators, but perhaps a broader initiative is called for now, to investigate developing a broader Canadian regulatory framework for platforms trading crypto assets that may not be securities, not necessarily based upon, nor limited by, securities or commodity futures legislation.
2. What best practices exist for Platforms to mitigate risks and what are the risks exactly?
The Regulators acknowledge that the risks associated with Platforms, in some cases, are not entirely different that those applicable to other types of regulated entities such as marketplaces and dealers. However, the introduction of crypto assets and the operational models of Platforms raise novel risks as well. Such novel risks include:
- Investors’ crypto assets may not be adequately safeguarded when controlled by the Platform, which is heightened by challenges associated with auditing the internal controls surrounding custody of participants’ assets;
- Investors may not have important information about the crypto assets (for example, about any difficulties in liquidating such asset) or the Platform’s operations (for example, details regarding custody of the crypto assets and any Platform fees); and
- Conflicts of interest, including Platforms acting as market maker, non-monitored trading and lack of transparency around price and volume in volatile markets.
The Regulators ask about the nature of substantial risks and how best practices for risk mitigation should be taken into consideration when developing the Proposed Platform Framework.
3. Are there any global approaches to regulating Platforms that would be appropriate to be considered in Canada?
The Regulators stated that “In developing the Proposed Platform Framework, we considered the approaches taken by securities and financial regulators in other jurisdictions.” The Consultation Paper mentions the regulatory frameworks of the United States, the European Securities and Markets Authority, Singapore, Hong Kong and Malaysia. We note that other global published approaches for Platform regulation could include those from the United Kingdom, Japan, Switzerland, Bermuda, Gibraltar or Malta. Commentators who have experience with the approach of another global regulator may wish to draw the attention of the Canadian Regulators to the structure, pros and cons of such alternative frameworks.
PROPOSED PLATFORM FRAMEWORK
The Proposed Platform Framework relies heavily on the Canadian regulations already governing marketplaces, dealers and exchanges. Readers should consider which of the existing regulations should apply to Platforms or be modified for application to Platforms, in either case as appropriate to mitigate the risks associated with a Platform in the face of novel operational challenges.
The Proposed Platform Framework contemplates Platforms becoming registered as investment dealers and becoming both dealer and marketplace members of IIROC. A footnote states “IIROC membership may not be appropriate in all cases, depending on the facts and circumstances”, but the Consultation Paper offers no suggestions on when and for what entities such membership may not be appropriate.
Part 5 of the Consultation Paper presents detailed questions around proposed requirements, including custody and verification of crypto assets, internal control reports, price determination, market surveillance, continuity planning, conflicts of interest, insurance and clearing and settlement on a Platform. For example, ordinarily all marketplace trades must be settled through a clearing agency. Perhaps a conditional exemption is appropriate, or, for non-custodial decentralized exchanges, specific controls should be in place to address technology and operational risks of the Platform. It would be useful for commentators to explain the operational challenges facing Platforms, which may prevent them from practically complying with existing frameworks, but such comments should also offer alternative risk mitigation recommendations to address the concerns of the Regulators.
The breadth of the consultation is illustrated in its final, catch-all question: “What regulatory requirements, both at the CSA and IIROC level, should apply to Platforms or should be modified for Platforms? Please provide specific examples and the rationale.”
It is important for interested parties to take advantage of this opportunity to further the development of the Proposed Platform Framework into a meaningful, practical, appropriate and comprehensive regime.
Submissions must be made by May 15, 2019 by email in Microsoft Word format to IIROC and all members of the CSA at the addresses identified in the Consultation Paper.