On February 14, 2018, the British Columbia Securities Commission (BCSC) published a notice and request for comment (the “Notice”) on the securities law framework for Fintech regulation in the province. The Notice summarizes the results of consultations the BCSC has undertaken in the Fintech space and poses related questions to stakeholders. The Notice provides useful information—and an important opportunity to provide input—for businesses with an interest in how regulatory rules for Fintech may change in the future.
The BCSC has actively monitored Fintech developments over the past 18 months. In January 2017, the BCSC established a dedicated support group, the Tech Team, for the Fintech sector and conducted a survey of Fintech stakeholders. The continued dialogue between the BCSC and stakeholders in the Fintech sector has led the BCSC to request comments on Crowdfunding, Online Advising, Cryptocurrency Funds, and Initial Coin Offerings/Initial Token Offerings (ICOs).
Crowdfunding and Online Lending
The current Canadian legislative framework for crowdfunding and online lending is a patchwork quilt between different provinces. In 2015, securities regulators in six provinces (British Columbia, Saskatchewan, Manitoba, Quebec, New Brunswick and Nova Scotia) adopted harmonized registration and prospectus exemptions aimed at helping start-up and early stage companies to raise capital without having to comply with the prospectus requirement (see our blog post summarizing the development here). In 2016, a different set of provincial securities regulators (in Ontario, Saskatchewan, Manitoba, Québec, New Brunswick and Nova Scotia, but not British Columbia) adopted Multilateral Instrument 45-108 Crowdfunding (45-108 exemption), which was available to both reporting and non-reporting issuers (see our blog post summarizing the development here). The Alberta Securities Commission has also adopted a similar prospectus exemption for start-up crowdfunding (ASC Rule 45-517 Prospectus Exemption for Start-up Businesses).
Crowdfunding exemptions have not been utilized as frequently as was originally anticipated. The BCSC’s consultations regarding crowdfunding portals highlighted the need for regulatory harmony as well as challenges to crowdfunding profitability such as investment limits, Know Your Customer (KYC) requirements, and costs of compliance. The consensus among stakeholders is that start-up crowdfunding could be spurred on via increased investor limits, fewer restrictions on the types of securities that can be issued and number of distributions that can be made per year, harmonized provincial rules, and expanded outreach and support from provincial securities regulators.
The Notice mentions several potential changes to crowdfunding rules, including the following:
- removing the offering limit and instead having a lifetime cap of $1 million that could be raised by issuers; and
- removing the “eligible securities” requirement for start-up crowdfunding.
The challenge of changing the rules is that doing so may mean British Columbia falls further out of harmony with other provinces. Provincial securities regulators have a delicate balancing act to perform to ensure both regulatory harmony and easier-to-use crowdfunding rules.
The development of online portfolio managers that use computer algorithms to manage investments, known as online advisors, is one of the biggest recent developments in the Financial Services sector. Currently portfolio managers are regulated by NI 31-103 Registration Requirements, Exemptions and Ongoing Registrant Obligations (NI 31-103). These requirements are the same for traditional portfolio managers and online advisors.
The Notice notes that online advisors are increasingly accepted in the Canadian market and that their use has raised concerns about KYC requirements, outsourcing, and automation of portfolio manager duties. The Notice asks whether online advising should have different regulatory requirements from traditional portfolio management.
Currently, online advisors and traditional portfolio managers are required to obtain KYC information directly from the customer. However, new regtech solutions offer the potential for third parties to gather this information and automate the KYC process. The BCSC is interested in feedback on what elements of the KYC process could be sourced to third parties or automated, as well as the potential verification processes for third-party information and associated risks. The Notice also asks how an artificial intelligence system could conduct KYC processes without human intervention, and what safeguards would need to be in place for such a process.
The Notice also indicates interest in partnership arrangements between online advisors and traditional portfolio managers. Increasingly, traditional portfolio managers are considering referral arrangements, licensing online advisor software, and outsourcing portfolio advice to online advisors. Currently, in order to avoid conflicts of interest, an individual cannot act as a registered advising representative for two unaffiliated firms. The BCSC is interested in whether outsourcing arrangements between traditional portfolio managers and online advisors can meet this underlying policy objective. Further, the Notice seeks comment on ways in which regulatory and administrative requirements result in inefficient flow of capital and burdensome costs when implemented with online business models.
The BCSC expects fund managers to continue with their interest in investing in cryptocurrencies. This raises several risk management considerations. Cryptocurrency exchanges and wallets often operate in an unregulated environment, which raises cybersecurity and anti-money laundering concerns about the security of the funds transacted. These concerns are particularly relevant because additional NI 31-103 requirements for external custodians regarding custody of client cash and securities are expected to come into effect in June 2018.
The Notice asks the market for current best practices for securing cryptocurrency investments and whether regulators have a role to play in this context. The Notice also asks whether uncertainty over whether a cryptocurrency or token is a security requires additional measures from securities regulators. The BCSC is also considering whether the operational requirements for cryptocurrency investment funds should differ from requirements for other types of funds.
ICOs & Cryptocurrencies
Interest in ICOs has led the Canadian Securities Administrators (CSA) to issue Staff Notice 46-307 Cryptocurrency Offerings. The Staff Notice is meant to clarify the situations in which ICOs are subject to securities regulation. However, stakeholders in the Fintech community continue to have questions about factors such as the presence of a secondary market for a coin or token, the availability of coin or token utility functions at sale, and whether there are parallels to non-securities crowdfunding. The market is also interested in the circumstances under which securities regulators will grant exemptive relief to businesses planning to conduct ICOs. The Notice invites comments from stakeholders on the relevance of these factors and the effectiveness of recent exemptive relief granted for ICOs.
The Notice also seeks input on the ongoing debate as to whether issuances of cryptocurrencies are investment contracts for purposes of securities regulation. There may be a grey area when there is no central governance for the coin, no central issuer, and no central counterparty regulating the exchange of coins. The BCSC is interested in whether these factors create conceptual distinctions between cryptocurrencies and securities.
The Notice also notes different models of ICOs, which securities regulators are monitoring. The most common of which is a business that raises capital by selling non-functional tokens and uses those proceeds to develop the advertised functionalities for that token. An ICO could also be structured with different types of tokens: for example, one token could be a security used for capital raising while a further utility token could be used for deployment once the platform is operational. In addition, developers could delay the release of the token to a later time period or engage in a multi-step process where purchasers first enter an agreement for the right to a functional token and then fulfill the agreement once the platform is built. The BCSC is interested in whether the Fintech community is considering these ICO models and whether securities regulators need to consider any additional models.
Like all regulators, the BCSC is endeavouring to make sure that regulation keeps pace with innovation to ensure investors are protected and capital markets are facilitated. At the same time, the BCSC does not want to impede important innovation and recognizes it may need to grant exemptions to Fintech startups. For example, the Notice asks whether British Columbia should have a Fintech licensing exemption similar to the 12-month exemption adopted by the Australian Securities and Investments Commission (ASIC). The key takeaway is that securities regulation of Fintech entities remains subject to change. Stakeholders with interests in Fintech regulation should consider engaging counsel to help them draft an appropriate response and ensure their voice is heard.