On February 22, 2023, the Canadian Securities Administrators (CSA) published CSA Staff Notice 21-332 Crypto Asset Trading Platforms: Pre-Registration Undertakings – Changes to Enhance Canadian Investor Protection (the Staff Notice). The Staff Notice imposes additional commitments on crypto asset trading platforms (CTPs) that operate in Canada, following the recent collapse of FTX and other insolvencies in the crypto space. Certain action is required from unregistered CTPs as early as March 24, 2023.
On August 15, 2022, the CSA announced their expectation that unregistered CTPs that continue to operate in Canada while taking steps to comply with applicable securities legislation provide to their principal regulator (PR) a pre-registration undertaking (PRU). By providing the PRU while their application for registration or related relief is under review, unregistered CTPs agree to comply with certain core business conduct and risk management obligations which the CSA have designed to address investor protection concerns, and which are consistent with requirements applicable to registered CTPs.
The CSA have cautioned that while the PRU is a precondition to CSA Staff considering an application, it does not guarantee that a CTP will be granted registration or relief in any CSA jurisdiction. If a CTP fails to become registered or obtain the relief necessary, it will be required to cease carrying on registrable activity in each CSA jurisdiction in which it is not registered or face enforcement action.
New PRU Provisions
Following several insolvencies involving a number of CTPs, the CSA further announced, on December 12, 2022, that expanded commitments would be expected in the standard form of PRU. These new commitments are now outlined in the Staff Notice and set out in the new “enhanced PRU”. They include detailed governance, risk management, operational, custodial, insurance, financial reporting and other compliance and reporting requirements, including those described below.
Custody and segregation of client-owned crypto assets
The enhanced PRU requires that CTPs undertake to hold assets – including cash, securities and crypto assets that are not securities – of a Canadian client:
- separate and apart from the CTP’s own property;
- in trust for the benefit of the client;
- in the case of cash, in a designated trust account or in an account designated for the benefit of clients with a qualified Canadian custodian or financial institution; and
- in the case of crypto assets, in a designated trust account or in an account designated for the benefit of clients with a custodian that is an “Acceptable Third-party Custodian” (as defined in the Staff Notice).
CTPs must also commit to providing an authorization and direction that would allow CSA Staff to obtain information about the status of Canadian client accounts directly from custodians.
Restrictions on using client-owned crypto assets
The enhanced PRU maintains the existing requirement that a CTP hold crypto assets separately in trust for the benefit of clients and not pledge, re-hypothecate or otherwise use any client-owned crypto assets. It now permits CSA Staff to request evidence of meaningful compliance systems and corporate governance controls to provide reasonable assurance that the CTP is complying with this requirement.
Restrictions on offering margin, credit or other forms of leverage
Whereas the existing form of PRU prohibits CTPs from offering margin, credit or other forms of leverage to clients other than “permitted clients” (as defined in National Instrument 31-103 Registration Requirements, Exemptions and Ongoing Registrant Obligations (NI 31-103)) in connection with the trading of crypto on the platform, the enhanced PRU expands this restriction to all clients – including retail and permitted clients.
Commitments from controlling minds and global affiliates
The global affiliates, parent entities and/or controlling minds of a CTP are required to co-sign the enhanced PRU to ensure the independence of the Canadian filer, and co-signers must provide commitments to this effect. The enhanced PRU also requires that, to the extent possible, the Canadian filer’s board of directors be independent from that of its global affiliates, parent entities and/or their controlling minds.
Restrictions on using crypto assets to determine capital
The enhanced PRU includes restrictions on a CTP’s reliance on crypto assets when determining its excess working capital and capital base. The excess working capital requirement applicable to registered firms will be subject to a 100% reduction on all crypto assets that are not offset by a corresponding current liability. The CTP will therefore have to exclude all crypto assets from its excess working capital calculation under Form 31-103F1 of NI 31-103.
Regular filing of financial information with CSA members
The enhanced PRU requires that a CTP deliver audited financial information as provided under section 12.12 of NI 31-103.
Designation of qualified Chief Compliance Officer (CCO)
During the pre-registration process, a CTP must designate a CCO who must generally meet the proficiency and experience requirements applicable to the CCO of a registered exempt market dealer.
The Staff Notice reiterates the prohibition on CTPs entering into crypto contracts to buy and sell any crypto asset that is itself a security or derivative with Canadian-resident persons. Based on the CSA’s assessment of certain risks associated with “Value-referenced Crypto Assets” (VRCAs) (as defined in the Staff Notice, but commonly referred to as “stablecoins”), the enhanced PRU further prohibits CTPs from allowing their clients to enter into crypto contracts to buy or deposit VRCAs without the prior written consent of the CSA. CTPs themselves are also prohibited from trading in crypto contracts based on proprietary tokens, except with the prior written consent of the CSA.
Unregistered CTPs that continue to operate in Canada while taking steps to comply with applicable securities legislation are expected to:
- provide a revised PRU based on the template set out by CSA Staff within 30 days of the Staff Notice (i.e., by March 24, 2023); and
- implement such systems changes as may be necessary to give effect to the PRU within the timeframes set out in the PRU.
Where a CTP is unable or unwilling to provide an enhanced PRU or implement the necessary systems changes within these timelines, the CSA will expect the CTP to:
- take appropriate steps to identify and off-board existing users in Canada;
- impose meaningful restrictions to prevent access to products and services offered by the CTP to users in Canada; and
- provide notice and timelines to their PR and other CSA members for the implementation of such steps and restrictions.
Staff of the applicable PR will separately contact registered CTPs to discuss whether any changes to their registration or relief are required.
Compliance and Enforcement
Finally, the CSA note that compliance and/or enforcement action against a CTP and its principals will be considered if:
- the CTP is currently operating in Canada, and engages in registration discussions with a CSA member, but is not prepared to file a revised PRU in a form acceptable to CSA Staff;
- the CTP files but does not abide by the provisions of the PRU;
- the CTP does not make bona fide attempts to progress through the registration process as quickly as possible; or
- other information that raises investor protection or other public interest concerns comes to the attention of CSA Staff.
The substantive requirements and associated timelines introduced by the enhanced PRU present significant compliance and operational challenges and will likely lead to most global CTPs deciding to opt for an orderly and structured offboarding of Canadian-resident users, leaving Canadian users with a more limited range of options for holding and trading crypto assets. While the imposition of more robust governance, risk management, trading and operational controls on CTPs is a crucial and welcome development, the new custodial requirements alone appear to be structurally inconsistent with the existing trading infrastructure of most global CTPs that have not been designed from the ground up to comply with these new Canadian rules. Recent developments in the tech banking space have signaled the downside of a greater concentration of assets in the hands of too few qualified custodians, resulting in arguably the same investor protection, redemption or “run” risk and systemic risks that the CSA’s current regulatory initiatives are seeking to address. While the CSA have stated that the terms of the enhanced PRU are essentially non-negotiable, certain transitional adjustments to the requirements to more closely address the current structural specificities of existing CTPs and of the asset class itself may in fact lead to better outcomes for Canadian users. It also remains to be seen if more flexible and customized conditions can be negotiated in the context of registration.
We continue to monitor these important developments and will keep our clients and readers apprised as they unfold. For more information, please review the Staff Notice.