Joint Canadian Securities Administrators/Investment Industry Regulatory Organization of Canada Consultation Paper 21-402: A Summary
On March 14, 2019, the Canadian Securities Administrators (“CSA”) and Investment Industry Regulatory Organization of Canada (“IIROC”) (both CSA and IIROC collectively “the Regulators”) released a consultation paper discussing potential avenues for regulation of digital and crypto assets platforms (the “Paper”). Their overarching goal is to seek feedback from the financial technology community, market participants, investors and other stakeholders on how requirements may be tailored for Platforms (defined below) operating in Canada, whose operations involve securities law. According to the Paper, there are currently over 2000 crypto assets that can be traded for either government issued currency or other types of crypto assets, that can be traded on over 200 platforms. Platforms are most easily understood as a type of digitized marketplace that facilitates the buying and selling or transferring of crypto assets (“Platforms”).
The Regulators have proposed that Platforms operating similar to stock exchanges, alternate trading systems, clearing agencies, custodians, or investment dealers will be regulated and required to operate in compliance with securities legislation. Specifically, the Regulators are considering a set of tailored regulatory requirements to address various investor protection concerns regarding Platforms (the “Proposed Platform Framework”). The following is a summary of the key findings and conclusions of the Paper.
Nature of crypto assets and application of securities legislation
The Paper states that crypto assets have many different attributes, functions, governance and rights. Some crypto assets allow holders to purchase goods via distributed ledger technology, which in its most basic form is a decentralized database for completing transactions. Other crypto assets are tokenized forms of traditional securities and have their value tied to an underlying financial asset. According to the Paper, if the crypto assets are considered commodities (raw materials, or agricultural products as an example) they would be exempt from applicable securities legislation. The Paper notes a series of evaluative questions to determine whether or not securities laws should apply to Platforms, with questions ranging from the structure of the Platform to who actually has control over the crypto assets.
Risks related to Platforms
One of the key concerns for the Regulators with respect to Platforms is the possibility of inadequate investor protection in regards to investor held crypto assets. Some of the specific risks relating to inadequate investor protection for crypto assets include:
- Non-segregation of investor assets from Platform assets and as a result there may not be sufficient assets to cover investor claims in the event of Platform bankruptcy;
- Manipulative and deceptive trading; and
- System resiliency, integrity and security controls may be inadequate to protect investors, given contemporary cybersecurity risks and data breaches.
Regulatory Approaches in other jurisdictions
The Regulators have looked to other jurisdictions in developing their Proposed Platform Framework. There is a range of regulatory approaches, with the U.S. Securities Exchange Commission (“SEC”) noting that a Platform operating a marketplace must be registered with the SEC as an exchange. By contrast, some European jurisdiction’s securities regulation applies when the crypto assets qualify as financial instruments.
The Proposed Regulatory Framework: An Overview
The Proposed Platform Framework will apply both to Platforms that may be currently subject to securities legislation (and Platforms that may not at present fall under securities legislation). In addition, the Proposed Platform Framework will apply to Platforms operating in Canada and to those that have Canadian market participants. According to the Paper, existing marketplace rules will apply to the Proposed Platform Framework, including NI 21-101 Trading Rules (“NI 21-101”) and NI 23-103 Electronic Trading and Direct Access to Marketplaces (“NI 23-103”). The Platform may also perform dealer functions, in which case the Proposed Platform Framework will include requirements to address those specific risks as well. Entities that are trading crypto assets that currently operate as exempt market dealers under a prospectus exemption pursuant to NI 45-106 Prospectus Exemptions can continue to do so, provided they do not fall under the definition of a marketplace.
Key Areas for Consultation
The Paper also discusses eight action item categories regarding Platforms where it is seeking additional feedback in determining the appropriate regulatory requirements for Platforms. The following section discusses the findings of the Regulators thus far regarding the eight action item categories.
1. Custody and Verification of Assets
A concerning fact for Regulators is that an estimated US 1 billion in crypto assets were stolen in 2018 from Platforms. Ownership of crypto assets is via private keys which are needed to execute crypto currency transactions. Currently Platforms have custody of private keys which are kept in the Platform’s wallets. From the Regulators perspective the key to regulation and reduction of risk involves an evaluation of whether the Platform has a robust system of internal controls, including records, that ensures that an investor’s crypto assets are accurately accounted for by the Platform. The Regulators anticipate having Platforms submit audit reports regarding verification and custody of crypto assets.
2. Price Determination
Platforms will be required to maintain and carry a fair price for their tradeable crypto assets.
3. Surveillance of Trading activities
Exchanges are responsible for conducting market surveillance of trading activities on the exchange and enforcing rules that promote the integrity of the market. All of the existing exchanges have retained IIROC to monitor trading activity and enforce market integrity rules. The challenge with Platforms is that crypto assets are traded globally, and outside regular trading hours. Further, given the decentralized nature of some Platforms it might be difficult to collect reliable reference data to conduct effective surveillance. The Regulators propose that Platforms do not permit dark trading or any short selling activities.
4. Systems and business continuity planning
The Regulators note that system resilience, reliability, and security controls is fundamental for investor protection. System failure for example may result in investors being unable to access their crypto assets and may have an adverse impact on market efficiency and investor protection. An independent systems reviews (“ISR”) is required of all marketplaces and may become a requirement for all Platforms. The Regulators have noted that exemptions have been granted to certain marketplaces provided the marketplace did not pose a significant risk to the capital markets and certain reports and information are provided to regulators. The Regulators also note that technology and cyber security are key risks for Platforms and as such they will have to comply with the provisions NI 21-101.
5. Conflicts of Interest
To address concerns regarding conflicts of interest, regulators propose that Platforms will be required to identify and manage potential conflicts of interest and be required to disclose whether they trade against their participants. In other words if Platforms are betting against the trend of the market but their market participants are trading with the trend, the specifics of these trades would need to be disclosed to the regulatory authority.
Most Platforms currently operate without insurance covering investor assets, while the Regulators have noted the difficulties surrounding Platforms carrying insurance on investors assets, the solution may lie with Platforms offering limited coverage extending to certain crypto assets. Given the high risk of cyber-attacks, it will likely be required that Platforms carry insurance for crypto assets.
7. Clearing and Settlement
The Regulators note that currently there are no regulated clearing agencies for crypto assets that are securities or derivatives. The Regulators note that on certain Platforms, transaction settlement occurs on the Platform’s internal ledger and is not recorded on the distributed ledger, and thus the Regulators are considering whether an exemption from the requirement to report and settle trades through a clearing agency is appropriate. It seems then, from the perspective of the Regulators that since certain Platforms have transaction settlement occurring internally (unlike a distributed ledger which is a database that is consensually shared across multiple sites), then it would be unnecessary to have a centralized repository ensuring settlement of trades on internally settled transactions. The Regulators do however note that some Platforms operate on a decentralized model where transfer of crypto assets is between two parties on a blockchain protocol, which would require some form of clearing agency regulation.
Overall, it seems the primary concerns regarding Platforms and crypto assets from the Regulators perspective is threefold: (i) First to ensure the safeguarding of investor assets; (ii) protecting marketplace efficiency and avoiding volatility of the marketplace and (iii) that average retail investors might not fully comprehend the nature of crypto assets and the nature of their investment.
The Regulators have released other staff notices regarding the application of securities laws to crypto assets, see: CSA Staff Notice 46-307 Cryptocurrency Offerings, and CSA Staff Notice 46-308 Securities Law Implications for Offerings of Tokens
Marketplace is defined in 21-101 Marketplace Operation as: in every jurisdiction other than Ontario as an: (i) an exchange, (ii) a quotation or trading system, (iii) a person or company not included in (i) or (ii) that: constitutes, maintains, provides, a market or facility bringing together buyers and sellers and sellers of securities, brings together the orders for securities of multiple buyers and sellers and uses established non-discretionary methods under which the orders interact with each other, and the buyers and sellers entering the orders agree to the terms of the trade, (iv) a dealer that excutes a trade of an exchange-traded security outside a marketplace, but does not include an inter-dealer bond broker; and (v) in Ontario has the meanign set out in subsection 1(1) of the Securities Act (Ontario).
An independent system review is a requirement for Marketplaces to retain an entity with relevant experience both in information technology and in the evaluation of related internal controls to conduct an independent systems review.