CSA and IIROC Consultation on Proposed Regulatory Framework for Crypto-Asset Trading Platforms
On March 14, 2019, the Canadian Securities Administrators (CSA) and the Investment Industry Regulatory Organization of Canada (IIROC) published a joint Consultation Paper 21-402 Proposed Framework for Crypto-Asset Trading Platforms (the “Consultation Paper”). The Consultation Paper is intended to outline a proposed regulatory framework which provides clarity for crypto asset trading platforms (“Platforms”), greater market integrity and protection for investors. The Consultation Paper notes that crypto assets continue to be a growing area of interest for regulators globally and that Platforms facilitate the buying and selling of crypto assets in Canada without any regulatory oversight. It notes that there are over 2,000 different types of crypto assets traded on over 200 Platforms worldwide.
Currently, there are no Platforms recognized as exchanges or which are authorized to operate as a marketplace or dealer in Canada. The Consultation Paper notes that Platforms, by facilitating the transfer of crypto assets, perform functions similar to exchanges, alternative trading systems, clearing agencies, custodians and dealers. Depending on how they operate, Platforms may be subject to securities regulation, though the scope and applicability of such regulation is the subject matter of ongoing consultation, including in the Consultation Paper. The CSA notes that through its “Regulatory Sandbox” (see our previous post on this subject), several Platforms have approached the CSA inquiring about requirements which may apply to them.
Applicability of Securities Laws
The Consultation Paper accepts that not all crypto assets are securities and/or derivatives, which if otherwise traded on a Platform, would be subject to regulatory requirements applicable to securities and/or derivatives. Some well-established crypto assets that function as a form of payment or means of exchange on a decentralized network, including bitcoin, are not currently treated as securities or derivatives. Rather, such crypto assets have features more analogous to currencies and precious metals.
Nonetheless, the Consultation Paper states that even crypto assets which are “commodities” may be subject to securities and/or derivatives legislation as the individual investor's contractual right to the crypto asset may constitute a security or derivative. As part of its consultation as to whether or not a security or derivative is traded on a Platform, some of the following factors, among others, will be considered:
- whether the Platform is structured so that there is intended to be delivery of crypto assets to investors;
- whether the investor can trade or rollover positions held by the Platform;
- whether investors' crypto assets are pooled together with those of other investors and with the assets of 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.
The Consultation Paper proposes several other factors to be considered and asks market participants to comment on whether additional factors ought to be reflected.
In respect of risks particular to crypto assets being traded on Platforms, the Consultation Paper notes the following areas of heightened risk, among others:
- Investors’ crypto assets may not be adequately safeguarded. For example, many Platforms keep investors’ crypto assets in a single account on a distributed ledger under the Platform's private key or the Platform holds its participants’ private keys on their behalf.
- Investors’ assets may be at risk as a result of a Platform's bankruptcy or insolvency. Platforms may not hold sufficient assets to cover investor claims and to return investors' assets and may operate in jurisdictions with limited asset protection and insolvency regimes.
- Investors may not have important information about the Platform's operations.
- Conflicts of interest may not be appropriately managed. There may be conflicts of interest between the Platform's operator and participants, particularly where Platforms act as market makers and trade as a principal or provide advice.
- Manipulative and deceptive trading may occur.
- Trading in crypto assets may not be suitable for many investors.
The Consultation Paper requests feedback on best practices to mitigate these risks and whether there may be other risks which have not been considered.
Proposed Platform Framework
The proposed Platform framework (the “Framework”) outlined in the Consultation Paper is intended to apply to Platforms which are subject to securities legislation and which may not fit within an existing regulatory framework; the Framework will also apply to both Platforms operating in Canada and to foreign-based Platforms that have Canadian participants. The following provides an overview of some of the features of the Framework:
- Application of marketplace requirements: In order to address many of the risks noted above, Platforms will be subject to requirements based on the existing regulatory framework applicable to marketplaces including those 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.
- Application of dealer requirements: Since Platforms may also perform dealer functions, such as providing custody of crypto assets and permitting direct access to trading by retail investors, the Framework will include requirements relating to risks arising out of these functions, in addition to those covered under the marketplace rules.
- Investment dealer registration, IIROC membership and custody requirements: The Framework contemplates Platforms becoming registered as investment dealers and becoming IIROC dealer and marketplace members and satisfying, if they offer custody, existing and yet-to-be determined custody standards for crypto assets.
- Recognition as an exchange: Platforms that carry on business as an exchange are advised to contact the relevant securities regulatory authority to discuss whether recognition as an exchange is appropriate, or whether they could benefit from the Framework.
- Price determination: Platforms will be required to foster price discovery for the crypto asset offered for trading and, when trading as a market maker against its participants, a Platform will be required to provide a fair price.
- Surveillance of trading activities: In the near term, the CSA is not proposing surveillance by a regulation services provider (RSP) such as IIROC which oversees all Canadian equity and fixed income marketplaces. Instead, the CSA proposes to ban dark trading and short selling activities on Platforms and not permit Platforms to extend margin to their participants.
- Clearing and settlement: All trades executed on a marketplace are required to be reported and settled through a clearing agency. However, as there are currently no regulated clearing agencies for crypto assets that are securities or derivatives, the CSA is considering exemptive relief but also will subject Platforms to certain requirements which apply to clearing agencies relating to operational, custody, liquidity investment and credit risks.
- Derivatives requirements: The CSA expects to consult on the appropriate regulatory framework applicable to marketplaces trading over-the-counter derivatives, including Platforms offering derivatives with exposure to crypto assets.
Foreign Regulatory Approaches
The CSA and IIROC are considering the regulatory framework for Platforms in the United States, Europe, Singapore, Hong Kong and Malaysia. Market participants are encouraged to suggest how foreign approaches to regulating Platforms may be suitable for consideration in Canada.
The Consultation Paper seeks feedback on 22 specific questions, particularly pertaining to: custody and verification of assets, surveillance of trading activities, business continuity planning, management of conflicts of interest, insurance requirements and applicable regulatory requirements.
Market participants are invited to make written submissions on the consultation questions posed in the Consultation Paper and on related matters pertaining to the regulation of Platforms. Comments are due by May 15, 2019. We would be pleased to assist you in framing your response to this significant and much-awaited consultation process.
For more information about our firm’s Fintech expertise, please contact the authors and see our Fintech group page.