On February 22, 2022, the Canadian Securities Administrators (CSA) started a 30 day countdown for unregistered crypto asset trading platforms (CTPs) operating in Canada pursuing registration to provide to their principal regulator a stricter pre-registration undertaking (PRU) with content prescribed in new CSA Staff Notice 21-332 Crypto Asset Trading Platforms: Pre-Registration Undertakings: Changes to Enhance Canadian Investor Protection (SN 21-332). CTPs that are unable or unwilling to provide the PRU are expected to off-board Canadian users and impose restrictions to prevent Canadian users from accessing the CTPs products or services. CTPs that are operating in Canada and have not yet engaged with the CSA appear to have one more month to set that process in motion if they deliver the required PRU.

Enhanced PRUs delivered by CTPs will reflect the guidance set out in SN 21-332, including stricter requirements regarding custody and segregation of client assets, blanket prohibitions on offering margin or leverage and prohibitions on offering stablecoins or proprietary tokens without the consent of the CSA. SN 21-332 provides detailed criteria for when stablecoins may be permitted, but guidance is not included for proprietary tokens, suggesting the likelihood of approval for proprietary tokens is low. Though each CTP will settle its own PRU, it is not expected that the CSA will be receptive to significant departures from the principles set out in SN 21-322.

SN 21-332 is a detailed elaboration of the CSA’s announcement on December 12, 2022, which previewed its strengthened oversight of CTPs and its view that stablecoins may be securities or derivatives, but did not provide much explanation of what might be in store for CTPs.

In its press release announcing SN 21-332, the CSA implied that the impetus for the CSA action and PRU deadline is recent CTP insolvencies. The CSA reminded Canadians that trading in crypto assets is a speculative, high risk activity which may not be suitable for many investors, particularly retail investors.

The CSA has also published a new Investor’s guide: Cryptocurrencies which explains that, “judging the inherent value in any crypto asset can be difficult, with its value largely determined by its evolving utility, public interest and the current levels of supply and demand. As such, determining the fair value of a…crypto asset…can be difficult or even impossible”.

SN 21-332 is focused on PRUs, which are expected to level the playing field for unregistered CTPs competing with those that are already registered as dealers under Canadian securities legislation (Dealer CTPs). But the CSA indicated that some of the guidance will also be relevant to Dealer CTPs, in particular the stablecoin restrictions which are directed toward “CTPs that are registered, or that…will be entering into a PRU”. Dealer CTPs will be contacted separately by their principal regulator to discuss whether any changes to their registration or exemptive relief are required to comply with the enhanced requirements.

Core Obligations

SN 21-332 outlines the core business conduct obligations to which unregistered CTPs will commit in their PRU, which are consistent with the obligations currently applicable to Dealer CTPs, including:

• Duty to act fairly, honestly and in good faith
• Supervisory controls, including with respect to the safeguarding of material, non-public information and monitoring personal trading by employees
• Policies and procedures for identifying and mitigating conflicts of interest
• Account appropriateness requirements, loss limit monitoring and, in some provinces, investment restrictions on crypto assets other than bitcoin, Ether, Litecoin and Bitcoin Cash (for details, see our blog post: Retail Investment Limits under the Canadian CTP Regulatory Regime)
• Risk disclosure, including a platform risk statement and crypto asset statements for each crypto asset available for trading on the CTP
• Requirement to hold not less than 80% of client assets with a third party custodian
• Insurance requirements
• Books and records and CSA reporting obligations
• Other core obligations listed in SN 21-332 and prescribed in the terms and conditions of registration of Dealer CTPs

The PRU also obliges CTPs to notify the principal regulator of any failure of its systems and controls, initiation by any regulatory authority of a compliance or enforcement action, bankruptcy or insolvency proceedings or any other material change. The PRU includes an acknowledgement that the CTP may not be granted registration or related exemptive relief, and that if it fails to do so within 12 months, it will cease carrying on registerable activities in Canada.

New Provisions

SN 21-332 describes “New Provisions” that have been introduced to the PRU in light of recent insolvency events. Although not explicitly stated, we expect that most of these new provisions will continue as permanent post-registration terms and conditions, and it is reasonable to expect that these will also be imposed on Dealer CTPs over time (to the extent such Dealer CTPs do not already comply). New provisions applicable to a CTP that gives a PRU include:

• Segregation of client assets: Client assets must be held separate and apart from the CTP’s own property, in trust for the benefit of clients, in a designated trust account.
• Acceptable Third-party Custodian: Client cash must be held with a regulated financial institution, and client crypto assets must be held with an “acceptable third party custodian” which meets prescribed qualifications, including appropriate licensing or regulation, specific audited financial statement reporting requirements (including reporting of client crypto asset liabilities and reserves, broken down by asset) and a current Systems and Organization Controls (SOC) report or comparable report. The qualifications also generally include minimum equity requirements (the equivalent of C$10 million for a Canadian custodian and C$100 million for a foreign custodian), however, CSA approval is always required for a foreign custodian, and the CSA may approve foreign custodians that do not meet the minimum equity requirement.
• Prohibition on re-hypothecation: The CTP is prohibited from pledging, re-hypothecating or otherwise using Canadian client assets.
• Prohibitions on margin and leverage: The CTP is prohibited from offering margin, credit or other forms of leverage to any client, including both retail and institutional (e.g. “permitted clients”).
• Commitments from controlling minds and global affiliates: The PRU must be signed by the Canadian legal entity that has applied for registration, as well as its global affiliates, parent entities and controlling minds which will undertake not to interfere with the Canadian firm’s activities and its directors independent judgment, and ensure that their activities will not undermine the Canadian firm’s compliance with its regulatory obligations. It remains to be seen how this commitment will be documented in the PRU, which should not impose the same obligations on the affiliates and controlling minds as fall on the entity that will be obtaining registration.
• Board independence: “To the extent possible”, the PRU will include a provision that the Canadian firm’s board of directors be independent from its global affiliates, parent entities and controlling minds. Whether controlling entities can simply refuse this requirement or must demonstrate why it is not possible is not clear from SN 21-322.
• Exclusion of crypto assets from working capital calculation: The CTP’s holdings of crypto assets (including proprietary tokens issued by the CTP or an affiliate, including as collateral) must be excluded from its calculation of minimum excess working capital. This may have adverse consequences for CTPs which deliberately hold reserves in crypto assets instead of fiat.
• Financial reporting: The CTP must file audited annual financial statements, consistent with the requirement applicable to Dealer CTPs.
• Qualified Chief Compliance Officer (CCO): During the pre-registration period while the PRU is in effect, the CTP must designate an individual as CCO who meets the proficiency requirements applicable to exempt market dealers under Canadian securities legislation, is responsible for maintaining a compliance system, and has direct access to the board of directors of the CTP.

Restrictions on Value-Referenced Crypto Assets (Stablecoins)

SN 21-332 notes that Dealer CTPs, and CTPs that give PRUs, are required to conduct a “know your product” (KYP) analysis of each crypto asset available on the platform, and are prohibited from offering crypto assets that are, themselves, securities or derivatives under Canadian securities legislation

In SN 21-332, The CSA reiterates its view that stablecoins (referred to as Value-Referenced Crypto Assets or VRCAs), or stablecoin arrangements, may constitute securities or derivatives. The CSA describes a VRCA as, “a crypto asset that is designed to maintain a stable value over time by referencing the value of a fiat currency or any other value or right, or combination thereof”. In their view, a VRCA backed by a fiat currency reserve likely constitutes an “evidence of indebtedness”, an enumerated head under the definition of “security” in most CSA jurisdictions, or falls within another head of the definition. The CSA does not – and does not need to – invoke the “investment contract” head of the definition of security that is most commonly associated with crypto assets under both Canadian and U.S. legislation.

SN 21-322 identifies redemption risk, or “run” risk, as the most significant risk associated with VRCAs, as well as the stabilization mechanism, management and custodianship of reserve assets and governance of the VRCA issuer. However, the CSA does not propose an outright ban on the offering of VRCAs by registered CTPs, acknowledging that VRCAs have legitimate utility as deposit on-ramps, for trading of other crypto assets, as a store of value or as a means of payment.

Consequently, the CSA prohibits CTPs from offering VRCAs without the written consent of the CSA, and sets out a long due diligence list which the CTP is required to address when seeking such consent, including that:

• the VRCA is fiat backed, as opposed to algorithmic stablecoins which appear to be completely prohibited;
• any distributions (e.g. primary issuances) of the VRCA in Canada are made in compliance with applicable securities laws (e.g. to an accredited investor or in reliance on another private placement exemption from the prospectus requirement);
• the issuer’s fiat reserve: (i) has a market value, calculated daily, equal to at least the value of all outstanding units of the fiat-backed VRCA; (ii) consists of highly liquid assets such as cash and cash equivalents; (iii) is held by a qualified custodian in favour of the fiat-backed VRCA holders; (iv) is segregated from the issuer’s assets; (v) is subject to publicly available monthly attestations and annual audits by an independent auditor;
• redemption rights are clearly articulated in policies and procedures that are publicly disclosed;
• the issuer maintains a plan for recovery or orderly wind-down in the case of crisis or failure;
• the issuer maintains effective governance practices;
• key, accurate information about the VCRA is publicly accessible in plain and non-technical language; and
• the CTP is not otherwise prohibited from offering the VRCA, for example under the restriction applicable to Dealer CTPs and set out in the PR which prohibits the offering of a crypto asset issued by or on behalf of a person or entity that has been the subject of certain regulatory actions or proceedings.

The CSA instructs CTPs to seek approval to offer, or continue to offer, fiat-backed VRCAs that satisfy its due diligence criteria. The CSA also invites issuers that would like to distribute their VRCA in Canada or to permit trading of their VRCA on regulated CTPs to contact the CSA and explain the steps they have taken to comply with Canadian securities legislation and to address the risks associated with fiat-backed VCRAs identified in SN 21-322.

SN 21-322 cautions that CSA approval for a CTP to offer a VCRA is not an endorsement or approval of the VCRA, that the CSA continues to monitor global developments in stablecoin regulation and the approach set out in the notice is interim only.

Enforcement Against Non-Compliant CTPs

The CSA warns that nothing in SN 21-322 should be interpreted as limiting any enforcement recourse that the CSA may take against any CTP, and that if a CTP refuses to file a PRU or breaches the terms of its PRU, the CSA will consider compliance and/or enforcement action against a CTP and its principals, including naming the CTP on a warning list, directing the CTP to withdraw from Canada or imposing a cease trade order or denial of exemptions under securities law.