Lori Stein, Evan Thomas
Jan 17, 2020
In this Update
- On January 16, 2020, the Canadian Securities Administrators (CSA) released CSA Staff Notice 21-327 Guidance on the Application of Securities Legislation to Entities Facilitating the Trading of Crypto Assets [PDF].
- Custodial Platforms that operate in Canada, including foreign Platforms that offer services to Canadian users, may need to make significant changes to their operations or take steps to register as dealers, seek exemptive relief, or otherwise comply with Canadian securities legislation.
- The Staff Notice suggests CSA members intend to take enforcement action against Platforms that do not comply with securities legislation, as interpreted in the Staff Notice.
- CSA staff’s interpretation could be subject to challenge on legal grounds. The Staff Notice does not explain why ownership, possession and control must be transferred to the customer for the transaction to avoid being characterized as a derivative or security, when ownership and possession are regularly separated in other commodity transactions.
On January 16, 2020, the Canadian Securities Administrators (CSA) released CSA Staff Notice 21-327 Guidance on the Application of Securities Legislation to Entities Facilitating the Trading of Crypto Assets [PDF] (the Staff Notice). This guidance has significant implications for Canadian and foreign cryptoasset trading platforms that maintain custody of a customer’s cryptoassets following a purchase by the customer. The CSA suggests that platforms which do not immediately transfer ownership, possession and control of all cryptoassets purchased by customers are likely dealing in derivatives or securities, and are therefore subject to regulation as dealers or marketplaces under applicable securities laws.
Although the notice is only guidance from CSA staff and could be challenged before securities commissions or the courts, the Staff Notice suggest CSA members intend to take enforcement action against Platforms that do not comply with securities legislation, as interpreted in the Staff Notice. Given the costs of dealer registration, exemptive relief and ongoing compliance, some cryptoasset trading platforms may question whether to continue operating in the Canadian market.
Cryptoasset trading platforms (Platforms) are online platforms that facilitate the buying and selling of cryptoassets, such as bitcoin. Often, when a customer buys bitcoin or other cryptoassets on a Platform, the cryptoasset is not immediately transferred to a wallet owned and controlled by the customer and instead remains in a wallet controlled by the Platform. Many Platforms hold cryptoassets owned by their customers on a pooled basis and record each customer’s holdings in the Platform’s own records. Customers may choose to leave their cryptoassets on the Platform to benefit from “cold storage” and other security features, and because they lack the technological sophistication or interest to set up their own wallets. Customers can take delivery of their cryptoassets at any time by instructing the Platform to send the cryptoassets to a wallet address designated by the customer. Platforms that offer to hold cryptoassets on behalf of their customers are often referred to as “custodial” Platforms, as they provide both trading and custody functions.
While custodial Platforms may offer certain benefits, they also pose risks to investors because cryptoassets may be misused, lost or stolen while in the custody of the Platform. In the case of the failed QuadrigaCX trading platform, the court-appointed monitor determined that QuadrigaCX’s founder had misappropriated cryptoassets in the platform’s custody, resulting in the loss of virtually all cryptoassets held by the platform, which may have been worth more than C$200 million.
CSA Staff Notice 21-327
CSA Staff Notice 21-327 confirms the approach proposed by the CSA and the Investment Industry Regulatory Organization of Canada (IIROC) in Consultation Paper 21-402 Proposed Framework for Crypto-Asset Trading Platforms published in March 2019 (the Consultation Paper). The Consultation Paper suggested custodial Platforms that facilitate trading in cryptoassets, including bitcoin and other cryptoassets that are commodities (and not securities or derivatives), may be subject to securities legislation because the customer’s contractual right to the cryptoasset is a derivative, as discussed in our prior Osler Update.
The Staff Notice indicates that unless ownership, possession and control of cryptoassets are immediately transferred to the customer at the time of purchase, the Platform is “merely providing users with a contractual right or claim to an underlying crypto asset,” and the user’s claim may constitute a derivative or a security, such as an evidence of indebtedness or an evidence of title to or interest in the assets or property of another person.
According to the Staff Notice, CSA staff consider immediate delivery to have occurred if the customer is free to use or deal with the cryptoasset without further involvement with the Platform or its affiliates and the Platform’s user is not exposed to insolvency risk (credit risk), fraud risk, performance risk or proficiency risk on the part of the Platform after delivery. The Staff Notice also suggests that securities legislation would likely apply to Platforms that offer margin or leveraged trading.
The guidance emphasizes that, in the view of CSA staff, securities legislation applies where cryptoasset purchases are recorded only in the Platform’s internal records (a so-called “book entry”) and there is no transaction on the blockchain transferring the cryptoassets to the purchaser unless and until specifically requested by the purchaser. As stated in the Notice: “In our view, a mere book entry does not constitute delivery, because of the ongoing reliance and dependence of the user on the Platform in order to eventually receive the crypto asset when requested.”
In contrast, the Staff Notice also explains that, in CSA staff’s view, securities legislation would not apply to a purchase of bitcoin where, among other things, the entire quantity of bitcoin purchased on the Platform is immediately transferred to a wallet that is in the sole control of the user, by way of a transaction on the Bitcoin blockchain.
Observations and implications
CSA members have put all custodial Platforms operating in Canada on notice that they intend to take enforcement action against Platforms that do not comply with securities legislation. Consequently, custodial Platforms that operate in Canada, including foreign Platforms that offer services to Canadian users, may need to make significant changes to their operations or take steps to register as dealers, seek exemptive relief, or otherwise comply with Canadian securities legislation.
While undoubtedly motivated by important investor protection concerns highlighted by the collapse of QuadrigaCX and other failed trading platforms, CSA staff’s interpretation could be subject to challenge on legal grounds. According to the Staff Notice, ownership, possession and control must be transferred to the customer for the transaction to avoid being characterized as a derivative or security. However, purchasers of precious metals and other commodities often leave their purchases in the custody of a custodian, and such transactions are not generally subject to securities legislation. The Notice does not explain why both ownership and possession need to pass to the customer for immediate delivery of cryptoassets to occur, when ownership and possession are regularly separated in other commodity transactions.
We anticipate that given the size of the Canadian cryptoasset market and current market conditions for cryptoassets, some Platforms will question the feasibility of maintaining operations in the Canadian market and may choose to exclude Canadian customers, rather than face the cost and compliance burden of seeking registration as a securities dealer or exemptive relief from registration. This would be a similar approach to that taken by some major Platforms which have chosen not to accept customers resident in New York, rather than comply with the “Bitlicense” requirements of the New York State Department of Financial Services.
Conversely, many Platforms have taken steps to register as money services businesses (MSBs) with the Financial Transactions and Reports Analysis Centre of Canada (FINTRAC) ahead of the June 2020 deadline when dealers in virtual currency will become reporting entities under Canadian anti-money laundering and anti-terrorist financing law, as discussed in our prior Osler Update.
Although the Notice focuses on the buying and selling of cryptoassets, the guidance may also have implications for cryptoasset lending platforms that require customers to transfer control of their cryptoassets to the Platform as part of lending transactions. The primary policy concern that appears to motivate the CSA’s guidance is the risk that cryptoassets will be lost, stolen or misused while in the custody of Platforms, a risk that may exist with cryptoasset lending platforms as well as trading platforms. This may also include so-called decentralized finance (DeFi) protocols, where cryptoassets are transferred to blockchain smart contracts and may be held in pooled accounts controlled by smart contracts.