Canadian Securities Administrators: If Sole Control of “CryptoAssets” Does Not Go to Customer, Trading Platforms Subject to Securities Laws

The Canadian Securities Administrators (CSA) have made a major announcement regarding the regulation of cryptocurrency and “cryptoasset” trading platforms in the country, one that could add significant operational costs in the near term.

Under the guidance, unless they have obtained an exemption, cryptocurrency trading platforms in Canada and those abroad serving Canadian customers will no longer be allowed to custody customer cryptocurrencies in pools controlled by the exchange.

Instead, they will have to store customer cryptocurrencies and “cryptoassets” in software wallets exclusively controlled by customers.

The new rules could prevent the recurrence of the debacle at QuadrigaCX, a Canadian cryptocurrency trading platform that folded in January 2019 after permanently losing access to $250 million CAD in customer funds.

In the Quadriga case, court-appointed monitors in bankruptcy proceedings found that, at the time of his untimely death, Quadriga founder Gerald Cotten had been running the Quadriga platform -with 76 000 users-  almost single-handedly.

The monitors also found that Cotten had been commingling customer and Quadriga funds, and had used volumes of his customers’ cryptos to conduct thousands of trades on other exchanges.

Cotten died from complications of Crohn’s disease in India in December 2018 while honeymooning.

QuadrigaCX did not announce Cotten’s death for several weeks and continued to allow deposits for 10 weeks from customers despite being unable to access the bulk of customers’ cryptocurrencies.

For years, Canadian securities regulators, concerned about not stifling innovation, have taken a mostly hands off approach to regulating crypto trading.

Instead, they have mostly focussed on providing sandbox programs and issuing warnings to investors about the unregulated nature and risks of crypto speculating.

But the failure of Quadriga and at least two other crypto trading platforms in British Columbia -and implied customer losses of more than $300 million CAD- appear to have spurned more scrutiny and action.

According to the CSA:

“Staff is aware that some Platform operators are of the view that the Platforms they operate are not subject to securities legislation because they only allow for transactions involving crypto assets that are not, in and of themselves, derivatives or securities. However, based on our analysis of how trading occurs on Platforms, we note that some Platforms are merely providing their users with a contractual right or claim to an underlying crypto asset, rather than immediately delivering the crypto asset to its users. In such cases, after considering all of the facts and circumstances, we have concluded that these Platforms are generally subject to securities legislation.”

The CSA states that, “Platforms would not generally be subject to securities legislation if each of the following apply (emphasis added):

a Platform offers services for users to buy or sell bitcoin and does not offer margin or leveraged trading;

• users send money to the Platform to purchase bitcoin at a given price;

• the terms of the transaction require that the entire quantity of bitcoin purchased from the Platform or counterparty seller be immediately transferred to a wallet that is in the sole control of the user, and the transfer is immediately reflected on the Bitcoin blockchain;

• there is no agreement, arrangement or understanding between the parties that would allow the transaction to be settled other than by immediate transfer of bitcoin;

the Platform’s typical commercial practice is to make immediate delivery in accordance with the terms of the transaction, and for the Platform or its affiliates not to have ownership, possession or control of the user’s bitcoin at any point following the transaction;

the sale or purchase of bitcoin is not merely evidenced by an internal ledger or book entry that debits the seller’s account with the Platform and credits the crypto assets to the user’s account with the Platform, but rather, there is a transfer of the bitcoin to the user’s wallet; and

the Platform or counterparty seller retains no ownership, possession or control over the transferred bitcoin.”

“Example of situation where securities legislation does apply,” include:

• “the contract or instrument does not create an obligation to make immediate delivery of the crypto assets to the user, and…

• the typical commercial practice of the Platform is not to deliver, since users that do not make a request to transfer crypto assets do not receive full ownership, possession and control over the crypto assets that they transacted in.”

Further:

“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.”

It is not clear from the announcement when companies will be expected to change their models or comply with securities laws.

The CSA has been contacted regarding this.

The CSA maintains a page on its website listing companies that have obtained an exemption in this regard.

These companies are ZED Network, TokenGX, Majestic Asset Management, Rivemont Investments, 3iQ Corp, Token Funder, Ross Smith Asset Management, Impak Finance, Angel List and Angel List Advisors.

UPDATE:

On January 20th, Ilana Kelemen, the Ontario Security Commission’s (OSC’s) Senior Advisor, Communications and Stakeholder Relations, provided these comment on when exchanges are expected to comply with last week’s guidance.

In short, the answer is “immediately.”

Here are Kelemen’s comments:

“Regarding your question on when crypto trading platforms will be obligated to comply with guidelines pertaining to custody of crypto- assets, the CSA Staff Notice 21-327 describes the situations in which securities legislation will and will not apply to crypto-asset trading platforms – and in particular, explains that if there is no obligation for immediate delivery of a crypto-asset, securities laws apply.”

“The notice provides clarity on a principle that already applies to crypto-asset trading platforms. As such, if a platform operates in such a way that securities laws apply to it, we expect the platform to comply or seek to comply immediately.”

Further, the first iteration of this article attributed the notice to the Ontario Securities Commission. In fact, Kelemen clarified:

“This is a Canadian Securities Administrators (CSA) initiative…The staff notice covers all jurisdictions in Canada.”

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