Regulation is coming … to cryptocurrency exchanges

The now infamous QuadrigaCX scandal, in which $190 million in customer funds went missing, has once again ignited debate regarding the appropriate regulation of cryptoasset exchanges. QuadrigaCX is hardly a unique case.

If you’ve been paying attention to crypto news, you will have seen the stories of exchanges across different jurisdictions being hacked, coins being stolen and consumers suffering the resulting loss. Who remembers the cyberattack on Mt. Gox, the world’s leading bitcoin exchange, and its subsequent bankruptcy? QuadrigaCX has hit close to home – it was one of Canada’s largest cryptoasset exchanges and was headquartered in Vancouver.

The need for clear regulation

Lack of clear regulation and regulatory oversight has left consumers vulnerable. Cryptoasset trading platforms that want to operate legitimately and reputably have also suffered, oftentimes being left unable to establish the banking relationships that are crucial for operations. Indeed, some existing platforms have stated that they would welcome regulation that balances the interests of consumers and industry.

While traditional financial market players are subject to strict rules and sanctions imposed by securities regulators, when those rules are broken, cryptoasset trading platforms have largely flown under the regulatory radar. Currently, no cryptoasset trading platform has been authorized under securities laws to operate as a marketplace or dealer in Canada. Canadian securities regulators have previously made it clear that, where a cryptoasset falls within the definition of “security,” traditional securities laws will apply. Consequently, cryptoasset trading platforms that facilitate the buying, selling or trading of cryptocurrencies that are considered securities are required to determine whether they are a “marketplace” under securities laws (meaning they are akin to a traditional exchange or alternative trading system). If necessary, they must then apply to securities regulators for recognition as a marketplace or for an exemption from recognition. However, uncertainty has remained as to which cryptoassets do in fact constitute securities, and Canadian regulators have not commented on how traditional securities laws will address the nuances of cryptoasset markets – until now.

New rules proposed for crypto in Canada

In March, Canadian securities regulators published a consultation paper, Proposed Framework for Crypto-Asset Trading Platforms, proposing new rules governing platforms that facilitate the buying, selling or transferring of cryptoassets. The regulators are requesting comments on these proposed rules from industry stakeholders. The proposed rules would apply to platforms subject to securities legislation that operate in Canada or serve Canadian investors. Clearly, platforms that facilitate trading in cryptoassets that are considered securities, such as certain tokens, will be subject to securities legislation.

A bigger issue is whether securities regulators can properly assert jurisdiction over platforms that facilitate trading of cryptoassets that function as a form of payment or medium of exchange, such as bitcoin. This remains unclear. The consultation paper acknowledges that bitcoin is not in and of itself a security (rather, it is analogous to a commodity such as a fiat currency or precious metal), but claims that securities legislation may nonetheless apply to platforms offering trading of cryptoassets that are analogous to commodities. The rationale proposed by the regulators is that an investor’s contractual right to such cryptoassets through the platform may constitute a security or derivative, depending on how the platform is structured. In determining this, the regulators suggest they will consider such operational factors as who has control or custody of the cryptoassets, who the legal owner is and the rights of the investors in the event of the platform’s insolvency.

The regulators note in the consultation paper that there are several areas of risk that are unique to cryptoasset trading platforms (as opposed to traditional marketplaces). They outline a proposed regulatory framework that leverages the existing regulations applicable to traditional marketplaces, “but with appropriately tailored requirements” that are relevant for the functions a cryptoasset marketplace performs. In particular, while cryptoasset trading platforms facilitate trading of cryptoassets, they may also perform dealer functions by taking custody of cryptoassets or the private keys needed to access such assets and permitting direct access to trading by retail investors rather than through a regulated intermediary, such as a broker. Consequently, the regulators propose that platforms may be subject to the traditional rules that govern marketplaces, in order to address risks such as:

• marketplace integrity;

• market surveillance;

• pricing transparency, including making pricing and volume information available;

• custody of assets;

• clearing and settlement;

• disclosure of conflicts of interest (for example, those posed by a platform’s market-making activities); and

• system resiliency and business continuity planning.

In addition, traditional rules governing dealers and clearing agencies may apply, such as those relating to proficiency requirements, insurance, know-your-client and suitability obligations, and custody requirements. The consultation paper notes that some traditional requirements may not be relevant and others may need to be tailored to address the specific risks posed by cryptoasset trading platforms.

Cryptoasset exchanges raise unanswered questions

What will be the ultimate result? The consultation paper certainly suggests that traditional rules will play a role. Perhaps the most significant questions are: How much will the existing rules be tailored and how far will the final rules reach? Will the rules ultimately apply to platforms trading in cryptoassets that are classified as commodities, such as bitcoin? Hopefully, any final rules will provide clarity as to their application and balance the interests of investors and industry, without stifling innovation. This is a tall order, no doubt, but this consultation paper is a promising start.

Interested parties may provide comments on the consultation paper, Proposed Framework for Crypto-Asset Trading Platforms, in writing by May 15, 2019.

Companies and investors that are weighing the options and risks when it comes to cryptoasset exchanges should seek legal advice from experienced lawyers. The team at EKB is able to help navigate the regulatory and legal issues facing business leaders operating in Canada and internationally.

Kelly Samuels is a partner and business lawyer at EKB.

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