Hong Kong has forged ahead. So, too, has Japan. A host of small countries and territories also have quickly moved forward, eager to roll out the welcome mat for nascent crypto-currency companies and projects searching for regulatory certainty.
But most regulators around the world are still grappling over their next moves, even as they face growing calls — including by industry — for greater regulation of virtual currencies to bring an element of control to a market that has often been described as the “Wild West.” A hands-off approach by policy-makers has been shelved after Bitcoin’s spectacular surge caught the public imagination while the growing numbers of crypto-currencies in the market, too, have sparked concerns. There are nearly 2,100 crypto products available, and dozens more are launching every month. All told, the market capitalization of crypto assets was pegged recently at $230 billion, and trading volume has grown almost a hundred fold in the past two years and is now estimated at $15 billion annually, according to figures by the Bank of Canada.
Most of the G20 countries, however, are unlikely to follow in the footsteps of Bermuda, Gibraltar, Malta and Liechtenstein, all of which recently introduced friendly and liberal regulatory regimes to foster crypto havens. Concerns over the price volatility of crypto assets, security breaches, the absence of investor and consumer protection and fears it could be used to launder money or finance terrorist activity loom large at G7 and G20 tables.
But striking a balance between providing adequate investor and consumer protection while imposing regulations that do not stifle innovation in the burgeoning sector is proving to be daunting for regulators, a bind that Canada, too, faces as it carves out its strategy. Indeed, Canada’s regulatory framework governing virtual assets is “still a work in progress,” said Timothy Lane, the deputy governor of the Bank of Canada, in a speech recently at the University of Calgary.
With so many federal and provincial authorities having their hands in the till, overseeing a byzantine array of laws and regulations, it is also extremely complex and convoluted. Provincial securities regulators have a say as do the Bank of Canada, the Competition Bureau, the Office of the Superintendent of Financial Institutions, the Canada Revenue Agency, the Financial Consumer Agency of Canada, and the Financial Transactions and Reports Analysis Centre of Canada. And then there is legislation that deals with securities, anti-money laundering and terrorist financing, privacy and consumer protection.
“There are still challenges for innovators, for startups where they can’t go to one point of contact and get clear, concise and definitive feedback on a financial services product that might have elements of banking, insurance, investments, all rolled into one,” says Blair Wiley, general counsel and head of regulatory affairs at Wealthsimple, who previously led the blockchain and cryptocurrencies multidisciplinary team at Osler Hoskin & Harcourt LLP. “There is no one-stop shop for people.”
Addison Cameron-Huff, a Toronto-based tech lawyer who until recently was the president of Decentral Inc., a leading Canadian blockchain startup, concurs. “The problem is that people are not sure what they are allowed to do,” says Cameron-Huff. “Clear answers are hard to come by.” A 2018 report by the Blockchain Research Institute said that innovators in the space lament the “lack of regulatory clarity and guidance.”
But while Canadian regulatory authorities are trying to work out the kinks, Canada may be losing out. Though figures are hard to come by, word on the street has it that growing numbers of crypto-currency companies are leaving Canadian soil for friendlier regulatory regimes. “From the perspective of a crypto-currency company, that sort of light touch regulatory regime is extremely welcome and compelling,” says Wiley. “We regularly see businesses come to us with questions on how to effectively structure their businesses to avoid the application of Canadian law. There is a whole host of places for people who have a perception that there is more willingness or welcoming environment for crypto-currency businesses.” Cameron-Huff, while working at Decentral, worked with many Canadian firms that were incorporated in a jurisdiction outside of Canada even though he “encouraged people to think very carefully about why they wanted to incorporate somewhere else.”
In the meantime, regulators worldwide are having a hard time figuring out what to do with crypto-currencies. In an unparalleled situation, the U.S. Securities and Exchange Commission has changed its stance several times over the past year on crypto-currencies. The SEC now seems to consider Bitcoin, the decentralized digital currency that set the ball rolling, and Ether, the second-largest crypto-currency by market cap after Bitcoin, as not being securities because of their decentralized structure. But the majority of this new digital asset class are deemed by the SEC to be securities. An SEC settlement reached with two digital coin startups in November 2018 seems to bolster that new stance. Paragon Coin Inc. and CarrierEQ Inc. agreed to comply with investor-protection rules, including filing audited financial statements and other disclosures about their business. More settlements with U.S. regulatory authorities are likely to take place. The North American Securities Administrators Association revealed that more than 200 active investigations of initial coin offerings, a form of fundraising popular among cryptocurrency firms, and crypto-currency-related investment products are currently underway by state and provincial securities regulators in the U.S. and Canada as part of Operation Cryptosweep.
“This is what we are going to have to deal with for the foreseeable future, this back and forth debate and discussion,” observes Charlene Cieslik, the chief anti-money laundering officer at Coinsquare, a fast-growing Canadian crypto-currency trading platform. “None of it is happening in Canada that is transparent to the rest of us. It is mostly happening in the U.S., and let’s face it: in Canada, we tend to follow.”
Canadian securities regulators have taken a similar stance to American authorities. Crypto-currencies are primarily regulated under provincial securities laws — except when they are not, such as Bitcoin and Ether. “Securities regulators are taking this on a one-off basis so they are looking at each business model and they are trying to determine how they need to regulate it and what the risks are,” explains Conrad Druzeta, co-head of the fintech and blockchain group at Bennett Jones LLP. Still, regulators who have devoted a lot of resources over the last 18 months to wrap their minds around this new digital asset are guided by well-established tests such as the investment contract test laid out by the Supreme Court of Canada in Pacific Coast Coin Exchange v. Ontario Securities Commission in 1978, itself based on U.S. jurisprudence. The four-pronged test requires that in order for an instrument to be classified as a security, there must be an investment of money, with an intention or expectation of profit, in a common enterprise, whose success or failure is significantly affected by the efforts of those other than the investor. But a virtual currency can be a security for other reasons, warns Wiley. The definition of a security under provincial securities legislation is broad and expansive, and there are “many things that could constitute a security, such as evidence of indebtedness that could lead one to conclude that a particular crypto-currency is a security,” independent of the investment contract test, adds Wiley, a member of the Securities Advisory Committee of the Ontario Securities Commission.
On top of that, some Canadian securities regulators have issued further guidance and notices that they assert are in line with the approach taken by regulators in other countries such as Australia, Great Britain and the U.S. The OSC warned in March 2017 that initial coin offerings, a form of fundraising popular among crypto-currency firms, may trigger certain Ontario securities law requirements, including registration or prospectus requirements. The Canadian Securities Administrators, an umbrella organization of Canada’s provincial and territorial securities regulators, also waded in and offered two notices over the past 18 months. In essence, the CSA stated that it will look at the substance of the transaction when considering whether securities laws apply. The use of new technology and new terminology, such as selling a coin or a token instead of shares or equity, to raise money will not determine whether securities laws apply. The CSA further cautioned that, depending on the facts and circumstances, coins or tokens may be considered derivatives and therefore be subject to legislative and regulatory requirements.
“Crypto people are wondering how far these rules go,” remarks Cameron-Huff. But “if you look at the language people use, talking about investments and returns and many of the things that are hallmarks about securities, people shouldn’t be surprised that securities regulators are interested.”
Securities regulators, such as the OSC, claim they are keen on supporting crypto-currency innovation through the implementation of regulatory sandboxes. The forward-thinking platform, such as the OSC’s LaunchPad, can provide exemptions from securities laws and requirements in a faster and more flexible manner than a standard application, allowing companies to test their products. But while the idea of regulatory sandboxes is “really compelling,” Wiley says far too few companies have been able to take advantage of it. Since it was launched in 2016, Canadian securities administrators granted less than 10 exemptions. “Given how quickly technology is evolving and competition in capital markets is ramping up, I would hope we can see more progress,” says Wiley. “Industry and regulators need to continue to find ways to kind of meet in the middle and find an appropriate balance to encourage innovation and hopefully we will see an uptick in the number of sandbox exemptions.”
Other players in the crypto industry also seek regulatory clarity. Coinsquare is one of them, forcefully arguing that clear rules would go a long way towards lending credibility to an emerging sector that buys and sells virtual currencies. Canada was the first country to approve regulation of crypto-currencies in 2014, which amended the Proceeds of Crime (Money Laundering) and Terrorist Financing Act. Bill C-31 laid out the framework for regulating entities in digital currencies by treating them as money services businesses, which meant that they would have to comply with numerous obligations including record keeping, know-your-customer requirements, registration and reporting certain electronic funds transfers and suspicious transactions to FINTRAC. But the rules have not yet come in force and will not come into effect any time soon. In the summer of 2018, the Department of Finance Canada published in the Canada Gazette proposed changes to strengthen Canada’s anti-money-laundering regime that would update customer due diligence and regulate businesses that deal in virtual currency. But Ottawa has postponed the release of its final regulations.
But that hasn’t stopped Coinsquare from forging ahead. It has registered itself as a money services business with FINTRAC at the federal level and with the Autorité des marchés financiers, Quebec’s securities regulator. All of which means that it has implemented a fully compliant anti-money laundering program. It has gone further. The trading platform completed a third-party consolidated financial statement audit conducted by a national accounting firm that covered 2015 to 2017. That in turn paved the road for Coinsquare to forge a relationship with the Bank of Montreal, a first in the crypto-currency exchange space. It is also the kind of move that industry observers assert will help to legitimize the sector.
But Cieslik is nevertheless concerned about where the crypto-currency exchange market is heading. In one of its staff notices, the CSA cautioned that these exchanges are generally unregulated and may not be efficient markets. It also warned that if a crypto-currency exchange facilitates trading in securities and operates in Canada, it would have to be recognized as a marketplace under Canadian securities law or be exempt from recognition. But so far no crypto-currency exchange has been recognized or exempt from recognition in Canada. There are signals that things may be about to change. “Recently securities commissions have started to sell lots and lots of information requests to these exchanges,” says Druzeta. “My understanding is that the theory is that even if these crypto-currencies are not securities, if the exchange is holding them and you have the right against the exchange, that right could be a derivative which allows securities commissions to take jurisdiction over these exchanges.”
Cieslik is concerned “about the interplay of securities, FINTRAC and the Department of Finance Canada and people taking different stances over what crypto-currencies are. We’re in the infancy. This is a developing area, and nothing is going to be settled in black and white any time soon. It makes it a bit challenging.”
It’s time for a co-ordinated international regulatory framework to deal with digital assets, according to Toronto lawyer and blockchain expert Amy ter Haar. “There are various regulatory ecosystems for these types of securities that need to be mapped out, and then the regulators need to work together and regulate because it is an increasingly interconnected world,” says ter Haar. “The solution can come through a contextual approach to principle-based regulations.”