On March 29, 2021, the Ontario Securities Commission (OSC) issued an announcement notifying crypto trading platforms (CTPs) offering trading in securities or derivatives that they must bring their operations into compliance with the securities laws. As an interim approach, dealer and marketplace CTPs were permitted to operate while they are seeking registration, subject to the conditions tailored to their business model. In 2022, the Canadian Securities Administrators (CSA) issued additional announcements that they would be expecting CTPs subject to securities legislation to sign pre-registration undertakings (PRUs) while they are applying for registration. The interim approach was expected to generally last for approximately two years, and in 2023, in staff notice SN 21-332, CSA re-iterated their expectations concerning PRUs and also announced additional commitments in enhanced PRUs for unregistered CTPs operating in Canada. As of June 2023, 12 CTPs have received exemptive relief to offer crypto products in Canada, and 10 provided their PRUs.
This note provides a brief overview of when and how Canadian securities legislation applies to platforms that facilitate trading in digital assets (crypto assets or cryptocurrencies) or CTPs.
Who Are Crypto Trading Platforms?
According to CSA staff notice 21-329 Guidance for Crypto-Asset Trading Platforms: Compliance With Regulatory Requirements (SN 21-329), a crypto asset trading platform (a CTP) is a platform that facilitates the trading of crypto assets that are securities (Security Tokens) or instruments or contracts involving crypto assets (Crypto Contracts), as indicated in CSA Staff Notice 21-327 Guidance on the Application of Securities Legislation to Entities Facilitating the Trading of Crypto Assets (SN 21-327). SN 21-329 does not spell out the meaning of a “platform”, so it is unclear whether a Bitcoin ATM or a decentralised exchange would be considered a platform. SN 21-327 offers some guidance by defining a “platform” as any entity that facilitates trades relating to crypto assets. Presumably, under this interpretation, an entity operating a Bitcoin ATM would be considered a platform.
It is worth noting that even though SN 21-329 refers to SN 21-327 in defining Crypto Contracts as instruments or contracts involving crypto assets, SN 21-327 does not specifically provide a list of such instruments or contracts nor it provides a relevant definition. As a result, to some extent, the interpretation of the definition of Crypto Contracts remains to some extent mysterious. More recently, the two decisions of the OSC Capital Markets Tribunal (In Re Mek Global Limited and In Re Polo Digital Assets) shed light on the interpretation of a “Crypto Contracts” term. In essence, a Crypto Contract is a contractual right or claim to an underlying crypto asset between a CTP and an investor, and it is a security when the investor is dependent on the CTP’s actions, custody arrangements, and solvency. For more information on the treatment of “Crypto Contracts” please see my post “Understanding Canadian Crypto Contracts”.
When Does Securities Legislation Apply?
The next question would be whether the securities legislation would apply to a CTP. Essentially, according to SN 21-327, a CTP would not be subject to securities legislation if (a) the underlying crypto asset is not a Security Token or a derivative instrument and (b) the contract or instrument for the purchase, sale or delivery of a crypto asset results in an obligation to make immediate delivery of the crypto asset, and is settled by the immediate delivery of the crypto asset to the CTP’s user according to the CTP’s typical commercial practice.
The key here is the immediate delivery of a crypto asset. Delivery is generally immediate when a CTP has an obligation to transfer a crypto asset to a wallet (i.e. to the customer’s ownership, possession, and control) designated by the CTP’s customer immediately after executing a transaction. The transfer of the crypto asset should be made without any security interest, and the customer should be free to use it without any further involvement of the CTP or its affiliates, Following the delivery of the crypto asset, the customer should not be exposed to CTP’s insolvency, fraud, performance or proficiency risk.
As an example, a CTP is not subject to the securities legislation, provided that all the criteria mentioned below are met:
- a CTP offers services to buy or sell bitcoin (where no margin or leveraged trading is offered),
- users send money to the CTP to purchase bitcoin at a fixed price and the terms of the transaction require that the entire quantity of bitcoin purchased from the CTP or seller should be immediately delivered to the customer’s wallet and the transaction is immediately reflected on the Bitcoin blockchain,
- there is no agreement, or understanding between the parties that would allow the transaction to be settled other than by immediate transfer of Bitcoin,
- the CTP’s typical commercial practice is to make immediate delivery and for the CTP or its affiliates not to have ownership, possession, or control of the customer’s Bitcoin at any point following the transaction,
- sale or purchase of bitcoin is not evidenced by internal books of the CTP, but the bitcoin is transferred to the customer’s wallet, and
- the CTP or counterparty does not retain ownership, possession, or control over the transferred Bitcoin.
As can be seen, the list of conditions is extensive. It looks like the exemption is for a small class of CTPs that do not retain their clients’ crypto assets and transfer purchased crypto assets directly to their customers’ digital wallets immediately following the transaction. Immediate examples of exempt CTPs are probably Bitcoin ATMs, a limited class of OTC trading desks with settlements being done at the customer digital wallet level.
In assessing whether a particular contract or instrument results in an obligation and reflects an intention of the parties to effect an immediate delivery of a crypto asset, CSA would look at all terms of the relevant contract or instrument (written and unwritten) as well as surrounding facts and circumstances, including the typical commercial practice to make delivery under the contract or instrument. In other words, in addition to looking at the service agreement between a customer and a CTP, the securities regulators might ask questions on how a particular CTP operates, how it maintains customer accounts, execute orders, perform settlement, and store customer records, and whether the CTP custodies crypto assets. If there is no obligation to immediately deliver the crypto assets, and potentially ongoing reliance and dependence of a client on their CTP subjecting the client to insolvency (credit) risk, fraud, performance, and proficiency risk on the part of the CTP, the securities legislation would apply.
Specific Categories of Securities Regulatory Regime Applicable to CTPs (dealers and marketplaces).
If the securities legislation applies to a CTP, how does it apply?
CSA SN 21-329 provides guidance in this respect. SN 21-329 describes that there are generally two modes of CTP operation: marketplace and dealer (although a mode combining marketplace and dealer could also exist). Certain dealers that facilitate trading in digital assets that are derivatives depending on how they operate could also be subject to the applicable derivatives requirements, including reporting and registration requirements, however, the scope of this note covers only CTPs that operate as marketplace or dealers (or maybe both).
Marketplace CTPs
Under National Instrument 21-101 Marketplace Operation (NI 21-101), a marketplace definition includes an exchange, a quotation, and a trade reporting system or an entity that:
- provides a market or facility for bringing together buyers and sellers of securities or Crypto Contracts,
- brings together the orders for securities or Crypto Contracts of multiple buyers and sellers and
- uses established methods under which the orders interact with each other and buyers and sellers entering the orders agree to the terms of the trade.
If the orders of multiple buyers and sellers or parties are brought together on a facility, and the interaction of those orders results in a trade, in the CSA view, if such facility acts as a marketplace.
If a CTP operates in a manner that constitutes “a marketplace”, it will be subject to the applicable regulatory requirements, including NI 21-101, National Instrument 23-101 Trading Rules, and National Instrument 23-103 Electronic Trading and Direct Access to Marketplaces. A CTP will operate under the oversight of the CSA and a self-regulatory organization (a newly formed Canadian Investment Regulatory Organization (CIRO)). The trading activities of the CTP operating as a marketplace will be subject to market integrity requirements and other requirements currently included in the Universal Market Integrity Rules (UMIR), such as transparency of orders and trades, recordkeeping requirements, confidentiality of trading information, and addressing conflicts of interest. NI 21-101 also requires that all trades executed on a marketplace must be reported and settled through a clearing agency, so if CTP also conducts clearing, it will have to register as a clearing agency, absent an applicable exemption.
Dealer CTPs
CSA SN 21-329 outlines the two main characteristics of a CTP that qualify it as a dealer rather than a marketplace: a dealer CTP should (a) only facilitate the primary distribution of Security Tokens and (b) act as the counterparty to each trade in Security Tokens and/or Crypto Contracts with client orders not interacting with each other on the CTP. In addition, SN 21-329 provides a non-exhaustive list of other activities that may be carried out by dealer CTPs (vs. marketplace): the onboarding of retail clients onto the CTP, acting as agent for clients for trades in Security Tokens or Crypto Contracts and offering custody of assets, either directly or through a third party. At the same time, the CSA staff guidance does not make it clear whether this list simply describes the activities of a dealer CTP or whether performing any of them would qualify an entity as a dealer CTP.
If a dealer CTP only facilitates distributions of prospectus-exempt Security Tokens and does not offer margin or leverage trading, such CTP would be required to register as an exempt market dealer (EMD). Similarly, if a dealer CTP trades or solicit trades with retail investors they would be expected to be registered as an investment dealer. Further, if a CTP facilitates trading of Crypto Contracts that are derivatives, in Quebec, such CTP would be expected to be registered as a derivatives dealer. Dealer CTPs that create and market derivatives must be qualified by the Quebec AMF before they are offered to retail investors.
Dealer CTPs would be required to comply with National Instrument NI 31-103 Registration Requirements, Exemptions, and Ongoing Registrant Obligations (NI 31-103). Dealer CTPs offering exempt Security Tokens would have to be registered as an EMD (restricted dealer category) with the applicable securities regulator, and dealer CTPs offering Security Tokens to retail investors will have to be registered with the Canadian Investment Regulatory Organization (CIRO) as investment dealers. Where a Dealer CTP also starts operating as a marketplace CTP, the regulatory framework applicable to marketplace CTPs will also apply. In addition, in certain jurisdictions, dealer CTPs that trade Crypto Contracts may need exemptive relief from the prospectus requirement to facilitate the distribution of Crypto Contracts and relief from OTC trade reporting requirements.
Conclusions
While the securities regulators provide a narrow exemption to a certain class of CTPs, the key to the availability of this exemption is ensuring immediate delivery of crypto assets to customers’ digital wallets. The customers should not be exposed to insolvency (credit) risk of the CTP as well as performance and proficiency risks. This also means that such CTPs should not have custody of their customers’ crypto (digital) assets. CTPs would need to carefully examine their operations to ensure that in the process of execution, settlement, and delivery of crypto assets, the CTP does not take custody of such assets. In addition, each crypto asset should be analyzed to ensure that it is not a security. If such a crypto asset is viewed by foreign regulators as a security, it can be deemed a security in Canada as well. CTPs also would need to review their operations and determine whether they might be subject to the securities legislation as a clearing agency, an alternative trading system, or a derivatives dealer.