On February 22, 2023, the Canadian Securities Administrators (CSA) published CSA Staff Notice 21-332 Crypto Asset Trading Platforms: Pre-Registration Undertakings. Changes to Enhance Canadian Investor Protection (the Notice) introducing additional investor protection provisions required for crypto asset trading platforms operating in Canada while pursuing their registration and/or applications for exemptive relief (CTPs). The Notice builds on the past staff notices issued on August 15 and December 12, 2022 announcing the regulatory expectations for CTPs. The Notice describes the core obligations of CTPs, adds new provisions, such as requirements on custody and segregation of client assets, delivery of financial information, restrictions on re-hypothecation/pledge, use of margins, credit or other forms of leverage, exclusion of proprietary tokens issued by CTP from the excess working capital calculation, requirements to have a Chief Compliance Officer and to have policies and procedures to determine whether a digital asset is a security and/or a derivative. If a CTP is informed by the securities regulators that a particular digital asset is a security and/or a derivative, the CTP is expected to take steps to orderly offload such digital assets from the platform and enable their clients to liquidate their positions.
Stablecoins as VRCA
In the Notice, for the first time, the CSA introduce a concept of a “Value-Referenced Crypto Asset” (VRCA), more commonly known as a “stablecoin”, but note that this term could be misleading because of loss of peg and volatility experienced by stablecoins recently. According to the Notice, a VRCA is a digital asset designed to maintain a stable value over time by referencing the value of a fiat currency or any other value or right or their combination by pegging to the reference value through maintaining a reserve of assets or relying on an algorithm embedded in a smart contract. VRCAs may be used as means of payment, a store of value during times of volatility in crypto asset markets, for trading of other crypto assets, as an on-ramp to deposit assets with CTPs and for other purposes. The most common form is intended to replicate the value of a fiat currency and may give holders of such VRCA evidence of a direct or indirect claim on the VRCA issuer. A VRCA issuer may try to maintain the value of the VRCA by setting aside assets denominated in fiat currency (a Fiat-Backed Crypto Asset or FBCA). The CSA staff are of the view that an FBCA (as well as other similarly-structured VRCA backed by other types of assets) generally meets the definition of a “security” and/or would meet the definition of a “derivative” in certain provinces.
Regulatory Concerns and CSA Approach
The Notice points out that governance, stabilization mechanisms and transparency are key issues requiring protection of VRCA holders. There are concerns that investors may be misled into believing that VRCAs will not deviate from their value or that they have a direct claim on the reserved assets. Significant risks associated with VRCAs are related to the stabilization mechanism to maintain peg, management and custodianship of reserve assets as well as their governance and redemption risks.
The CSA expect a CTP to obtain CSA consent before allowing its clients to buy or deposit a particular VRCA. A CTP should also conduct due diligence regarding a particular VRCA to ensure that appliable risks have been addressed, including ensuring that reserve assets are held by a qualified custodian in trust for the benefit of VRCA holders, are segregated from the assets of a VRCA issuer and are subject to monthly attestation and annual audit by an independent auditor. Further, a CTP must be satisfied that (a) the reserve assets consist of highly liquid assets (such as cash or cash equivalents), (b) redemption rights of VRCA holders are articulated and properly disclosed, (c) key accurate information about a VRCA is publicly available in plain language and (d) there are appropriate governance mechanisms. In addition, a VRCA must be a FBCA and distributions of such FBCA in Canada must be made under applicable securities laws.
Both CTPs and VRCA issuers would be expected to address the risks mentioned above. CTPs would need to contact their principal regulator to obtain permission to enable buying and deposit of digital assets that are VRCA. VRCA issuers are also encouraged to contact the securities regulator and be able to explain how they address these risks and would comply with the applicable securities laws.
According to the Notice, a VRCA based on algorithm (algorithmic stablecoins) in the CSA’s view, is riskier as it is not collateralized and relies on an algorithm and market incentives to peg its price to the reference value. The CSA are unlikely to provide consent to a VRCA that maintains its value through an algorithm but is not backed up fiat assets.
What does this mean?
The securities regulators are likely to consider the majority of stablecoins backed by cash and cash equivalents to be and/or derivatives. The Notice, however, does not explain how the regulators have come to this conclusion, although in a footnote, the Notice mentions that a FBCA would generally be an “evidence of indebtedness” under the definition of “security” in several jurisdiction. This view is interesting because indebtedness usually implies there is interest to be paid and maturity. These two aspects are generally not available in the current popular fiat-backed stablecoins, such as UST. The design of stablecoins backed by cash and cash equivalents seems to be similar to exchange-traded funds (ETFs), such as money market funds and short-term investment funds. Both money market funds and short-term investment funds usually invest their net assets in highly liquid money market instruments, certificates of deposits and other highly liquid securities, and investors and portfolio managers typically use those types of funds to park their cash temporarily.
Regardless of classification, treating FBCA as a security means that a FBCA issuer must comply with the prospectus and continuous disclosure requirements. A FBCA issuer could also rely on a prospectus exemption (such as an offering memorandum exemption available pursuant to National Instrument 45-106 Prospectus Exemptions), however, those exemptions have limitations and resales of FBCA would have to be made in reliance on a prospectus exemption. The latter aspect could affect the trading market liquidity of such FBCA. In addition, given the global nature of FBCA circulation through different networks and self-custodied nature of many digital asset wallets, it is unclear how the proposed arrangement is expected to be operated within and outside of Canada. FBCA issuers would probably have to implement technological solutions allowing their FBCAs to be resold in Canada only through the applicable network of registered dealers in compliance with the securities law requirements and outside of Canada under respective applicable laws, which may treat FBCA/stablecoins differently.
Still, it is impressive that the Canadian securities regulators are acknowledging the benefits and potential uses of stablecoins and are thinking about introducing this class of digital assets while keeping in focus investor protection concerns. At the same time, even preliminary roadmap in terms what is expected would help to keep the pace of innovations in this area and help CAD-denominated FBCAs to gain liquidity. For example, further clarification on whether a FBCA is a security of a corporate issuer or an investment fund issuer would be relevant in determining the appropriate compliance and regulatory framework for issuance and distribution of FBCAs. In addition, guidelines on parameters of stabilization mechanisms if a pool of assets is backing a stablecoin, do we need asset management professionals to manage this pool of assets? If a FBCA issuer is an investment fund, are there any fees for such a product, how they are determined and should be disclosed? Finally, the language in the Notice shows that the “CSA is of the view that stablecoins, or stablecoin arrangements may constitute securities and/or derivatives” may suggest that there could be a small class of stablecoins that are not securities, and providing regulatory clarity on potential exemption (or the absence thereof) would be helpful.
In the meantime, CTPs would need to consider offloading from their platforms stablecoins operating outside of the applicable securities regulatory framework in Canada. Foreign stablecoin issuers would need to consider contacting the relevant Canadian securities regulator to determine appropriate parameters for distribution of such stablecoins in Canada. Canadian stablecoin issuers would need to ensure compliance with the applicable securities regulatory regime of distribution of their stablecoins as FBCA.
This update is intended as a summary only and should not be regarded or relied on as advice to any specific client or regarding any specific situation.
On February 22, 2023, the Canadian Securities Administrators (CSA) published CSA Staff Notice 21-332 Crypto Asset Trading Platforms: Pre-Registration Undertakings. Changes to Enhance Canadian Investor Protection (the Notice) introducing additional investor protection provisions required for crypto asset trading platforms operating in Canada while pursuing their registration and/or applications for exemptive relief (CTPs). The Notice builds on the past staff notices issued on August 15 and December 12, 2022 announcing the regulatory expectations for CTPs. The Notice describes the core obligations of CTPs, adds new provisions, such as requirements on custody and segregation of client assets, delivery of financial information, restrictions on re-hypothecation/pledge, use of margins, credit or other forms of leverage, exclusion of proprietary tokens issued by CTP from the excess working capital calculation, requirements to have a Chief Compliance Officer and to have policies and procedures to determine whether a digital asset is a security and/or a derivative. If a CTP is informed by the securities regulators that a particular digital asset is a security and/or a derivative, the CTP is expected to take steps to orderly offload such digital assets from the platform and enable their clients to liquidate their positions.
Stablecoins as VRCA
In the Notice, for the first time, the CSA introduce a concept of a “Value-Referenced Crypto Asset” (VRCA), more commonly known as a “stablecoin”, but note that this term could be misleading because of loss of peg and volatility experienced by stablecoins recently. According to the Notice, a VRCA is a digital asset designed to maintain a stable value over time by referencing the value of a fiat currency or any other value or right or their combination by pegging to the reference value through maintaining a reserve of assets or relying on an algorithm embedded in a smart contract. VRCAs may be used as means of payment, a store of value during times of volatility in crypto asset markets, for trading of other crypto assets, as an on-ramp to deposit assets with CTPs and for other purposes. The most common form is intended to replicate the value of a fiat currency and may give holders of such VRCA evidence of a direct or indirect claim on the VRCA issuer. A VRCA issuer may try to maintain the value of the VRCA by setting aside assets denominated in fiat currency (a Fiat-Backed Crypto Asset or FBCA). The CSA staff are of the view that an FBCA (as well as other similarly-structured VRCA backed by other types of assets) generally meets the definition of a “security” and would meet the definition of a “derivative”.
Regulatory Concerns and CSA Approach
The Notice points out that governance, stabilization mechanisms and transparency are key issues requiring protection of VRCA holders. There are concerns that investors may be misled into believing that VRCAs will not deviate from their value or that they have a direct claim on the reserved assets. Significant risks associated with VRCAs are related to the stabilization mechanism to maintain peg, management and custodianship of reserve assets as well as their governance and redemption risks.
The CSA expect a CTP to obtain CSA consent before allowing its clients to buy or deposit a particular VRCA. A CTP should also conduct due diligence regarding a particular VRCA to ensure that appliable risks have been addressed, including ensuring that reserve assets are held by a qualified custodian in trust for the benefit of VRCA holders, are segregated from the assets of a VRCA issuer and are subject to monthly attestation and annual audit by an independent auditor. Further, a CTP must be satisfied that (a) the reserve assets consist of highly liquid assets (such as cash or cash equivalents), (b) redemption rights of VRCA holders are articulated and properly disclosed, (c) key accurate information about a VRCA is publicly available in plain language and (d) there are appropriate governance mechanisms. In addition, a VRCA must be a FBCA and distributions of such FBCA in Canada must be made under applicable securities laws.
Both CTPs and VRCA issuers would be expected to address the risks mentioned above. CTPs would need to contact their principal regulator to obtain permission to enable buying and deposit of digital assets that are VRCA. VRCA issuers are also encouraged to contact the securities regulator and be able to explain how they address these risks and would comply with the applicable securities laws.
According to the Notice, a VRCA based on algorithm (algorithmic stablecoins) in the CSA’s view, is riskier as it is not collateralized and relies on an algorithm and market incentives to peg its price to the reference value. The CSA are unlikely to provide consent to a VRCA that maintains its value through an algorithm but is not backed up fiat assets.
What does this mean?
The securities regulators are likely to consider the majority of stablecoins backed by cash and cash equivalents to be and/or derivatives. The Notice, however, does not explain how the regulators have come to this conclusion, although in a footnote, the Notice mentions that a FBCA would generally be an “evidence of indebtedness” under the definition of “security” in several jurisdiction. This view is interesting because indebtedness usually implies there is interest to be paid and maturity. These two aspects are generally not available in the current popular fiat-backed stablecoins, such as UST. The design of stablecoins backed by cash and cash equivalents seems to be similar to exchange-traded funds (ETFs), such as money market funds and short-term investment funds. Both money market funds and short-term investment funds usually invest their net assets in highly liquid money market instruments, certificates of deposits and other highly liquid securities, and investors and portfolio managers typically use those types of funds to park their cash temporarily.
Regardless of classification, treating FBCA as a security means that a FBCA issuer must comply with the prospectus and continuous disclosure requirements. A FBCA issuer could also rely on a prospectus exemption (such as an offering memorandum exemption available pursuant to National Instrument 45-106 Prospectus Exemptions), however, those exemptions have limitations and resales of FBCA would have to be made in reliance on a prospectus exemption. The latter aspect could affect the trading market liquidity of such FBCA. In addition, given the global nature of FBCA circulation through different networks and self-custodied nature of many digital asset wallets, it is unclear how the proposed arrangement is expected to be operated within and outside of Canada. FBCA issuers would probably have to implement technological solutions allowing their FBCAs to be resold in Canada only through the applicable network of registered dealers in compliance with the securities law requirements and outside of Canada under respective applicable laws, which may treat FBCA/stablecoins differently.
Still, it is impressive that the Canadian securities regulators are acknowledging the benefits and potential uses of stablecoins and are thinking about introducing this class of digital assets while keeping in focus investor protection concerns. At the same time, even preliminary roadmap in terms what is expected would help to keep the pace of innovations in this area and help CAD-denominated FBCAs to gain liquidity. For example, further clarification on whether a FBCA is a security of a corporate issuer or an investment fund issuer would be relevant in determining the appropriate compliance and regulatory framework for issuance and distribution of FBCAs. In addition, guidelines on parameters of stabilization mechanisms if a pool of assets is backing a stablecoin, do we need asset management professionals to manage this pool of assets? If a FBCA issuer is an investment fund, are there any fees for such a product, how they are determined and should be disclosed? Finally, the language that the “CSA is of the view that stablecoins, or stablecoin arrangements may constitute securities and/or derivatives” may suggest that there could be a small class of stablecoins that are not securities, and providing regulatory clarity on potential exemption (or the absence thereof) would be helpful.
In the meantime, CTPs would need to consider offloading from their platforms stablecoins operating outside of the applicable securities regulatory framework in Canada. Foreign stablecoin issuers would need to consider contacting the relevant Canadian securities regulator to determine appropriate parameters for distribution of such stablecoins in Canada. Canadian stablecoin issuers would need to ensure compliance with the applicable securities regulatory regime of distribution of their stablecoins as FBCA.
This update is intended as a summary only and should not be regarded or relied on as advice to any specific client or regarding any specific situation.