An extract from The Virtual Currency Regulation Review, 5th Edition
Introduction to the legal and regulatory framework
Canada currently has no comprehensive framework governing the regulation of digital assets. Securities regulation has emerged as the main regulatory instrument in Canada and is primarily a matter of provincial jurisdiction. While each province and territory has its own rules and securities regulators, the securities regulatory framework is largely streamlined and harmonised across Canada, with certain provincial or regional variances. However, legislative jurisdiction in the area of derivatives is divided between the federal and provincial governments, and the harmonisation of rule-making in this area has been more challenging. Jurisdiction is also exercised by the federal government through federal anti-money laundering legislation, which requires registration of certain virtual currency exchange or transfer services as money service businesses.
Generally, the basic purposes of provincial securities laws are to provide protection from unfair, improper or fraudulent practices, foster fair and efficient capital markets, and confidence in those capital markets, and contribute to the stability of the financial system and the reduction of systemic risk. Securities regulation in Canada generally governs the distribution and trading of both securities and derivatives. These activities are primarily regulated through the imposition of prospectus requirements, dealer, adviser and investment fund manager registration requirements, and certain requirements imposed upon those operating exchanges, alternative trading facilities or other marketplaces that facilitate trading activities, as well as related reporting and disclosure requirements.
The Canadian Securities Administrators (CSA) is an umbrella organisation of Canada’s provincial and territorial securities regulators whose objective is to improve, coordinate and harmonise regulation of the Canadian capital markets. While there are no specific rules or regulations for digital assets, the CSA has published guidance in the form of a number of staff notices with respect to virtual currencies with a view to addressing rapidly evolving developments in retail crypto markets and adapting the existing regulatory framework to digital assets. The CSA and the investment industry self-regulatory organisation known as the Investment Industry Regulatory Organization of Canada (IIROC) have most recently set out the current framework and proposed approach to regulating this asset class in Staff Notice 21-329 – Guidance for Crypto-Asset Trading Platforms: Compliance with Regulatory Requirements. Staff Notice 21-329 provides an actionable roadmap, building on earlier guidance, including the 2019 Consultation Paper 21-402 – Proposed Framework for Crypto-Asset Trading Platforms (the Consultation Paper), Staff Notice 46-307 – Cryptocurrency Offerings, Staff Notice 46-308 – Securities Law Implications for Offerings of Tokens, Staff Notice 21-327 – Guidance on the Application of Securities Legislation to Entities Facilitating the Trading of Crypto Assets, and Staff Notice 51-363 – Observations on Disclosure by Crypto Assets Reporting Issuers. As discussed below, this guidance has been backed by aggressive enforcement action directed against certain global market participants that have failed to engage with the CSA on a path to regulation.
Securities and investment laws
i Applicability of Canadian securities laws to virtual currencies
Virtual currencies may be subject to Canadian provincial securities laws to the extent that a virtual currency is considered a security or a derivative for the purposes of those laws, such as the Securities Act (Ontario) (the Securities Act). The Securities Act defines a security to include, among other things, an investment contract. The seminal case in Canada for determining whether an investment contract exists is Pacific Coast Coin Exchange v. Ontario (Securities Commission),2 where the Supreme Court of Canada identified the four central attributes of an investment contract, namely:
- an investment of money;
- in a common enterprise;
- with the expectation of profit; and
- this profit is to be derived in significant measure from the efforts of others.
If an instrument satisfies the Pacific Coin test, it will be considered an investment contract and therefore a security under Canadian securities laws.
The application of the Pacific Coin test to virtual currencies is not always straightforward, however. Industry participants have taken the position that proper utility tokens, which have a specific function or utility beyond the mere expectation of profit (such as providing their holders with the ability to acquire products or services) should not be considered securities. This position appears to have been accepted by the CSA, an umbrella organisation of Canada’s provincial and territorial securities regulators, and the IIROC in the joint consultation paper seeking input on various considerations relating to the potential regulation of virtual currencies.3 The CSA and IIROC have also acknowledged that it is widely accepted that some of the well-established virtual currency assets that function as a form of payment or a means of exchange on a decentralised network, such as BTC, are not currently in and of themselves, securities or derivatives and have features that are analogous to commodities such as currencies and precious metals.4
In assessing whether a particular virtual currency will be considered a security subject to Canadian securities laws, the CSA has generally taken a very broad approach and will consider the substance of the virtual currency over its form.5 The CSA has outlined a number of considerations in determining whether an investment contract exists. While no single factor is determinative, the CSA has stated that the existence of some or all of the following circumstances may cause a virtual currency to be considered an investment contract:
- the underlying blockchain technology or platform has not been fully developed;
- the token is not immediately delivered to each purchaser;
- the stated purpose of the offering is to raise capital, which will be used to perform key actions that will support the value of the token or the issuer’s business;
- the issuer is offering benefits to persons who promote the offering;
- the issuer’s management retains a significant number of unsold tokens;
- the token is sold in a quantity far greater than any purchaser is likely to be able to use;
- the issuer suggests that the tokens will be used as a currency or have utility beyond its own platform, but neither of these things is the case at the time the statement is made;
- management represents or makes other statements suggesting that the tokens will increase in value;
- the token has a fixed value on the platform that does not automatically increase over time, or change based on non-commercial factors;
- the number of tokens issuable is finite or there is a reasonable expectation that access to new tokens will be limited in the future;
- the issuer permits or requires purchasers to purchase tokens for an amount that does not align with the purported utility of tokens;
- the token is fungible;
- the tokens are distributed for a monetary price; and
- the token may be reasonably expected to trade on a trading platform or otherwise be tradeable in the secondary market.6
A particular virtual currency that meets the criteria of the Pacific Coin test or has certain of the characteristics described in the CSA guidance discussed above may be properly considered an investment contract and therefore a security, subject to Canadian securities laws. Similarly, the CSA has generally taken a broad approach and noted that most of the offerings of virtual currencies purporting to be utility tokens that its staff had reviewed involved the distribution of a security, usually in the form of an investment contract.7 While this guidance predates the proliferation of tokens such as non-fungible-tokens (NFTs), a similarly broad approach can be expected to apply. More recently, the CSA has expanded its regulatory approach to cover arrangements that are securities or derivatives because they are crypto contracts, and as discussed below, the consequences of characterisation a security or a derivative include distribution requirements as well as requirements to be registered as a dealer or marketplace, or both.
Virtual currency offerings in Canada
To the extent that a virtual currency is considered a security or a derivative, the issuance or distribution to the public is subject to prospectus, qualification or similar requirements, or must be effected pursuant to applicable exemptions from prospectus or derivatives qualification requirements.
There are a number of options available for distributing securities in Canada on a prospectus-exempt basis, generally referred to as exempt distributions or private placements. Most of these are harmonised under National Instrument 45-106 Prospectus Exemptions. The CSA has indicated that persons who wish to distribute virtual currencies may do so pursuant to these exemptions.8
Recently, a number of investment funds completed prospectus offerings qualifying the distribution of units of pooled fund vehicles whose underlying investments are cryptoassets such as BTC and ETH. The first such offering was completed by 3iQ for its Bitcoin Fund in April 2020 and then in December 2020 for the Ether Fund. CI Galaxy Bitcoin Fund, managed by CI Asset Management and Bitcoin Trust, managed by Ninepoint Partners LP were also launched in December 2020 and let to a number of similar offerings of crypto-based ETFs (for further details see under Subsubsection ‘Asset management and investment funds’ below).
ii Regulatory considerations for platforms, exchanges and other intermediaries Regulation of crypto contracts
The guidance set out in Staff Notice 21-327 – Guidance on the Application of Securities Legislation to Entities Facilitating the Trading of Crypto Assets (Staff Notice 21-327) further expands upon the circumstances in which the CSA will consider ‘any entity that facilitates transactions relating to cryptoassets’ to be subject to securities legislation requirements relating to platform recognition and dealer registration (discussed below). In particular, the CSA has cautioned that securities legislation may also apply to platforms that facilitate the buying and selling of cryptoassets, including cryptoassets that are commodities, because the user’s contractual right to the cryptoasset may itself constitute a derivative. This will generally be the case where the platform is determined to be merely providing users with a contractual right or claim to an underlying cryptoasset, rather than immediately delivering the cryptoasset.
While regulators will consider all the terms of the relevant contract or instrument, the CSA has taken the view that if there is no immediate delivery of the cryptoasset, then securities legislation will generally apply.
Immediate delivery will be considered to have occurred if:
- there is immediate transfer of ownership, possession and control of the cryptoasset and the user is free to use, or otherwise deal with, the cryptoasset without any further involvement with, or reliance on the platform or its affiliates, and the platform or any affiliate retaining any security interest or any other legal right to the cryptoasset; and
- following the immediate delivery, the user is not exposed to insolvency risk (credit risk), fraud risk, performance risk or proficiency risk on the part of the platform.
Other factors to be considered include:
- contractual arrangements between the platform and the user;
- immediate settlement of transaction;
- margin and leverage trading;
- typical commercial practice with regards to immediate delivery;
- immediate transfer to a user’s wallet; and
- ownership, possession or control over the transferred cryptoasset.
Another consequence of treating a particular virtual currency as a security or derivative under Canadian securities laws is the triggering of a registration requirement. Any person or company engaging in, or holding themselves out as engaging in, the business of trading or advising in securities and, in certain Canadian jurisdictions, in derivatives, must register as a dealer or as an adviser or, where available, conduct these activities pursuant to an exemption from the dealer or adviser registration requirement under the applicable securities or derivatives laws. A person or entity that directs the business, operations and affairs of an ‘investment fund’ must comply with the investment fund manager registration requirement or obtain an exemption from that requirement (see below).
In Canada, the requirement to register as a dealer or adviser is triggered where a person or company conducts a trading or advising activity with respect to securities or derivatives for a business purpose. The mere holding out, directly or indirectly, as being willing to engage in the business of trading in securities may trigger the requirement to register as a dealer. However, a number of factors must be considered when determining whether registration is required, including whether a business:
- engages in activities similar to a registrant;
- intermediates trades or acts as a market maker;
- carries on an activity with repetition, regularity or continuity;
- expects to be remunerated or compensated; and
- directly or indirectly solicits.
In the context of virtual currency distributions, the CSA has noted the following additional factors in determining whether a company may be considered to be trading in securities for a business purpose:
- soliciting of a broad range of investors, including retail investors;
- using the internet to reach a large number of potential investors;
- attending public events to actively advertise the sale of a virtual currency; and
- raising a significant amount of capital from a large number of investors.
On 7 August 2020, the OSC granted Wealth Digital Assets Inc. (WDA, then a wholly owned subsidiary of Wealthsimple Financial Corp.) time-limited relief from certain registrant obligations, relief from the prospectus requirement and derivatives trade data reporting requirements to allow WDA to trade cryptoassets and operate a platform that facilitates the buying, selling and holding of cryptoassets. This decision represented the first such authorisation for a platform that facilitates trading of cryptoassets through bespoke exemptive relief. Since then and following the regulatory approach outlined in Joint CSA/IIROC Staff Notice – 21-329 (Staff Notice – 21-329), a number of domestic platforms have been granted restricted dealer registration while other domestic and global platforms continue to engage with CSA members with a view to being appropriately regulated.9
Exchanges and other platforms
As marketplaces, exchanges are regulated pursuant to their applicable provincial securities statutes, as well as National Instrument 21-101 Marketplace Operation (NI 21-101), National Instrument 23-101 Trading Rules (NI 23-101) and their related companion policies.
NI 21-101 defines a marketplace as a facility that brings together buyers and sellers of securities, brings together the orders for securities of multiple buyers and sellers, and uses established non-discretionary methods under which the orders interact with each other.
An exchange is a marketplace that may:
- list the securities of issuers;
- provide a guarantee of a two-sided market for a security on a continuous or reasonably continuous basis;
- set requirements governing the conduct of marketplace participants; or
- discipline marketplace participants.
To operate as an exchange in Canada, a person or company must first apply for recognition as an exchange or for an exemption from the recognition requirement. As another type of marketplace, alternative trading systems, which provide automated trading systems that match buyer and seller orders, are also regulated under NI 21-101 and NI 23-101.
It follows that exchanges or other platforms that facilitate the purchase, transfer or exchange of virtual currencies that are considered securities or derivatives may be subject to recognition requirements as securities or derivatives exchanges or marketplaces. In the institutional market, prescribed or negotiated exemptions may be available in respect of platform-related recognition requirements under securities or derivatives laws, subject to the satisfaction of certain conditions and acceptance by the applicable regulators.
Staff Notice – 21-329, issued on 29 March 2021, provides a path to transition into the Canadian regulatory framework for both domestic and global platforms that admit Canadian-resident users. The framework outlined in Staff Notice 21-329 provides guidance related to the regulation of both dealer platforms and marketplace platforms.
The appropriate category of dealer platform registration depends on the nature of the platform’s activities. Relevant factors include whether the platform offers margin or leverage.
Dealer platforms that trade crypto contracts and trade or solicit trades for retail investors will generally be expected to be registered as investment dealers and become members of IIROC. However, they will be able to access a transitional interim period process by seeking ‘restricted dealer registration’ (under the stated guidance, provided that they do not offer leverage or margin trading) while they ramp up to full investment dealer registration and compliance. The interim period is currently expected to be two years. During that period, applicant platforms can expect to undergo a detailed regulatory screening of trade flows, financial controls and auditing, custody, valuation, insurance, market integrity, cybersecurity and risk management.
Staff Notice 21-329 sets out areas where the CSA may consider flexibility in the application of existing regulatory requirements to dealer platforms seeking registration. Dealer platforms are therefore encouraged to reach out to discuss the specificities of their business models, the appropriate registration category and how applicable requirements may be tailored, including through exemptive relief.
In CSA and IIROC Joint Staff Notice 21-330 Guidance for Crypto-Trading Platforms; Requirements relating to Advertising, Marketing and Social Media Use issued on September 2021, the regulators also provided requirements, best practices and examples with respect to advertising, marketing, social media activities, fee disclosure and other compliance matters for crypto-trading platforms under Canadian securities legislation.
Asset management and investment funds
Until the recent turmoil in global crypto markets, demand for economic exposure to virtual currencies had been high in Canada and investment funds have been a popular vehicle for obtaining this exposure. However, persons operating or administering collective investment structures that hold or invest in virtual currencies may also be subject to investment fund manager registration requirements in addition to dealer, adviser and prospectus or private placements requirements. The structures themselves may also be subject to reporting and conduct requirements that apply to investment funds.
In September 2017, First Block Capital Inc. became the first registered investment fund manager (IFM) in Canada for a fund dedicated solely to investments in virtual currencies. The British Columbia Securities Commission (the BCSC) granted First Block Capital registration as an IFM and exempt market dealer in order to operate a Bitcoin investment fund, subject to certain bespoke exemptions from the applicable regime.
Canada has been at the forefront of regulatory and market breakthroughs in the retail crypto fund space. In 2020, Canada’s 3iQ launched North America’s first major exchange-listed Bitcoin and Ether funds. In 2021, Canada’s Purpose Investments obtained approval from the CSA for the world’s first actively managed crypto-based exchange-traded fund (ETF). The CSA has since registered several managers of pooled investment vehicles and approved a number of retail closed-end funds and ETFs investing in cryptoassets.