CSA expands obligations required immediately from unregistered trading platforms for cryptoassets operating in Canada | Stikeman Elliott LLP

On February 22, 2023, the Canadian Securities Administrators (CSA) published. CSA Staff Notice 21-332 Crypto Asset Trading Platforms: Pre-registration Firms – Changes to Improve Canadian Investor Protection (employee notice). The staff notice imposes additional obligations on crypto-asset trading platforms (CTPs) operating in Canada, following the recent collapse of FTX and other insolvencies in the crypto space. Certain measures are required from unregistered CTPs as early as 24 March 2023.

Background

On 15 August 2022, the CSA announced that it expects unregistered CTPs that continue to operate in Canada while taking steps to comply with applicable securities laws to provide their principal regulator (PR) with a pre-registration undertaking (PRU). By providing the PRU while the application for registration or related relief is under consideration, unregistered CTPs agree to comply with certain core business conduct and risk management obligations designed by the CSA to address investor protection concerns, and which are consistent with the requirements applicable to registered CTPs -is.

The CSA has cautioned that although the PRU is a prerequisite for CSA staff considering an application, it does not guarantee that a CTP will be granted registration or relief in any CSA jurisdiction. If a CTP fails to register or obtain the required relief, it will be required to cease conducting registrable activity in each CSA jurisdiction where it is not registered or faces enforcement.

New PRU regulations

Following several insolvencies involving a number of CTPs, the CSA further announced it 12 December 2022, that extended obligations are expected in the standard form of PRU. These new obligations are now outlined in the staff notice and set out in the new ‘enhanced PRU’. They include detailed governance, risk management, operational, custody, insurance, financial reporting and other compliance and reporting requirements, including those described below.

Custody and segregation of client-owned crypto assets

The enhanced PRU requires CTPs to commit to holding assets – including cash, securities and non-securities crypto-assets – of a Canadian client:

1. separate and distinct from CTP’s own property;
2. in trust for the benefit of the client;
3. in the case of cash, in a designated trust account or in an account designated for the benefit of customers at a qualified Canadian custodian or financial institution; and
4. in the case of crypto assets, in a designated trust account or in an account designated for the benefit of clients with a custodian that is an “acceptable third party custodian” (as defined in the Staff Statement).

CTPs must also commit to providing an authorization and direction that allows CSA staff to obtain information about the status of Canadian customer accounts directly from custodians.

Restrictions on the use of client-owned crypto assets

The enhanced PRU maintains the existing requirement that a CTP hold cryptoassets separately in trust for the benefit of clients and not pledge, re-mortgage or otherwise use any client-owned cryptoassets. It now allows CSA staff to request evidence of meaningful compliance systems and corporate governance controls to provide reasonable assurance that the CTP is complying with this requirement.

Restrictions on offering margin, credit or other forms of leverage

While the existing form of PRU prohibits CTPs from offering margin, credit or other forms of leverage to customers other than “permitted customers” (as defined in National Instrument 31-103 Registration requirements, exceptions and ongoing registrant obligations (NI 31-103)) in connection with the trading of crypto on the platform, the enhanced PRU extends this restriction to all customers – including retail customers and permitted customers.

Obligations of controlling minds and global affiliates

The global affiliates, parent entities and/or controlling minds of a CTP are required to co-sign the Enhanced PRU to ensure the independence of the Canadian file type, and co-signatories must provide commitments to this effect. The enhanced PRU also requires that, to the extent possible, the Canadian filer’s board of directors is independent of its global affiliates, parent entities and/or their controlling minds.

Restrictions on the use of crypto assets to determine capital

The enhanced PRU includes restrictions on a CTP’s reliance on cryptoassets when determining its excess working capital and capital base. The excess working capital requirement applicable to registered firms will be subject to a 100% reduction on all crypto assets that are not offset by a corresponding current liability. CTP will therefore have to exclude all crypto assets from the calculation of excess working capital under form 31-103F1 of NI 31-103.

Regular submission of financial information to CSA members

The enhanced PRU requires a CTP to provide audited financial information as provided under section 12.12 of NI 31-103.

Designation of a qualified Chief Compliance Officer (CCO)

During the pre-registration process, a CTP must appoint a CCO who must generally meet the skills and experience requirements applicable to the CCO of a registered non-market dealer.

Further prohibitions

The staff notice reiterates the prohibition on CTPs entering into crypto contracts to buy and sell crypto assets that are themselves a security or derivative with Canadian-resident persons. Based on the CSA’s assessment of certain risks associated with “Value-referred Crypto Assets” (VRCAs) (as defined in the Staff Notice, but commonly referred to as “stablecoins”), the Enhanced PRU prohibits CTPs from allowing their clients to enter enter into crypto contracts to purchase or deposit VRCAs without the prior written consent of the CSA. CTPs themselves are also prohibited from trading crypto contracts based on proprietary tokens, except with the prior written consent of the CSA.

Action required

Unregistered CTPs that continue to operate in Canada while taking steps to comply with applicable securities legislation are expected to:

• provide a revised PRU based on the template established by CSA Staff within 30 days of the staff notice (i.e. by 24 March 2023); and
• implement such system changes as may be necessary to give effect to the PRU within the time frames specified in the PRU.

Where a CTP is unable or unwilling to provide an enhanced PRU or implement the required system changes within these timelines, CSA will expect the CTP to:

• take appropriate steps to identify and terminate existing users in Canada;
• impose meaningful restrictions to prevent access to products and services offered by CTP to users in Canada; and
• provide notice and timelines to its PR and other CSA members for implementing such steps and restrictions.

Staff in the current PR will separately contact registered CTPs to discuss whether changes to registration or relief are required.

Compliance and Enforcement

Finally, the CSA notes that compliance and/or enforcement action against a CTP and its clients will be considered if:

• CTP currently operates in Canada, and is engaged in registration discussions with a CSA member, but is not prepared to submit a revised PRU in a form acceptable to CSA staff;
• the CTP files, but do not comply with the provisions of the PRU;
• CTP makes no bona fide attempt to get through the registration process as quickly as possible; or
• other information that raises investor protection or other public interest concerns comes to the attention of CSA staff.

What will be next?

The substantive requirements and associated timelines introduced by the enhanced PRU present significant compliance and operational challenges and are likely to result in most global CTPs deciding to opt for an orderly and structured offboarding of Canadian-resident users, providing Canadian users a more limited range of options for holding and trading crypto assets. While the introduction of more robust governance, risk management, trading and operational controls on CTPs is a crucial and welcome development, the new custody requirements alone appear to be structurally inconsistent with the existing trading infrastructure of most global CTPs which are not designed from the ground up to comply with these new Canadian rules. Recent developments in the technology banking space have signaled the downside of a greater concentration of assets in the hands of too few qualified custodians, arguably resulting in the same investor protection, redemption or “run” risks and systemic risks as the CSA’s current regulatory initiatives. seeks to address. While the CSA has stated that the terms of the enhanced PRU are essentially non-negotiable, certain transitional adjustments to the requirements to address the current structural specificities of existing CTPs and of the asset class itself may actually lead to better outcomes for Canadian users. It also remains to be seen whether more flexible and adapted conditions can be negotiated in connection with registration.