On March 14th of this year, the Canadian Securities Administrators and a national non-profit funded by investment industry dealers and marketplaces, IIROC, put out a consultation paper for the regulation of crypto asset marketplaces. The paper is titled "Consultation Paper 21-402: Proposed Framework for Crypto-Asset Trading Platforms" and it asks 22 questions about how the industry should be regulated. Many people have written about this and will be submitting comments to the CSA, but this blog post looks at what assumptions exist in the consultation itself. I will leave answering the questions posed by the consultation to other smart people in the field who are working on this.

This is a complicated topic that deserves a much more comprehensive discussion, but I hope that this article about assumptions will help others who are responding to the CSA/IIROC before the May 15th deadline.

Assuming The Conclusion: Investor or Purchaser?

The language of the consultation assumes a key question: are cryptocurrency transactions the purchase of securities?

The consultation paper describes the purchases of cryptocurrency as "investors" and assumes the answer to the above question (while stating that it's a possibility, rather than certainty). But this is a key threshold question because if purchasers are not "investors" (i.e. purchasers of securities) then securities laws don't apply, and the regime that the consultation envisions is inappropriate. The true meaning of "investors" is revealed in the paper when the term "retail investors" is used in the conflicts of interest section.

It's understandable why the CSA would use the term "investors", and especially so given that many cryptocurrency industry participants refer to buying crypto assets as "investing", but to frame the consultation with a loaded word like this is to assume the conclusion. A more neutral term would have helped to ensure that the important distinction between securities and everything else in the Canadian economy is preserved. A more neutral term would have also helped respondents understand the subtle difference between crypto assets that are themselves securities that are traded on unregulated marketplaces vs. trading non-securities crypto assets (e.g. Bitcoin) on an unregulated marketplace in a way that creates a security out of the cryto asset purchase process. Most Canadian cryptocurrency exchanges, and all of the ones of any size, are trying to avoid the first class of securities (i.e. "securities tokens" or ERC20 tokens that are illegal securitiese offerings), whereas the second kind of security is difficult to avoid with the existing models.

There is a limit to securities laws, and they're not intended to cover every type of valuable property that someone in Canada might want to buy. Do they cover cryptocurrency exchanges? Should they?

How Far Do Securities Laws Go?

The CSA uses the term "investors" because they're of the opinion that buying crypto assets involves either buying a security directly or buying cryptocurrency in a way that turns what wouldn't be a security into a security ("investment contract" or "derivative"). Even the CSA isn't sure if this is true, or at least whether it's always true:

However, securities legislation may still apply to Platforms that offer trading of crypto assets that are commodities, because the investor's contractual right to the crypto asset may constitute a security or derivative. We are evaluating the specific facts and circumstances of how trading occurs on Platforms to assess whether or not a security or derivative may be involved.

A stronger first step would have been to release a paper that discusses this issue head-on, rather than simply jumping to the conclusion and calling the purchasers of crypto assets "investors". There is a point at which the connection to securities is so tangential that a different legal regime is involved. The vast majority of Canadian economic activity is not captured by securities laws and if it was, the economy would grind to a halt underneath a torrent of rules designed for stocks and bonds, and not for other kinds of valuable property. But it seems in the consultation that the CSA and IIROC consider that the best analogy to Bitcoin/Ether/etc. is traditional stocks or bonds rather than digital goods like songs, social media accounts, or video game activation keys:

Fair and efficient capital markets are dependent on price discovery. The wide availability of information on orders and/or trades is important to foster efficient price discovery and investor confidence.

The above comment in the consultation is in reference to the availability of order books on stock markets, except even stock trading often happens on marketplaces where order books aren't available ("dark pools"). This type of data is not commonly considered to be required for other types of marketplaces like eBay, Kijiji, and other familiar types of consumer marketplaces in Canada (although most cryptocurrency exchanges publish this data without any rule requiring them to do so). Generally when Canadians purchase non-securities goods or services they receive very little information about other purchasers.

A secondary issue is: if rules were put in place, would foreign exchanges follow them? Is Canada an important enough market for them that they would participate, or would they simply ban Canadians from their platforms?

Who Is This Consultation Aimed At?

Who would be covered by any rules that result from this consultation? In the introduction to the paper there's an important note:

Today, there are over 2000 crypto assets that may be traded for government-issued currencies or other types of crypto assets on over 200 platforms that facilitate the buying and selling or transferring of crypto assets (Platforms). Many of these Platforms operate globally and without any regulatory oversight.

In the consultation paper, the phrase "200 platforms" links to footnote 3, which is the CoinMarketCap exchange listing page. What's interesting about this is that I only see two exchanges on that list that are Canadian: Coinsquare (#97 of 257 exchanges) and ezBTC (184/257, with only 1% of the volume of Coinsquare). There are three if you count the failed exchange QuadrigaCX (228/257 on the list). 99% of the exchanges on the CSA's list are foreign exchanges. Is this consultation aimed at two specific companies?

The consultation paper makes it seem like there are many companies involved in the activities described, but almost all of them are foreign companies that do business primarily in other countries. The actual scale of the industry in Canada is dramatically less than the paper makes it out to be, and raises an important question about the necessity of regulation, effectiveness of rules, and diversion of scarce securities regulator resources.

Is This A Problem That Needs Solving?

Should the CSA be working on rules that only affect two companies? And taken by dollar value, just one company, Coinsquare? The CSA must consider this a big issue, or they wouldn't be spending significant time thinking about these issues and consulting with industry.

This is a small industry. There are not hundreds of exchanges trading billions of dollars a year of cryptocurrency in Canada. Instead, there's essentially one exchange that does about $10 million in volume (according to their reported figures) per day. In contrast, the TMX group of exchanges (which includes the Toronto stock exchange) recorded nearly $7 billion per day in averaging trading volume in 2017. Cryptocurrency trading in Canada is, without a doubt, much less than 1% of the market for trading equities. And on top of the small market, it's not nearly as lucrative as this consultation makes it out to be. Coinsquare laid off nearly a third of their staff a month before this consultation began.

Could new rules prevent "the next QuadrigaCX" from happening? Perhaps. But that's a much more focussed discussion than what is being put forward and not stated in the consultation.

What Would It Cost For Blockchain Companies To Become IIROC Members?

Part 5 of the consultation mentions that "Platforms" will need to become IIROC members:

Like the Marketplace Rules, the Proposed Platform Framework contemplates Platforms both becoming registered as investment dealers and becoming IIROC dealer and marketplace members (IIROC Members)

But what would this cost? IIROC has a complicated membership fee structure. For a "Marketplace", there are two membership fees required (Dealer and Marketplace Member) of $25000 each, a $66500 "Information Technology Fee" plus "[a]ll costs of information technology development, including any third party costs, for a new marketplace ...", a minimum monthly fee of $4800, and administrative fees of $900 per month. The total is approximately $120k in initial fees plus ~$6000 per month in ongoing fees. These fees are inconsequential to major players in the traditional securities world, but for startups that are generally operating at a loss, these are substantial additional costs that are in effect being proposed as part of the consultation.

On top of existing IIROC fees, there would likely be further costs for crypto asset exchanges to become members of IIROC:

Nevertheless, we contemplate that Platforms seeking registration as an investment dealer registration and IIROC membership that plan to provide custody of crypto assets will not only need to satisfy existing custody requirements but will also be expected to meet other yet-to-be determined standards specific to the custody of crypto assets.

And on top of IIROC charges: the cost of regulatory compliance and legal expenses.

Unfortunately the cost of regulation/IIORC membership is not a part of the consultation.

The Reality of Order Books In A Global Market

Price discovery, transparency, and lack of self-dealing are obviously important to the authors of this consultation. But this focus ignores the reality of Canadian crypto asset exchanges. Because trading is global and Canada is a small country, prices are not set in Canada, they're set on the global market. Most exchanges make use of "liquidity pools" (i.e. trading on their own account with other exchanges in order to fulfill orders) or rely on people running arbitrage bots to ensure that large orders can be processed quickly without too much slippage. Users want this to happen because they want to be able to trade on Canadian exchanges, rather than using foreign exchanges that have substantially more volume.

Unlike traditional exchanges, most crypto asset trading that's relevant to Canadians isn't happening here, and it never will be, because the world is much larger than Canada. Furthermore, insisting on features or rules that foreign exchanges won't follow will likely result in an erosion of the competitive position of Canadian exchanges, and further offshoring of cryptocurrency trading activity.

Crypto markets are global. Canadian pricing transparency rules will never provide transparency in the global markets where prices are set, and to assume that any rules will be followed is a significant (and mistaken) assumption.

Is Bitcoin Just Too Risky For Canadians? Under Any Regime?

The consultation describes the operation of exchanges where "participants may purchase crypto assets, many of which can be complex, high risk and volatile products, that are not suitable investments for [buyers]." Although most people would agree that crypto assets are high risk and volatile, that's quite different from the consideration of whether buying them is a "suitable investment" because whether or not something is suitable is a personal evaluation that's normally left up to customers in the market. It's not left up to customers in the market for securities, and checking whether investments are suitable for an investor is something that some regulated securities market participants must do. And in a decision by the Ontario Securities Commission (the largest regulator of the CSA) released a month before the consultation, staff had this to say about crypo assets:

The cryptoasset market, which includes the bitcoin market, is particularly vulnerable to market abuse and manipulative behaviour because of a number of factors, including the immature stage of development of the market and its actors, a lack of information about the identity of market participants and their activity, and the possibility of new abusive behaviours that may not be captured by current monitoring tools due to the novel nature of the market.

The CSA and IIROC are so concerned about the risks of crypto assets that it seems that even US securities regulation of commodities markets & exchanges (e.g. CME/CBOE) isn't good enough for them. In Part 1 of the consultation this thought is expressed in a short paragraph with a subtle meaning:

Currently there are no Platforms recognized as an exchange or otherwise authorized to operate as a marketplace or dealer in Canada. As such, the CSA has urged Canadians to be cautious when buying crypto assets.

The meaning of the above paragraph is only made clear by the footnote that accompanies it, which references the CSA's 2017 warning aimed at Canadian dealers and investors who might be considering buying Bitcoin futures on US markets. There aren't any Canadian markets, but there are US markets that are (highly) regulated by US authorities, where Bitcoin derivatives are traded. And if that's not good enough for the CSA and IIROC, what would be?