The British Columbia and Ontario securities regulators have taken a leap forward in the regulation of bitcoin and other cryptocurrencies with the first registration of a fintech start-up, First Block Capital Inc., which intends to launch a fund that will invest all of its assets in bitcoin.
The regulatory backdrop for this landmark registration is provided by the Canadian Securities Administrators (CSA) in Staff Notice 46-307 – Cryptocurrency Offerings (Staff Notice), which was published in August (see our September 2017 Blakes Bulletin: Industry Responds to CSA Guidance on Cryptocurrency Offerings). The Staff Notice also included a discussion of the issues raised by cryptocurrency investment funds, which fund sponsors and distributors must be prepared to address.
The B.C. and Ontario regulators have demonstrated considerable flexibility in granting the registration, which will permit First Block Capital to launch a Canadian bitcoin fund on a prospectus-exempt basis. No Canadian securities regulatory authority has yet authorized a prospectus-qualified investment fund to invest in cryptocurrency. First Block Capital will also be permitted to launch other cryptocurrency funds, subject to further approval by the B.C. Securities Commission (the principal regulator).
REGULATION OF CRYPTOCURRENCY INVESTMENT FUNDS
The Staff Notice discusses the application of securities laws to ordinary investment funds that propose to invest in cryptocurrencies. Permitting an investment fund to invest in bitcoin and other cryptocurrencies could give ordinary investors a simplified vehicle for investment in a familiar form which could be held directly as a traditional security or through an existing brokerage relationship as compared to the more complicated process currently required to open a cryptocurrency “wallet” in Canada. Moreover, investors may prefer to rely on an investment fund manager to take the necessary precautionary security measures (such as securing passwords) and complete the necessary due diligence recommended before depositing money with a wallet provider or cryptocurrency exchange and engaging in trading.
As discussed in the Staff Notice, the Canadian prospectus regime would apply to an offering of shares or units of a cryptocurrency fund in Canada subject to the important additional restriction that the offering memorandum exemption is not available for distributions of investment funds in Ontario or Quebec and this exemption is subject to other restrictions in certain other provinces.
Securities regulators can more directly oversee the establishment of cryptocurrency funds by placing specific requirements on investment fund managers and securities dealers that wish to establish or manage cryptocurrency funds or distribute fund investments since such managers and dealers are generally subject to securities registration requirements and regulatory oversight. In particular, the Staff Notice refers to a range of diligence activities that a fintech business that is establishing a cryptocurrency fund must undertake in respect of cryptocurrency exchanges and custodians that will be used, and fintech businesses are advised to also be prepared to discuss other issues with securities regulators.
FIRST REGISTRATION OF A CRYPTOCURRENCY INVESTMENT FUND MANAGER (IFM)
The IFM registration was granted to First Block Capital subject to a number of restrictions and requirements, including the following:
Prior approval must be granted by the principal regulator for any new cryptocurrency fund established by the IFM. However, approval has already been granted to the initial fund, which will invest subscription proceeds solely in bitcoin and hold such bitcoin under a purely passive investment strategy.
Changes to a fund’s cryptocurrency custodian or to the entity principally responsible for the execution of trades for a fund will also be subject to prior approval of the principal regulator.
As part of the IFM’s oversight duties, it must require cryptocurrency custodians and brokers to maintain compliance systems that provide reasonable assurance of compliance with regulatory requirements, and to manage business risks in accordance with prudent business practices.
Independent auditor reports reviewing the sufficiency of the cryptocurrency custodian’s security practices as well as regulatory compliance documents received by the IFM from its cryptocurrency custodians and brokers must be provided to the principal regulator.
Annual audited financial statements must be available to securityholders for each cryptocurrency fund, and net asset value reports must be available on a monthly or more frequent basis for each cryptocurrency fund.
Prior to making a trade in a cryptocurrency, the IFM must “make its own determination of a current and reasonable fair price” for the cryptocurrency.
First Block Capital was also granted registration as an exempt market dealer, which permits it to act as a securities dealer in British Columbia and Ontario in respect of exempt distributions (such as under the accredited investor exemption and the crowdfunding exemption) but not in respect of prospectus offerings. First Block Capital may also offer investments in its cryptocurrency funds through traditional securities dealers registered in applicable provinces in Canada.
First Block Capital was not required to register as a portfolio manager in order to manage investment activity for the initial bitcoin trust, which suggests that the underlying bitcoin that the fund will purchase are not considered by the regulators to be securities.
The registration terms and conditions issued for First Block Capital noted that the British Columbia and Ontario securities commissions consulted with other Canadian regulators on cryptocurrency funds as part of the Canadian Regulatory Sandbox initiative, a program that was launched in February 2017, which assesses innovative products, services and applications on a coordinated and flexible basis. Regulatory Sandbox approvals are typically time-limited in keeping with their testing status, and it is notable that the Ontario registrations for First Block Capital will expire in December 2019.
REGULATION OF MARKETPLACES PERMITTING TRADING OF SECURITIES
The Staff Notice also pointed out that cryptocurrency exchanges that permit trading of coins, tokens or cryptocurrencies that qualify as “securities” against national fiat currencies or other cryptocurrencies will also be subject to Canadian securities law requirements if some market participants are located in Canada.
Given that the Staff Notice does not suggest that bitcoin itself is a security, some cryptocurrency exchanges may take the view that they are not subject to Canadian securities regulation because they do not permit the trading of securities. However, many cryptocurrency exchanges also permit the trading of coins or tokens that may be securities, and some cryptocurrencies may also be considered securities. Accordingly, such cryptocurrency exchanges may be subject to Canadian securities laws to the extent there are Canadian market participants. At this point in time, no cryptocurrency exchange has obtained the recognition required, or an exemption from such recognition requirement, in order to allow Canadians to participate in on-exchange securities trading.
We note that anti-money laundering and money services business laws may also apply to cryptocurrency exchanges operating in Canada or with Canadian clients.