Welcome to Bennett Jones' quarterly Fintech in Canada update, where our fintech lawyers address timely issues shaping the industry. We look at what industry participants need to know in the areas of financial regulation, securities, commercialization of IT, AI, digital currencies, IP, data governance and privacy, tax, corporate finance, private equity, M&A and asset tracing.
In this Q1 2023 update, we look at:
- New and developing federal policies in banking, artificial intelligence, privacy and tax.
- What's new in the regulation of payment services, crypto-asset trading and stablecoins.
- Crypto crime—especially scams.
- Canadian and global trends in M&A and corporate finance.
- What all of this means for fintech companies and investors.
A Pivotal Moment for Fintech
Fintech in Canada today is at a pivotal moment that will set the industry's foreseeable path in the country. This is due to the impending convergence of three developing, interrelated issues, discussed below:
AI and Financial Services
Several use cases for AI in the financial services industry are evident and present fintechs with opportunities to develop and expand offerings in lending and risk management, customer service, financial advice and planning, fraud protection and payments, to name a few. Fintechs' inherent and relative strength in innovation and agility can give them a competitive advantage over traditional financial services enterprises in leveraging AI.
Open Banking
Despite Canada's relatively slow movement in implementing a formal open banking system in Canada, if, and when, it does come, its adoption promises to open pathways to fintech offerings. The government's open banking steering committee and working groups continue their work on establishing a Canadian regime—whatever they come up with will be a key determinant in Canada's fintech future.
Bill C-27
Canada's Bill C-27 An Act to enact the Consumer Privacy Protection Act, the Personal Information and Data Protection Tribunal Act and the Artificial Intelligence and Data Act and to make consequential and related amendments to other Acts proposes a number of material changes to Canadian federal private sector privacy law. Of note for fintechs, the Act will introduce penalties for non-compliance, a private right of action, rules around de-identification and anonymization of information, algorithmic transparency and security safeguards. Bill C-27 also proposes an Artificial Intelligence and Data Act, which would regulate the use of artificial intelligence systems. These new privacy and AI regulatory frameworks will also be a key determinant in Canada's fintech future.
Bank of Canada's Draft Regulations for PSPs
The Canadian retail payments industry will soon be subject to a new regulatory regime overseen by the Bank of Canada pursuant to the Retail Payments Activities Act. The regime will apply to every payment service provider (PSP) that performs a payment function related to an electronic funds transfer, if the PSP has a place of business in Canada, or the payment function is directed at an end-user in Canada. The Act received royal assent in June 2021 but is not yet in force.
In February 2023, the Bank of Canada released draft regulations for public comment. The comment period has now closed. The draft regulations exempted certain entities from regulation, such as financial institutions, the SWIFT network and entities that perform a payment function that is "incidental" to another service or business activity.
PSPs that are subject to the regulatory regime will be required to:
- register with the Bank of Canada;
- pay a $2,500 fee;
- implement a risk management framework;
- safeguard client funds; and
- deliver an annual report to the Bank of Canada.
There is no official timeline of when the regime will take effect. We would estimate that the Act would come into force at the earliest in 2024, and that time we would expect to see regulations that prescribe a date by which PSPs will be required to comply.
CSA Announces Increased Oversight on CTPs and Clarifies Stablecoin Guidance
In February 2023, the Canadian Securities Administrators (CSA) released Staff Notice 21-332, which introduces enhanced pre-registration requirements that apply to unregistered crypto-asset trading platforms (CTPs) operating in Canada. The Notice also clarifies the CSA's approach to regulating stablecoins, or as the CSA refers to them, Value-Referenced Crypto Assets (VRCAs).
SN 21-332 builds on guidance previously released by the CSA. In August 2022, the CSA announced that every CTP which continues to operate in Canada while seeking platform registration is expected to complete a pre-registration undertaking (the PRU). The PRU sets out the conditions that every platform must satisfy to operate in Canada while awaiting the results of its registration application. SN 21-332 introduces new PRU conditions to address risks and investor protections in connection with a platform insolvency event (the Enhanced PRU). CTPs are expected to take all necessary steps to comply with the Enhanced PRU conditions within the specified timelines.
If any CTP is not prepared to file an Enhanced PRU or fails to abide by any of its conditions, the CSA expects the platform to take appropriate steps to off-board existing Canadian clients and restrict them from accessing the platform's products or services. If such steps are not taken, Canadian securities regulators have shown that they are ready and willing to take regulatory enforcement action against non-compliant platforms, such as imposing penalties and sanctions.
Through SN 21-332, the CSA has now confirmed it is of the view that VRCAs are generally considered to be securities, derivatives or both. Specifically, the CSA has stated that VRCAs which are pegged or backed by fiat currency assets generally meet the definition of a security and/or would meet the definition of a derivative in multiple jurisdictions. The CSA also stated that VRCAs which are pegged or backed by assets other than fiat currency or baskets of such assets are also generally considered to be securities and/or derivatives.
However, the final assessment of whether a VRCA is a security and/or derivative remains a fact-specific exercise. All CTPs, whether registered or unregistered, should review their policies and procedures for determining whether each crypto asset they provide exposure to or make available to clients is a security and/or derivative and consider if changes are necessary.
Cryptocurrency Tax Update
Under certain provisions in the Income Tax Act, taxpayers are required to report offshore holdings and property when the cost of such property exceeds $100,000 and it is not held or used in the course of an active business in the particular foreign jurisdiction (specified foreign property), using form T1135.
In 2014, the Canada Revenue Agency (CRA) took the position that cryptocurrency constitutes funds or intangible property and is specified foreign property that must be disclosed on the taxpayer’s form T1135 to the extent that the cryptocurrency is located, deposited or held outside Canada and is not used or held exclusively in an active business. When asked, in 2021, about how a situs or location of cryptocurrency is to be determined for the purposes of this reporting, the CRA responded that it was a question still under consideration.
In the October 7, 2022 Taxation of Financial Strategies and Instruments Roundtable at the 2022 APFF Conference, the CRA was again asked this question and again provided that the issue is still under consideration—noting a taxpayer's general obligations of reporting and keeping financial records in respect of cryptocurrency—but not providing any further guidance on determining the situs or location of cryptocurrency for the purposes of the foreign reporting rules. The CRA also noted that work was underway at the Organization for Economic Cooperation and Development (OECD) to develop the Crypto-Asset Reporting Framework (CARF). This new global tax transparency framework will include reporting requirements to tax administrations and procedures for exchanging information relating to taxpayers’ transactions with crypto-asset service providers.
The CARF has now been released by the OECD and can be accessed here. The issue has been one of considerable discussion, but was not addressed in the March 28, 2023 Canadian federal budget. Accordingly, all taxpayers can do for now is wait and see when the CRA may finalize their consideration of the questions above and whether new legislation dealing with this will be proposed later in the year.
Cryptocurrency and Crime: Responding to Crypto Scam Losses
The significant insolvencies in 2022 of the various cryptocurrency exchanges and platforms around the world has resulted in the crypto market experiencing a downturn. However, this has not prevented cryptocurrency scammers from continuing to successfully perpetrate a variety of schemes causing significant losses to investors. Even sophisticated investors can fall prey to well-advertised and promoted businesses that appear credible.
In the annual 2023 Crypto Crime Trends Report published by Chainalysis, a blockchain data and software service provider, there is a comprehensive analysis of multiple categories of illicit activity. Of these categories, scams remain the largest form of cryptocurrency-based crime. This is despite crypto scam revenue falling in 2022, from $10.9 billion in 2021 to $5.9 billion.
The scam known as "pig butchering" is currently the fastest growing and involves the fraudster establishing a rapport with a victim, through social media or text and thereafter. Time is spent gaining confidence and trust. Eventually the fraudster remarks how successful they have been with particular investments and offers to coach victims through the investment process. Fake websites or apps allow the victims to see what appear to be their purportedly growing investments. When the victims seek to liquidate their investments, they are met with requests for various fees or taxes resulting in a further loss. Eventually the fraudsters cease contact and close the fraudulent website or app.
While the approach of gaining trust to entice people to part with their money is not new, there is an increasing use of cryptocurrency as a method of payment. This is due to, among other things, that user identities remain private. However, many blockchain networks operate as a public record-keeping database, making blockchain transactions easier to track than cash. This allows for a forensic analysis to trace the stolen cryptocurrency to particular wallets in the blockchain or to the fiat off-ramps or crypto-exchange platforms where criminals seek to convert the proceeds of crime to cash. Often these off-ramps are in foreign jurisdictions that may seem difficult to pursue.
However, when armed with a blockchain forensic report, there are multiple civil litigation remedies that can be pursued such as world-wide freeze orders or disclosure orders which can be obtained in one jurisdiction and enforced in foreign courts. Although pursuing the recovery of such losses may seem impossible, a comprehensive civil litigation strategy that employs lawyers who specialize in international asset tracing can indeed provide for some recovery.
Fintech M&A and Corporate Finance
The start to 2023 was marked by ongoing trends and new developments in the fintech marketplace. The first quarter saw a rare combination of challenges with continued market uncertainty, higher interest rates, reduced valuations and the collapse of Silicon Valley Bank. How all of this plays out over the rest of 2023—and the effects on fintech deal making and financing—remains to be seen.
KPMG reported in February that investment in Canada’s fintech sector dropped in 2022, as valuations declined more than five-fold and the number of deals slowed significantly towards the end of the year. There were 169 fintech investments worth US$1.3 billion in Canada in 2022, down from a record 217 deals worth US$7 billion in 2021. Despite the slowdown, 2022 was still the second-best year for deal volume. The decline in 2022 is attributed to market conditions and the record-breaking heights of fintech investments in 2021.
For all of the sector's challenges, deals continued to be done in Canadian fintech in the first quarter of 2023. Nuvei Corporation's US$1.3 billion acquisition of Atlanta-based Paya Holdings was announced in early January and completed in late February. The first three months of 2023 also saw M&A activity in areas such as digital asset trading, smart contracts, credit card program management, carbon credit technology and digital transformation solutions.
