On February 14, 2018, the British Columbia Securities Commission (BCSC) published for comment BC Notice 28/01, Notice and Request for Comment Consulting on the Securities Law Framework for Fintech Regulation (the Notice), with the aim of understanding the nature and growth of the financial technology (fintech) industry in British Columbia.
The Notice sets out the result of consultations with stakeholders that the BCSC held in the Summer of 2017 and seeks comment on potential regulatory action to clarify or modernize securities laws to benefit all stakeholders, including investors in fintech. The Notice identifies specific subjects and poses a series of questions for comment and discussion regarding fintech and fintech regulation, with the aim of developing a competitive regulatory environment that fosters innovation and gives investors the confidence to invest in British Columbia’s capital markets.
This update will examine in detail at two parts of the Notice: Part Five, Cryptocurrency Funds and Part Six, Initial Coin Offerings and Cryptocurrencies. The complete Notice is available for download from the BCSC’s website.
Part Five: Cryptocurrency Funds:
In Part Five, BCSC staff noted that as cryptocurrency use increases, they expect continued registration applications from fund managers looking to operate cryptocurrency investment funds. These may range from investments in established cryptocurrencies such as bitcoin and ethereum, to investing in speculative cryptocurrencies that may have other functionalities. These funds may also look to invest in ICOs and initial token offerings (ITOs). Staff identified the following areas that could merit further regulatory consideration:
Risk management for cryptocurrency investment funds:
The BCSC is studying how to best mitigate the risks posed by cryptocurrencies, including those identified in CSA Staff Notice 46-307 (the CSA Staff Notice). These risks range from the operational (e.g. the risks associated with using specific cryptocurrency exchanges, cryptocurrency wallets and custodians; difficulties in determining a fair price for a cryptocurrency transaction) to the systemic (e.g. the lack of regulation of cryptocurrencies overall; the lack of transparency in cryptocurrency trading).
Incoming changes to custody requirements in NI 31-103:
BCSC staff also examined the impact on cryptocurrencies of the proposed amendments for NI 31-103 (the Amendments), which are expected to come into force on June 4, 2018. The Amendments will impose requirements on registrants regarding custody of client cash, securities or other assets and will set out additional requirements for external custodians used by registered firms to hold cash or securities. The Amendments also set specified restrictions on self-custody of cash and securities for registrants. The requirements for custody of client assets that are not cash or securities will remain essentially unchanged.
Investment and operational concerns for cryptocurrency investment funds:
The BCSC is also studying the implications of the CSA Staff Notice, more specifically whether funds investing in ICOs may give rise to additional concerns such as:
- if the fund’s assets include securities (which could include coins or tokens), the fund would need a registered PM to oversee its investment activities.
- coins or tokens that are securities may be subject to resale restrictions, adding liquidity risks to the fund.
- as market participants must evaluate each cryptocurrency offering on a case-by-case basis, a fund could incur significant risks if it invests in an ICO before there is clarity on whether the ICO is a distribution of securities. For instance, if an investment manager for a fund is not a registered PM and causes the fund to invest in an ICO that is later determined to be a distribution of securities, that investment manager would have advised the fund on securities without being properly registered. This may result in sanctions against the investment manager or the fund, such as a cease trade order of the securities.
Operational requirements for cryptocurrency funds:
In addition, BCSC staff are also are considering whether operational requirements for cryptocurrency investment funds should differ from requirements for other types of funds. There has been some stakeholder concern raised that the proficiency and operational requirements for advisers and IFMs may not be pertinent to cryptocurrencies.
Part Six: ICOs and Cryptocurrencies:
In opening this section, the BCSC refers to the CSA Staff Notice, in which CSA (Canadian Securities Administrators) staff notes the increase in ICOs and ITOs. (The term ICO used here includes the distribution of coins or tokens, but can also refer to an initial token offering, token generation event, or token distribution event.)
Exemptive Relief Decisions for ICOs:
Since August 2017, the CSA has granted exemptive relief to two businesses proposing to conduct ICOs. The relief granted consisted of:
- in both cases, dealer registration relief that provided for the ICO coins or tokens to be distributed using prospectus exemptions; and,
- in one case, prospectus relief, to facilitate the tokens’ circulation in a defined ecosystem as a form of currency.
The relief allowed these novel businesses to raise capital with tailored restrictions. The prospectus relief demonstrates the regulators’ willingness to consider a flexible approach to tokens with unique characteristics, if investor protection concerns are adequately addressed.
ICOs as a distribution of securities:
In the CSA Staff Notice, the CSA noted that in many cases, the determination of whether a coin or token is a security depends on whether it is an investment contract. However, BCSC staff have received requests for additional stakeholder guidance on the factors that staff consider in determining whether an ICO is an offering of securities. Stakeholders have identified the following list of variables as potential factors to consider whether an investment contract exists with a given ICO:
- Whether a secondary market exists and is available for a coin or token. For example, tokens compliant with the Ethereum standard ERC-20 are structured in a way that makes them readily tradable on many cryptocurrency exchanges. This may increase the potential for speculation in a token.
- Whether a buyer is intending to use a coin or token for a utility function or speculation. Sellers of tokens often purport that there is a “utility” function to the token that constitutes the reason for its purchase, that is separate from its potential function as an investment. However, tokens are often traded from the time they are sold, indicating that buyers may be treating the token as a speculative instrument without an intention to participate in its future utility. BCSC staff also note instances of futures trading for some tokens prior to their distribution under an ICO.
- Functional differences to forms of non-securities crowdfunding. Stakeholders argue that many businesses proposing ICOs use a coin or token in a manner similar to a prepayment of a good or service. However, we have observed that some ICOs issue coins or tokens that are readily tradable with an available secondary market, unlike the standard lack of transferability observed with prepaid promises to deliver under non-securities crowdfunding platforms such as Kickstarter.
- Whether the utility function is available at the time the tokens are sold. Most businesses that conduct ICOs are prospective and looking to raise capital to build out the utility function for the token. However, it has been argued that where some businesses have already built out the product for which the tokens are needed, the token may be less of a speculative instrument compared to a token whose utility function is not available at the time the token is sold.
- Whether the business conducting the ICO has created an impression that the token is an investment or profit opportunity. ICOs are conducted through the internet and can attract a wide range of potential buyers. Where a business is offering tokens and indicates that such token may generate positive returns for a buyer outside its use, the business may be creating the impression that such coin or token is actually an investment instead of a token with a specific use. This promotional aspect may be observed even where the business is separately asserting that the token is intended to be used for a utility function.
BCSC staff note that this list may not encompass all the factors that they may wish to consider.
Proposed ICO models:
The most common ICO model, noted the BCSC, is where a business raises capital by selling non-functional tokens and uses those proceeds to develop the functionalities it advertised for that token. The business issues the non-functional tokens immediately to purchasers following the ICO. Staff do add however, that other proposed or in-use ICO models used by business include:
- an ICO structured so that one token is a security used for capital raising prior to the development of the platform, and a second, functional token is used for deployment once the platform is operational;
- an ICO where the developer delays release of the token to a later time, such as once the platform is functional; and,
- an ICO in which the first step involves the purchasers and developer entering into an agreement for the right to a functional token, and then a second step involves fulfilment of the agreement by releasing the token when the platform/ecosystem is functional.
BCSC staff note when considering a transaction, they look at the substance of a transaction, and not simply its form. However, they also advise that the choice of ICO model that a business uses may affect the legal analysis of whether there is a distribution of securities.
Securities Regulatory Approach to Virtual Currencies:
Financial regulators are monitoring and taking varying approaches to respond to the challenges posed by virtual currencies. The BCSC defines a “virtual currency” as meaning a cryptocurrency purported to function solely as a medium of exchange, without any added utility or purpose (e.g. bitcoin).
There have been arguments made that virtual currencies fail the investment contract test when they are highly decentralized. For these virtual currencies it is argued there is no common enterprise, and no expectation of profit that relies on the significant efforts of others. Stakeholders have identified the following additional factors securities regulators should consider in determining when a virtual currency is not an investment contract, and therefore not a security:
- No central governance for the coin. For example, bitcoin has no entity or entities with authority to set rules applicable to the coin on an ongoing basis;
- Creation or distribution of coins not dependent on a central issuer. For example, new coins could be created or distributed through mining, staking or other decentralized forms of coin creation/distribution; and,
- Transfer and trading of coins not dependent on a central party. There are no restrictions on who may record new transactions on the blockchain ledger for the coin, and there is no central entity that can influence which transactions occur.
BC Notice 28/01, Notice and Request for Comment Consulting on the Securities Law Framework for Fintech Regulation, is available for download from the British Columbia Securities Commission website.
For more information, please call Barbara Hendrickson at BAX Securities Law (416) 601 -1004.
This publication is not intended to constitute legal advice. No one should act on it or refrain from acting on it without consulting with a lawyer. BAX does not warrant or guarantee the accuracy or currency or completeness of the publication. No part of this publication may be reproduced without the prior written permission of BAX Securities Law.