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A Global Review Of The Regulatory Considerations Relating To Crypto-Asset Trading Platforms
McCarthy Tetrault | Sonia Struthers, Laure Fouin and others | July 12, 2019
In May 2019, the International Organization of Securities Commissions (IOSCO) published a consultation paper entitled Issues, Risks and Regulatory Considerations Relating to Crypto-Asset Trading Platforms (the "Consultation Paper") on the issues and regulatory considerations regarding crypto-asset trading platforms. The Consultation Paper follows a similar paper published by the Canadian Securities Administrators (CSA) and the Investment Industry Regulatory Organization of Canada (IIROC) in March 2019, covered in our earlier post. IOSCO is the global international policy forum for securities regulators and is comprised of securities regulators from more than 115 jurisdictions, including Ontario, Quebec, British Columbia and Alberta. The purpose of the Consultation Paper is to identity the novel issues, risks and key considerations associated with crypto-asset trading platforms ("CTPs"). The Consultation Paper also provides frameworks to assist regulatory authorities when addressing the key issues and considerations. In preparing this report, IOSCO conducted a survey (the "Survey") of various CTP operational models and the regulatory approaches currently applied or being considered in IOSCO member jurisdictions.
The Consultation Paper does not provide guidance to help determine if a crypto-asset is a security or whether it falls within a regulatory authority's jurisdiction. When a regulatory authority determines that a crypto-asset is a security, the basic principles and objectives of securities regulation are meant to apply. The focus of the report is on the secondary market trading – as opposed to initial coin offerings – of crypto-assets on CTPs, assuming that the regulatory authority has the legal authority to regulate those assets.
What Are CTPs?
The Consultation Paper defines a crypto-asset trading platform as "a facility or system that brings together multiple buyers and sellers of crypto-assets for the purpose of completing transactions or trades." CTPs perform a function comparable to traditional trading venues. Therefore, some of the issues and risks associated with trading on CTPs are similar to those with trading securities on regulated trading venues generally. Accordingly, most jurisdictions indicated that their existing regulatory frameworks may be applicable to CTPs and crypto-assets. However, the Consultation Paper notes that CTPs may perform many additional functions that are typically conducted by intermediaries, custodians, transfer agents and clearinghouses. The Survey indicated that only a small number of jurisdictions have proposed or introduced frameworks specific to crypto-assets and CTPs. However, the CSA Business Plan 2019-2022 published on June 13, 2019 mentions that the CSA is considering developing a regulatory regime for CTPs.
See: NCFA Comments: CSA/IIROC Joint Consultation Paper 21-402: Proposed Framework for Crypto-Asset Trading Platforms
The Consultation Paper sets out the following seven key considerations for regulators to review when evaluating a CTP.
Key Consideration #1: How Access is Provided to CTPs
Typically, intermediaries that are approved participants of the trading venue access such venue on behalf of their clients. These intermediaries are responsible for the on-boarding process, which includes complying with suitability and know-your-client (KYC) requirements. The Survey revealed that most CTPs tend to provide non-intermediated and direct access to retail investors, meaning that the CTP is responsible for the on-boarding process. Most jurisdictions indicated that current on-boarding processes used by CTPs are limited compared to the requirements imposed on intermediaries that traditionally perform this function. This raises further concerns regarding anonymous trading of crypto-assets and investors accessing a CTP from prohibited jurisdictions, as the on-boarding process is crucial in preventing prohibited trading activity on CTPs and limiting participation to eligible investors. The Survey responses indicated that most jurisdictions believe it might be necessary to impose requirements typically applicable to intermediaries on CTPs, especially if the CTP allows for direct access to retail investors.
Recommended IOSCO Framework
A regulatory authority may want to consider an assessment of the access criteria and on-boarding process used by CTPs by:
Reviewing the CTP's policies and procedures regarding access criteria and the on-boarding process to ensure KYC, anti-money laundering, anti-terrorism and product suitability requirements are met;
Allowing only intermediated access to CTPs; and
Considering whether CTPs should provide risk disclosure.
Key Consideration #2: Custody and Safeguarding of Participant Assets
Custody functions of participant assets are typically performed by parties other than trading venues, such as by intermediaries, custodians, transfer agents and clearing houses. The Survey revealed that many CTPs tend to provide the custody of participant assets by providing the service themselves. Some CTPs may outsource custody services to a third-party or allow participants to self-custody their crypto-assets in their own wallets using private keys.
See: Crypto Custody: Our Shared Journey Towards Mass Adoption
Risks associated with a CTP providing custody services include:
Operational failure (e.g. a cyber-attack) and insufficient technology governance arrangements, causing assets to be lost or inaccessible;
Theft, loss or inaccessibility of private keys;
Assets of the CTP may be co-mingled with participant assets which may cause participant assets to not be fully protected in the event of a default;
The CTP may have inaccurate record-keeping; and
The CTP may not have sufficient financial assets to cover participants' claims in the event of financial difficulties or assets being lost due to technological failures.
A regulatory authority may want to assess the process used by a CTP to safeguard and maintain accurate records of participant assets by requiring the following:
Disclosure of participant ownership rights and claims;
Arrangements by the CTP to secure participant assets in the event of theft or loss;
Segregation of participant assets from the CTP and/or other participant assets;
Accurate and reliable records of participant assets and positions;
An audit trail of the movement of crypto assets between the participant, the CTP, and any third parties.
Determining who has access to the private keys for all CTP wallets and whether there are any backup arrangements to prevent a single point of access;
If the CTP uses a third party for its custody services, ensuring the adequacy of measures taken by the CTP relating to the security of the assets held by the third party;
Financial arrangements to compensate investors in the event of a loss of assets (e.g. insurance policies, compensation funds); and
Capital requirements on CTPs to protect against bankruptcy or insolvency, especially if the CTP is performing intermediary functions such as custody of assets.
Statement on "Framework for 'Investment Contract' Analysis of Digital Assets"
Architecting a New World: Investment Crowdfunding and Digital Assets
Key Consideration #3: Conflicts Of Interest
The full-service function provided by CTPs may result in additional conflicts unique to CTPs over and above those applicable to traditional trading venues, such as:
Trading on the CTP by the CTP itself can result in conflicts related to information asymmetry, market abuse and unfair pricing to participants.
CTPs may provide advisory services resulting in potential conflicts when the CTP has a direct or indirect interest in a crypto-asset traded on the CTP.
Conflicts can arise when the system design of a CTP gives preferential treatment to a subset of participants or to the operators of the CTP.
A regulatory authority may want to assess any potential conflicts of interest in a CTP by considering the following:
An evaluation of any policies and procedures established by the CTP to manage conflicts of interest;
Procedures regarding access to confidential information about participants on the CTP;
If a CTP allows its employees, operators or directors to engage in trading on the platform, a review of their trading activities and financial interest in the crypto-assets;
Transparency of policies and procedures that address fair pricing and execution of trades with participants; and
Disclosure of whether an issuer of a crypto-asset is a participant on the CTP.
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