Cryptocurrency regulations don’t serve customers

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Reading Time: 4 minutes

By Daniel Duarte
Research associate
Frontier Centre for Public Policy

Canadian regulators are putting a crosshair on exchanges that hold cryptocurrencies for their clients.

This business model, also called a custodial or centralized exchange, is prevalent all over the world but is headed for extinction in Canada, setting back the nascent financial technology (fintech) industry.

On Jan. 16, the Canadian Securities Administrators (CSA) – an umbrella organization of provincial regulators – issued a formal notice telling custodial crypto-exchanges they are subject to securities legislation and regulations. It expands a March 2019 guidance document stating exchanges must abide by securities laws if they allow the trade of crypto-assets that are securities or derivatives.

Most initial cryptocurrencies, such as bitcoin or litecoin, are decidedly not securities. Their creators designed them to work as digital money, period.

However, several spinoffs mimic more sophisticated financial instruments: they give holders voting powers, promise dividends or offer an option to purchase an asset in the future. This is the case with many initial coin offerings (ICOs) and security token offerings (STOs), new ways startups can raise capital outside the traditional banking system.

Before the new notice, an exchange in Canada could avoid being subject to securities law if it refrained from listing digital assets like ICOs/STOs on its platform. Now, no matter the cryptocurrencies listed on an exchange, all it needs to do to fall under CSA jurisdiction is hold those assets for its clients – even for a short time.

Syskinds, an Ontario-based law firm, has noted the CSA’s view is that custodial exchanges offer a “promise” to deliver cryptocurrencies, exposing investors to risk and speculation. Thus, it’s a form of investment contract or derivatives sale subject to securities law. The only way for exchanges to be exempt is for them to deliver cryptocurrencies to users right away.

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“It is not enough for a crypto-platform to merely record the transfer on an internal ledger. It is also not enough if the transfer only occurs on client request. It has to be immediate, automatic, and full,” Syskinds associate Eva Markowski explained.

Exchanges are online platforms that facilitate cryptocurrencies’ trade and storage. For instance, once clients purchase bitcoins for dollars from a custodial exchange, they can keep them there until they decide to trade them again for dollars or another cryptocurrency. This increases liquidity and reduces transaction costs.

Digital wallets are where individuals and firms keep their coins. Only those who have a wallet’s password can move funds inside it. People can choose to hold their wallets themselves – e.g. in a computer or a smartphone – or entrust them to specialized firms, akin to bank accounts (minus the lending operations). Both approaches entail risks: the former that the device gets stolen, thrown away, or becomes unusable; the latter usually involves insolvency, fraud or security breaches.

Unfortunately, crypto-exchanges losing their customers’ funds due to hacking or outright theft by the custodians is not rare. Canada has had some recent high-profile cases. QuadrigaCX, the country’s largest bitcoin exchange until 2019, collapsed when its founder took the master wallet’s password to his grave, along with US$190 million worth of clients’ crypto assets. In November, another exchange simply shut down without notice, cutting off owners from $12.4 million worth of cryptocurrencies held in their custodial wallets.

These cases may have precipitated the CSA decision, seeking to protect consumers from similar losses.

Regulators should be careful what they wish for. Virtually all major exchanges operate custodial models because fintech firms have better cyber security practices than the average investor.

The new rule shifts all the burden and risks to consumers. Pamela Draper, president and CEO of the Canadian exchange Bitvo, has warned the move might push out many investors. “Not everyone, [not] every consumer transacting in the crypto space has their own wallet or is comfortable with their own wallet,” she said.

For instance, users who forget their personal wallet’s passwords generally lose their funds forever. Custodial exchanges provide for a recovery method with identity verification. Personal wallets may work fine for some traders but a one-size-fits-all approach is ripe to backfire. Investors who feel they’re not prepared to handle security risks should be able to delegate that function, otherwise they will stay out of the crypto market altogether.

Custodial exchanges unwilling or unable to comply could no longer be able to operate in Canada. This will hurt small and new startups seeking to enter the industry.

Due to the borderless nature of cryptocurrencies, however, the CSA decision not only affects Canada-based exchanges. Christine Duhaime, a Canadian crypto-law specialist, has explained that any operator who onboards Canadian residents is now subject to Canada’s securities law.

This will probably lead to exchanges across the globe blacklisting Canadian residents, as is the case with New York residents in the United States to avoid the onerous BitLicense.

Canadian regulators “are pushing back against custodial exchanges hard. … If this happened in the United States, it would be catastrophic for that industry,” Nic Carter, a partner with the Boston-based investment firm Castle Island Ventures, has noted.

We should heed the warning of our neighbours.

Daniel Duarte is a research associate with the Frontier Centre for Public Policy.

© Troy Media

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The views, opinions and positions expressed by columnists and contributors are the author’s alone. They do not inherently or expressly reflect the views, opinions and/or positions of our publication.

By Daniel Duarte

Daniel Duarte is Econ Americas’ Spanish and English editor. A journalist and university instructor, he studied philosophy at the National University of Asunción, Paraguay. He holds a certificate in English-Spanish translation from the University of Toronto, Canada

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