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A few years ago, cryptocurrency was largely viewed as the domain of techno-utopians, anarchists and criminals. But financial services regulators are slowly but surely charting a path to regulating mainstream crypto trading.

Last year, the Canadian Securities Administrators (CSA) and the Investment Industry Regulatory Organization of Canada (IIROC) initiated efforts to regulate crypto trading, and released a joint consultation paper on the matter in March 2019. The CSA and IIROC plan to publish an update this autumn, but progress is already being made elsewhere.

In early August, the Ontario Securities Commission (OSC) issued a decision permitting Toronto-based Wealthsimple Digital Assets Inc. to operate the first regulated crypto-asset trading platform via the CSA’s regulatory sandbox. The sandbox allows companies to test ideas without having to meet the full set of traditional regulatory requirements.

Among other measures, the OSC ruling exempts Wealthsimple from trade reporting, prospectus requirements and certain other obligations for up to 24 months. These measures will allow Wealthsimple to test its platform while working toward IIROC registration.

With this ruling, the OSC gave the first green light to regulated crypto trading in Canada, and indicated the operating model that may get regulatory approval.

Regulators are concerned about the added risks to inves-tors posed by the crypto market. One of the key risks is the security of clients’ cryptoassets. The crypto sector’s brief history is already littered with examples of inves-tors losing money to hacking and other misconduct.

According to the OSC decision, Wealthsimple will not hold any client assets in its
own crypto wallets. Instead, Gemini Trust Company LLC — which is licensed and regulated by the New York State Department of Financial Services and meets the requirements of a “qualified custodian” under the CSA’s rules — will have custody of Wealthsimple clients’ assets.

In addition, Wealthsimple will operate a “closed loop” system. Clients won’t transfer their assets to a personal wallet and won’t be able to transfer assets into their Wealthsimple account from another crypto platform. This approach is expected to “significantly reduce the likelihood of fraud, money laundering or client error in sending or receiving cryptoassets to incorrect wallet addresses,” the OSC’s decision states.

The OSC ruling also demonstrates that regulators increasingly view crypto trading as falling under securities regulation unless clients take immediate delivery of their crypto purchases.

In January, the CSA issued new guidance that states crypto trading platforms won’t fall under securities regulation if three conditions are met: the cryptoasset is not a security or derivative; a client’s trade creates an immediate delivery obligation; and the cryptoasset is delivered to the client.

Absent immediate delivery, regulators decided that an investor’s claim to the cryptoassets held by a firm on the investor’s behalf amounts to a security (or derivative) — meaning the crypto trading is subject to securities law, even if the cryptoassets involved aren’t defined as securities or derivatives.

For example, under the OSC’s decision, investors will enter into “crypto rights contracts” with Wealthsimple, allowing them to trade Bitcoin and Ethereum on the platform. That trading will constitute securities trading as far as regulators are concerned.

This same concept came up in an enforcement case brought forward by the OSC in mid-July regarding Toronto-based Coinsquare Ltd., a crypto trading platform, and a couple of its executives. In that case, the OSC alleged that Coinsquare engaged in wash trading in an effort to pump up its reported trading activity; the OSC argued such action amounts to market manipulation.

In a settlement with the OSC, Coinsquare and the executives admitted to breaching securities law by engaging in manipulative trading that accounted for about 90% of Coinsquare’s reported volume; lying to investors who were skeptical of the reported trading activity; and retaliating against a whistleblower who raised concerns about the trades.

The case begins a series of firsts for Canadian regulators. It marked the OSC’s first use of provisions to protect industry whistleblowers; its first settlement with a crypto trading platform; and the first case to establish that fake crypto trading could be considered market manipulation under securities law — even though the securities being manipulated were not the crypto itself, but the clients’ contractual rights to cryptoassets held by Coinsquare in its wallets on behalf of clients.

The findings in the Coinsquare settlement follow a higher-profile case — the OSC’s investigation into QuadrigaCX, the failed crypto platform run by Quadriga Fintech Solutions. That case also touched on some of the same concerns about the lack of security and transparency in the crypto sector.

The OSC’s investigation of QuadrigaCX concluded that the platform was essentially a traditional fraud wrapped in crypto clothing — involving unauthorized trading, misappropriation and Ponzi scheme tactics — that ultimately cost $169 million of investors’ money.

The Quadriga case was “an extreme example” and “not necessarily representative of the broader cryptoasset trading platform industry,” an OSC report, released in June, stated. “However, these events serve to highlight for investors the risks that can arise in relation to crypto asset trading platforms, particularly those that are not registered.”

Since the downfall of QuadrigaCX, regulators have determined that crypto trading platforms that hold assets on behalf of clients are likely to be subject to securities regulation. Now, with the decision to permit Wealthsimple to play in the CSA sandbox, the OSC has begun setting the terms for crypto trading platforms getting registered as securities dealers.