Amid the rapid global adoption of blockchain technologies and the expansion of decentralized finance into areas previously dominated by centralized intermediaries, crypto platforms – including some exchanges – have begun offering interest-bearing opportunities to holders of crypto assets, enabling their clients to earn interest on crypto assets or to lend such crypto assets through the facilities of the crypto platform. Notably, many of these offers include interest-rate returns significantly higher than those offered by traditional financial institutions but the accounts are not insured in a manner similar to traditional bank accounts or brokerage accounts. Although the regulatory landscape in Canada continues to evolve, recent regulatory developments in the United States offer platforms enabling the lending of crypto assets (Crypto Lending Platforms) potential clues as to the issues likely to be considered by Canadian securities regulators evaluating the business, operations, and marketing of Crypto Lending Platforms in Canada.

This insight addresses key considerations for Crypto Lending Platforms operating in Canada in light of recent regulatory developments in the United States.

Regulatory developments in the United States applicable to Crypto Lending Platforms

While interest-bearing accounts have generated significant interest among crypto investors, they have also drawn scrutiny from regulators. For example, this year, state securities regulators in New Jersey, followed by securities regulators in Texas, Alabama, Vermont and Kentucky, questioned whether the BlockFi’s Interest Accounts (BIAs) were unregulated securities offerings. New Jersey went as far as to issue a cease and desist order to BlockFi.

More recently, on September 7, 2021, Coinbase issued a public statement disclosing it had received a notice from the Securities and Exchange Commission (SEC) with respect to its proposed “Lend” program, which is intended to permit users to earn interest on specified assets held with Coinbase, warning that the SEC would take formal action against Coinbase if the company were to launch the program as proposed. According to the September 7 statement by Coinbase, the company was informed by the SEC that it views the Lend program as a security pursuant to the applicable tests under US securities laws. Coinbase maintained its position that its Lend program did not constitute an offering of securities but announced on September 17 that it will not launch its USD Coin annual percentage yield program as it continues to seek regulatory guidance. The actions of the SEC and the Coinbase example are likely to have an impact on the proposed offerings of all Crypto Lending Platforms given the penalties applicable to the unregistered offering of securities.

Considerations for Canadian Crypto Lending Platforms

Although the examples involving BlockFi and Coinbase relate to US securities laws, the regulatory experience of Crypto Lending Platforms and related programs in the United States has raised two questions that would also seem applicable to Crypto Lending Platforms operating in Canada given the existing guidance from Canadian securities regulators:

1. Are cryptocurrencies, tokens and similar assets (“Crypto Assets”) securities under applicable Canadian law?
2. Are Crypto Lending Platforms subject to registration under applicable Canadian law?

1. Are crypto assets securities?

As discussed in our previous insight¹, whether or not a Crypto Asset is a security is a question to be determined on a case-by-case basis. A Crypto Asset will be a security if it satisfies any of the following criteria: (i) the Crypto Asset is an investment contract, (ii) the Crypto Assets issued are securities under one or more of the other enumerated branches of the definition of security, or (iii) the Crypto Assets may be a security that are not covered by the non-exclusive list of enumerated categories of securities. The latter category is broad enough to potentially capture any asset provided the other criteria of a security are satisfied.

With respect to the first category, in analyzing whether a Crypto Asset is an investment contract, businesses and their professional advisors should assess the technical characteristics of the Crypto Asset, the economic realities of the asset and of any offering as a whole. In particular, they should focus on substance over form and consider if the offering of the Crypto Asset involves: (i) an investment of money, (ii) a common enterprise, (iii) the expectation of profit, and (iv) to come significantly from the efforts of others. Another key consideration is how the Crypto Assets are marketed and whether there is a reasonable expectation that the Crypto Assets will be traded on one or more Crypto Asset trading platforms.

In addition to the above noted factors, crypto issuers should be aware of a number of factors, which will be considered by regulators in determining whether a Crypto Asset is a security:

• The stage of development of any software, platform or application necessary for the proposed function of the Crypto Asset;
• The timing of delivery of tokens to purchasers;
• The stated purpose of the offering and use of proceeds;
• The establishment of any “bounty” or similar programs that offer free assets or other benefits to persons who promote the offering;
• whether the issuer’s management team retains a significant number of unsold tokens from the offering or “pre-mines” a significant number of tokens before they are publicly available;
• Whether the token is intended for use as a currency or to have utility beyond the issuer’s platform but there is no demonstrated acceptance or wide usage;
• Whether management’s skill or expertise will likely increase the value of the token (or if management has made such representations);
• Whether the token has a fixed value on the applicable platform that does not automatically increase over time or change based on non-commercial factors;
• Limits on the number of tokens issuable;
• The target market of the tokens;
• Statements from management as to the expected appreciation in value of the tokens; and/or
• Whether tokens are distributed for free.

Issuers should also be aware that, with respect to so-called “utility” tokens – those that have one or more specific functions – the fact that a token has a utility is not, on its own, determinative as to whether an offering involves the distribution of a security.

Whether a Crypto Asset is a security will have significant impact on, among other things, the marketing efforts of crypto issuers, including Crypto Lending Platforms, the ability to offer crypto lending services, and the ability of participants to achieve desired returns. Accordingly, businesses and investors should be mindful of the following conclusions drawn from CSA guidance:

1. If a Crypto Asset is a security, distribution of such Crypto Asset will be subject to the prospectus requirement under securities laws and applicable re-sale restrictions;
2. Crypto Assets distributed in multi-step offerings may nevertheless be deemed securities if they have the features described above;
3. A person or company in the business of trading in Crypto Assets that are securities is subject to the dealer registration requirement under securities laws; and
4. A person or company in the business of promoting a Crypto Asset that is a security may be deemed a promoter of the security.

2. Are Crypto Lending Platforms subject to registration under securities laws?

A second consideration for Canadian Crypto Lending Platforms, based on recent developments in the United States, is the applicability of registration requirements under Canadian securities laws. As mentioned above, a person or company in the business of trading in Crypto Assets that are securities is subject to the dealer registration requirement under Canadian securities laws. As a threshold matter, the guidance in CSA/IIROC Staff Notice 21-329 – Guidance for Crypto Asset Trading Platforms: Compliance with Regulatory Requirements (the “Notice”) applies to platforms that facilitate or propose to facilitate trading of Security Tokens or Crypto Contracts (as such terms are defined in the Notice). Security Tokens are, generally, tokens that satisfy the definition of “security” under Canadian securities laws and, based on prior guidance from the CSA and IIROC, Crypto Contracts include: (i) contracts or instruments that are derivatives based on Crypto Assets; and (ii) contractual rights or claims to an underlying Crypto Asset.

Platforms that do not facilitate or propose to facilitate the trading of Security Tokens or Crypto Contracts are not Crypto Asset Trading Platforms (as defined by the Notice) and are, currently, outside the scope of existing guidance, which indicates that platforms that facilitate the trading of other products or contracts structured as “traditional” derivatives that also provide exposure to Crypto Assets (including commodity futures contracts, contracts for differences or swaps) are also subject to the securities regulation.

Accordingly, it is critical that Crypto Lending Platforms and their advisors determine whether the platform is involved in the trading of Crypto Contracts and/or offers products or contracts structured as traditional derivatives while providing exposure to Crypto Assets. The appropriate category of registration for a Crypto Lending Platform will depend on the nature of its activities and multiple registrations may be required depending on the nature of the platform’s business model and operations. Crypto Trading Platforms that apply to securities regulators for approval, as required by the Notice, should also note that regulators are likely to impose limitations on the types of activities that may be undertaken during the interim period, as a measure to mitigate the risks presented by the platform’s operational model. Such constraints could include limits on: (i) the number and types of products offered, (ii) the types or number of participants, or (iii) the amounts invested by any particular participant. Key considerations in assessing the appropriateness of any limitations, include: (A) whether the platform provides any advice to participants, (B) whether the platform trades on a proprietary basis, and (C) whether there is any differentiation between client types (for example, relating to the sophistication or experience of the participant).

Conclusion

There continues to be an increased regulatory scrutiny of crypto lending activities in the United States and around the world relating to Crypto Lending Platforms. Those operating in Canada should be mindful of the securities law considerations applicable to the lending of Crypto Assets and the regulations applicable to the platforms that enable such activity. For more information or advice with respect to crypto lending and applicable rules, cryptocurrencies and other digital assets, blockchain technology, smart contracts or the evolving regulatory landscape relating to such matters, contact Michael C. DeCosimo or Suraj Rammohan.