If only law and commerce evolved in tandem, on a parallel timeline that yielded the certainty that business craves. Unfortunately, that hopeful yearning — at least as it relates to the emerging cryptocurrency conundrum — may be more wishful than ever.
In an era where rapid technological advancement is the order of the day — and seemingly becoming more so each and every day — the law, reactive by necessity and restrained in its development by the need for balance among competing societal forces, cannot hope to keep up. This is especially so in the early stages of progress, where lawmakers, regulators and courts can only watch as innovation lunges and lurches at its commercial promise, frequently turning to capital markets to sustain its development as it seeks the forms and outlets that will give it stability and a meaningful bottom line.
It’s not surprising, then, that investor euphoria frequently reaches boiling points in regulatory vacuums, only to dampen when regulators first step in. Of necessity, these initial steps are usually tentative and transitional measures aimed at the bad apples in the capital markets, but lacking the guidance that creates the certainty that propels investor confidence. In the meantime, as investors blink, the pace of innovation can suffer.
So it is with cryptocurrency and its underlying blockchain platform. Consider, for example, that Canada was the first nation to confront the legal issues surrounding cryptocurrency when it amended its money-laundering and terrorism-financing legislation to compel cryptocurrency dealers to register with the Financial Transactions and Reports Analysis Centre of Canada (FINTRAC), keep detailed records and report suspicious transactions. Almost five years later, final regulations have not been published, the rules have not yet come into force and may not come into force until 2020.
Even core questions about the nature of blockchain assets remain unanswered.
“We still don’t have a formal position by several regulators as to the nature of digital assets and whether or when blockchain-based offerings such as tokens are securities as opposed to currencies,” says Usman Sheikh in Gowling WLG’s Toronto office. “If there’s a lack of clarity on this most basic issue, we can see how uncertainty continues to reign in many areas of the law.”
It is true that 2018 saw domestic and foreign regulators take longer, harder looks at cryptocurrency regulation and enforcement. In 2018, both the Canadian Securities Administrators (CSA) and the US Securities and Exchange Commission (SEC) confirmed that most initial coin offerings (ICOs) were subject to their jurisdiction. Later in the year, both regulators cautioned stakeholders about the potential unlawfulness of online platforms for trading digital assets. The CSA also issued a staff notice emphasizing the importance of token purchasers’ reasonable expectation of profit in acquiring tokens as a sign that the ICO was an investment contract subject to securities laws.
There’s little doubt that the increasingly focused regulatory atmosphere and the accompanying investor uncertainty — both of which represent a moving dot on the continuum from the “Wild West” atmosphere that prevailed to propel Bitcoin to a market high near $20,000 in December 2017 — is at least partially responsible for the fall in Bitcoin’s value to about $3,600 in January 2019.
“We were taking three calls a day in this space until about June 2018, when the OSC issued Staff Notice 46-308, which essentially said that almost all token offerings would be treated as securities,” says Allan Goodman in Goodmans LLP’s Toronto office. “After that, interest dropped off tremendously.”
In other words, the regulatory action that has been taken to date may have done more to fray investors’ nerves as opposed to quelling them.
“The guidance given so far hasn’t been particularly helpful,” Goodman says. “It’s true that the regulators have been going after the bad actors, but the vast majority of stakeholders, who aren’t in that category, are still waiting for authorities to come out with formal policies and rules.”
Daniel Fuke in Fasken Martineau DuMoulin LLP’s Toronto office maintains that regulatory postures so far have amounted to little more than a knee-jerk initial reaction that securities laws apply to cryptocurrency offerings.
“All the regulators have done is punt the question of when a token is a security,” he says. “On the whole, there is absolute acknowledgement in industry circles that a token will often be a security, but at the same time there’s a significant space in which a token could be a currency or a utility.”
As it turns out, the idea that a unit of exchange can take different forms is not a unique concept. US dollars or any other established international monetary units could be currency for people who use it to pay for goods and services at the same time that they represent a securities investment for those participating in the currency exchange market.
As well, and perhaps more importantly — because cryptocurrency’s potential as a ubiquitous decentralized currency has many naysayers — part of cryptocurrency’s uniqueness is in creating economic incentives to participate in a platform that benefits the whole network. Bitcoin, for example, uses cryptocurrency to reward “miners” who provide network security by validating transactions.
Interestingly, it’s a Canadian company, Waterloo-based Kik Interactive, that may be the first to have the US courts pronounce on the characterization of cryptocurrency. After the OSC came to a preliminary conclusion that the company’s 2017 offering of about $100 million in digital tokens constituted a securities offering, Kik decided to limits its offerings to the US. But when the SEC came to the same conclusion as its Canadian counterpart, Kik advised that any enforcement action would be challenged in the US courts.
“It’s important for the industry that regulators’ interpretations of the law are being challenged,” Fuke says. “The SEC’s test for whether an offering is a ‘security’ is outdated and didn’t contemplate the emergence of digital assets when the test was formulated. This challenge is clearly needed.”
Kik’s position is that the tokens are intended for use as a currency on its platform, a social networking enterprise aimed at interconnecting a variety of third-party apps that integrate Kik’s messaging app into their software. Services that do so or otherwise promote Kik’s app will be rewarded in “Kin,” digital tokens that can then be spent in the interconnected network.
According to Fuke, the company has strong supporting arguments for its position that Kin tokens are not securities, including the fact that only small amounts were sold to individual purchasers.
“Kik wants people to spend Kin and circulate it in the network,” Fuke says. “It’s not intended as an appreciating investment nor does Kik intend to be responsible for anyone else’s money.”
Vern Krishna, a tax lawyer at TaxChambers LLP in Toronto, says tax authorities are no further along than their securities brethren. But unlike many securities lawyers, he believes that cryptocurrency should be treated as a speculative commodity rather than a currency for tax purposes.
“It’s a sinkhole that no one knows anything about, a highly risky commodity in respect of which gains or losses should be treated as income rather than capital,” he says. “I don’t see any new principle emerging from this particular asset.”
Despite the uncertainty, however, pretty well everyone interviewed agreed that good regulation takes time.
“We’re dealing with novel and complex developments,” Sheikh says. “Regulators and legislators need time to get up to speed on exactly what this technology is about and how to apply existing laws to it.”
Compounding the problem is the shifting landscape. “The markets have been changing so rapidly that it’s difficult for anyone to catch their breath and figure out rules that meet everyone’s needs,” Fuke says.
Meanwhile, it’s not as if securities regulators are standing still. Apart from the guidance that securities regulators have offered, the CSA has established its Regulatory Sandbox, aimed at gaining “a better understanding of how technology innovations are impacting capital markets, [at assessing] the scope and nature of regulatory implications and [at determining] what may be required to modernize the securities regulatory framework.” Several provincial commissions also have dedicated teams to help startups.
To its credit, the Regulatory Sandbox has been the conduit through which authorities have provided exemptive relief to two token offerings and allowed four registered firms to act as investment fund managers for a private cryptocurrency investment fund.
Arguably, however, CSA members haven’t gone quite as far as other regulators in soothing cryptocurrency startups and potential investors.
“FINTRAC will answer certain questions, the SEC will issue ‘no action letters’ and the Canada Revenue Agency has long issued advance rulings,” Fuke notes.
In response, CSA spokesperson Ilana Kelemen advises that “our views on/approach to the cryptocurrency space are in line with most international regulators.”
But CSA, through Kelemen, offered little in the way of assuring investors that greater certainty is on its way.
“The CSA continues to closely monitor the regulatory issues surrounding cryptocurrencies in Canada,” she wrote in an email. “We continue to assess the scope and nature of regulatory implications, and review applications from businesses in the cryptocurrency sector that are subject to securities law.”
As Krishna sees it, that’s not surprising.
“Government and regulators rarely lead,” he says. “They’re more inclined to follow.”