CheckFirst Crypto Investor Guide
Cryptocurrencies and the broader crypto asset landscape have seen significant growth and interest from the public. As a high risk alternative investment, there are considerations and scams you should be mindful of before you invest. Learn the fundamentals of crypto assets with the unbiased CheckFirst crypto investor’s guide.
- What crypto assets are and how securities law applies
- How crypto assets are bought, sold and held
- The major risks, scams and investor considerations
- And much more
What are cryptocurrencies?
Cryptocurrencies are digital coins or tokens that typically rely on distributed ledger technology and cryptography to permit the holding and transfer of the value or interest represented by the coin or token. Although many are decentralized, some are operated by one or more parties with centralized control. Although they are commonly referred to as “cryptocurrencies”, this can be misleading, as to date, they have not been legal tender under the Currency Act (Canada). We generally call them “crypto-assets” to avoid this confusion. In many cases, crypto-assets are subject to securities law in Canada.
Crypto-assets may act as a store of value (like money), perform a function or represent an interest in an asset or enterprise. Crypto-assets like Bitcoin and Litecoin have been offered to the public including through initial coin or token offerings and may be made available on a variety of trading platforms and in private transactions. Unfortunately, the parties making these crypto-assets available for sale may not be complying with securities law.
Do Canadian securities laws apply to cryptocurrencies?
Alberta securities laws can apply to the trading of a crypto asset in a variety of circumstances.
Crypto assets are sometimes referred to by names such as “utility token”, “payment token”, “virtual asset”, “digital currency” or “stablecoin”. The name given to the crypto asset does not determine whether or not it is subject to Alberta securities laws. It is important to consider the definitions of “security” and “derivative” in Alberta securities laws, having regard to the characteristics of the crypto asset itself, as well as the way it may be offered or traded. See the full definitions of those terms in the Securities Act (Alberta).
Generally, Alberta securities laws will be engaged in respect of a crypto asset if the crypto asset is a security or derivative itself. However, securities law may apply to a trading platform even if the crypto asset is not itself a security or derivative if the way it is traded creates a security or derivative. Securities law will also apply if the crypto asset is the asset underlying an investment pool or underlying a derivative.
Crypto Trading Platforms: Regulation and Enforcement
The Canadian Securities Administers (CSA), has published a webpage with up-to-date information on registered crypto trading platforms, banned crypto trading platforms, and information on platforms currently seeking registration.
Canadians considering buying or selling crypto assets should use platforms registered with Canadian securities regulators and avoid using platforms banned by Canadian securities regulators. Platforms that do not comply with Canadian securities laws present significant risks to customers because investors’ assets may not be adequately safeguarded.
When do Alberta securities law apply to crypto assets?
Alberta securities laws will apply to crypto assets in many cases, but not all. Crypto assets are sometimes referred to by names such as “utility token”, “payment token”, “virtual asset”, “digital currency” or “stablecoin”. The name given to the crypto asset does not determine whether or not it is subject to Alberta securities laws.
Generally, Alberta securities laws will apply to a crypto asset if any of the following circumstances apply:
- The crypto asset itself meets the definition of “security” as set out in the Securities Act (Alberta). For example:
- It has the characteristics of a commonly known security, such as a share or a unit of an investment fund.
- It is a document constituting evidence of title to or interests in the capital, assets, property, profits, earnings, or royalties of a person or company.
- It is a bond, debenture, note or other evidence of indebtedness (other than a deposit issued by a financial institution).
- It is a profit sharing agreement.
- It is an evidence of an option, subscription or other interest in or to a security.
- The crypto asset is offered or sold in a manner that creates an “investment contract” as that term has been interpreted by the courts.
- CSA Staff Notice 46-308 Securities Law Implications for Offerings of Tokens provides guidance respecting when a crypto asset offered in an initial token offering or initial coin offering will be considered an investment contract and therefore a security. Although they may be labelled ‘utility tokens’ the offering of tokens under an initial coin offering or an initial token offering has generally appeared to constitute a sale of securities.
- The crypto asset is one of the assets in an investment pool offered to investors.
- The crypto asset itself meets the definition of “derivative”, as set out in the Securities Act (Alberta) for example, as an option, swap, forward contract or other financial instrument whose market price is derived from an underlying price, value or thing.
In addition, even if the crypto asset is not a security or a derivative, Alberta securities law will apply if the crypto asset is traded in a manner that creates a derivative or a security, for example, by a platform that holds custody of the crypto asset such that the client only has a contractual right or claim to the underlying crypto asset. See CSA Staff Notice 21-327 Guidance on the application of Securities Legislation to Entities Facilitating the Trading of Crypto Assets.
Considerations before investing in cryptocurrencies
Lack of regulation or regulatory compliance: Capital-raising efforts involving selling crypto assets to investors in Canada will often need to comply with securities laws for the sale of securities, e.g., a prospectus or prospectus exemption. Similarly, the platforms that allow trading of crypto assets often need to comply with securities laws, such as the requirement to be registered as a dealer and regulated as a marketplace. Some offerings may have occurred that were not made in compliance with securities laws and platforms may be operating without complying with the requirements applicable to them. Further, in some cases, platforms may not be subject to securities law. See CSA Staff Notice 21-327.
These situations give rise to real investor protection concerns. Offerings that do not comply with securities laws will often not provide investors with appropriate disclosure or may provide information that is false or misleading. Offerings may be so highly risky that they are not suitable for most investors. Worse, in some cases the offerings may be fraudulent as, unfortunately, the anonymous nature of crypto assets can attract parties engaged in illegal business.
Regulated dealers and marketplaces are subject to various requirements designed to protect investors, such as relating to:
- Background checks on the people who operate the trading platform.
- Working capital and insurance requirement.
- Minimum levels of proficiency and experience.
- Keeping accurate records of client assets and reporting to clients.
- Keeping client assets in safe custody and separate from the platform’s own assets.
- Protection of personal information.
- Addressing conflicts of interest and not taking advantage of clients.
- Minimum amounts of capital and insurance.
- Fair trading rules.
- Prevention of market manipulation.
- Ongoing regulatory oversight.
None of these protections may exist with an unregulated platform. As a result, the people running the platform may not have the necessary experience or financial resources and there may be no insurance or other protection to cover losses. Further, if the platform is located in a foreign jurisdiction, there may be significant limitations on commencing legal action or recovering assets.
There are many other risks associated with crypto assets, including:
Volatility: Trading in many cryptocurrencies has been extremely volatile. Investors may lose all their investments.
The value of a cryptocurrency is often determined solely by the public’s interest in it and current levels of supply and demand. There is often no inherent value to it. Media coverage of a cryptocurrency can have a major impact on its value over a short period of time without any organization or mechanism mitigating volatility. The price of a cryptocurrency may be driven primarily or solely by speculative demand that may be unsustainable. The resulting volatility can result in dramatic fluctuations in the value of your investment. Further, publicly available reports have suggested that trading on some platforms is overstated and fake, creating unreliable pricing information and misrepresenting the level of interest. A collapse in demand for a cryptocurrency may result in you losing all or most of your investment.
Liquidity: It may not be easy or cost-effective to trade your cryptocurrency for another cryptocurrency or for money that is legal tender. There is limited liquidity in some cryptocurrencies and prices and bid-ask spreads (that is, the spread between the price sought by a seller and the price offered by a buyer) may vary widely across cryptocurrency trading platforms. Cryptocurrency trading platforms may limit or suspend trading, or there may be limitations or suspensions imposed on funding and withdrawals from accounts. These risks may limit your ability to liquidate your investment on a timely basis or without significant expense.
Loss through fraud, theft or hacking: Cryptocurrencies are represented digitally and as such are susceptible to loss through theft, hacking and the compromising or loss of digital wallets and keys. Further, there is a risk that software code behind the crypto asset may not actually function as it is represented and/or it may be subject to change. Since cryptocurrencies are typically sold online, their creation and sale may be by persons located in foreign jurisdictions making it difficult for law enforcement agencies to monitor or take action. Additionally, because trading in cryptocurrencies is largely anonymous, it can attract parties engaged in illegal businesses and with unscrupulous practices. These characteristics make cryptocurrencies attractive to those intending to perpetrate scams and fraud. These risks could result in the loss of your investment.
Important questions to ask when investing in new crypto coins, tokens and projects
A key element to investing successfully is researching and fully understanding what you’re investing in. Before investing in any crypto assets that interest you, consider the following questions to help you better qualify the legitimacy and purpose of the token or coin.
- What is the intended purpose of the token or coin?
- Is it used significantly for illegal or illicit activities?
- Who created it and how do they profit from the use or trading of the token or coin?
- Is it a security? Was it issued in compliance with securities legislation?
- What is the risk of law enforcement or regulatory action?
- Is there any significant litigation in respect of the token or coin?
- What are the risks with the coding or underlying distributed ledger technology e.g., bugs or loopholes in a smart contract that can be exploited?
- Is anyone or any group controlling or potentially able to control the network?
- How liquid is it, how much does it trade? Is the information about trading volumes from a reliable source?
- How volatile is the price? What is the trading history?
- Is there a risk that the crypto asset is being promoted as part of a “pump and dump” scheme e.g., a group of parties hyping and promoting buying and/or creating a false impression of demand to inflate the price so that the initial group can sell and profit before the price collapses?
- Does it trade on regulated platforms? What are the risks associated with the platform? See “What are the risks if a crypto asset trading platform is not registered?”
- How many coins or tokens are in circulation? How many can be created, minted or mined? When?
- Are there any planned forks, air drops, or other events that can be anticipated to affect the investment?
- Is there an active developer community in respect of the coin or token?
- What is the consensus mechanism e.g., proof of work or proof of stake?
- If it is a stablecoin, what independent assurance is there with respect to the existence of the backing or reserve? Is the issuer a regulated financial institution? Is the reserve independently audited? What risks are there that a holder will not be able to redeem on demand? What limitations or conditions are there to redemption?
Other ways to invest in cryptocurrency
You can invest indirectly in certain cryptocurrencies, i.e., Bitcoin and Ethereum, without having to directly acquire the digital coins. There are now a number of exchange-traded funds (ETFs) that hold Bitcoin or Ethereum, two of the most highly traded crypto assets. Publicly traded funds are generally required to hold predominantly liquid assets so that they are able to provide redemption on demand. Private investment funds typically only allow redemption on an annual basis and therefore may invest in less liquid assets. If the fund is private, you may not be able to access it unless you qualify for a prospectus exemption. Both public and private investment funds are generally required to use a licensed custodian to hold the fund assets. While more readily accessible, cryptocurrency investment funds are still susceptible to the inherent risks of the cryptocurrencies they invest in, including market volatility, cyber-attacks, reliance on technology, and the fact that most cryptocurrency marketplaces are not currently regulated. If you are considering investing in a cryptocurrency fund, you should be mindful that you could lose some or all of your investment.
Remember that cryptocurrency investment funds offered to Albertan investors need to comply with Alberta laws.
Starting a business involving cryptocurrencies
If you are looking to deal or advise in cryptocurrencies or start a cryptocurrency trading platform, please refer to to the ASCs section on Financial innovation in the capital markets.