Bitcoin and crypto regulations often sound in favor of crypto enthusiasts and investors but that is not always the case. Recently, cryptocurrency exchange Kraken outlined flaws in the regulations proposed by the Canadian Securities Administrators (CSA) and the Investment Industry Regulatory Organization of Canada (IIROC). Kraken went ahead and suggested amendments to the proposed Canadian framework by publishing a document that covers all the necessary aspects of crypto dealings overlooked by CSA and IIROC.

CSA and IIROC issued a consultation paper that explained the proposed regulations and asked exchanges for their feedback on it. Replying to the proposed solution, Kraken appreciated regulators for clarifying when crypto assets acted as securities and when they were considered as a mode of payment. However, Kraken suggested that cryptocurrency exchanges should not be regulated under the framework applicable to securities or derivatives. While respectfully disagreeing, Kraken stated that assets are owned by the customers and not the exchange operator so assets shouldn’t be treated as securities. Therefore, Kraken concluded that application of a securities legal framework was neither appropriate nor necessary.

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Kraken stated that operating models of exchanges varied but there were some set of rules that could be tested against exchanges to ensure that customer’s interests were not derived from the underlying asset. Instead, their interests were the underlying assets. The key elements suggesting that assets were owned by customers instead of exchanges were:

“1. Contractual terms indicating that the relationship is in the nature of a custodial

2. A customer has the right to dispose of the assets at any time by transferring them off of the

3. Contractual terms governing escheatment of the underlying asset

4. With respect to bank accounts holding customer funds, titling of the bank account as a “for the benefit of” (FBO) or “custodial” account, or similar wording”.

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Kraken also addressed risks associated with crypto trading and pointed to the matter that exchanges often acquired SOC (System and Organization Controls) certification most of the time to assure customers that internal control and operations of the company are not harmful to user’s interests. Furthermore, Kraken stated that regulators defining a ‘suitability’ model to protect customers wasn’t the way to go. The paper explains that while the model was dependent on the user’s income or assets, it restrained customers to invest in accordance with their risk appetite. By clarifying that the extent to which an investor can invest is better understood by him than regulators, Kraken advised that educating people rather than protecting them was necessary to make sure that smart decisions were made by the customers.

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Through the paper, Kraken also dealt with several issues related to conflict of interests raised in the framework. After demonstrating that the proprietary trading was scarcely practiced by exchanges, it was suggested that this practice benefited customers by adding liquidity to the markets and resulted in better prices for customers. So, even when it is practiced, customers gain from it. On the issue of trading of insider information, Kraken clarified that crypto assets are decentralized, therefore they can’t be controlled. Hence, trading of insider information was not possible at all.

The Friction Between Crypto Exchanges and Canadian Regulators

Regarding possession of user’s cryptocurrency in wallets controlled by exchange, the paper stated that as people lacked sources and technology to secure their wallets, exchanges took care of the crypto assets on the behalf of their customers. Furthermore, if users accidentally forget their key, they can be retrieved after going through a procedure to confirm their identity. Kraken stated that this was something which was not possible if users lost their keys to a private wallet.

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This shows that having wallets on an exchange was way more favorable for customers who otherwise had to choose private wallets. However, Quadriga CX incident reveals that exchanges having control over cryptocurrency wallets, created a lot more problems than it solved. It all began with the sudden demise of Gerald Cotten, founder of Canada’s largest crypto exchange, Quadriga CX. Following his death, panic spread as Cotten was the only one who knew the password of cold storage wallets containing $190 million worth of digital assets. So, Kraken’s solution can readily backfire as Quadriga’s incident undermines this claim.

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On the matter of surveillance to prevent market manipulation, Kraken elaborated that prices of bitcoin were almost impossible to be manipulated by exchanges. It was explained that in order to manipulate bitcoin’s price, several global exchanges needed to be manipulated which was both very difficult and expensive task.

At the moment, cryptocurrencies are not considered as legal tender in Canada but the government bodies have been taxing crypto gains since 2013. On the other hand, cryptocurrency exchanges are legal in the country. In 2017, CSA extended securities law to cryptocurrencies and have now proposed a framework to modify rules imposed on cryptocurrencies.

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Kraken was one of the 10 exchanges mentioned in Bitwise’s report that didn’t fudge data and showed authentic trading volume. Kraken has addressed several concerns highlighted in the consultation paper but there’s no guarantee that Kraken’s response will impact the future of cryptocurrencies and regulations in Canada. The case might become stronger if several other exchanges also participate in the process as it will increase the chances to influence crypto framework.

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