A few precautions before investing in cryptocurrencies

Risks of cryptocurrencies

“In my view, one of the main risks is investing without understanding the product you’re investing in or the various factors that can affect your positions,” warns Laure Phuen, co-head of the digital assets and blockchain group and partner . at the Osler office in Montreal.

At the same time, the expert reminds that the term “cryptocurrency” covers several different realities. “Cryptocurrency is a virtual digital asset based on blockchain technology and an encrypted computer protocol. This covers both traditional cryptocurrencies, such as Bitcoin and Ether, as well as ‘stablecoins’, which are backed by an asset whose price is considered stable (such as the dollar),” Lor Phuen summarizes.

Therefore, the risks of investing differ depending on the type of cryptocurrency, and in each case it is important to consider internal and external risks. “The main internal risk of investing in Bitcoin is that the short price of Bitcoin will fall because the investor for one reason or another wants to liquidate his position, while the main external risk, as with any other asset, remains investing through dangerous means. channels (for example, foreign platforms that were the subject of warnings from Canadian securities administrators), the expert emphasizes.

Another theoretical intrinsic risk associated with a stablecoin is that the value of the asset backing it will fall. However, it is important to understand how a stablecoin is “backed” by an asset, and thus the actual level of correlation.

“Stablecoins can be backed by a currency (FIAT), a cryptocurrency or a commodity (such as gold) with real collateral, often over-collateralized, which is actually set aside to reimburse stablecoin holders when needed. but they can also be purely algorithmic, meaning they do not maintain a reserve of the underlying asset, but rather rely on an algorithm that increases or decreases the supply of tokens in the hope of stabilizing the price in a way that correlates with the underlying asset. As Terra’s LUNA has proven, the risk of investing in an algorithmic stablecoin is not limited to the price of the underlying instrument, and rather one should study how the algorithm and arbitrage mechanisms work to understand the respective risks,” Lor Phuen concludes.

Towards a more rigid legal framework

The CSA makes it clear that cryptocurrencies may themselves be securities or derivatives, or contracts or instruments in which cryptocurrencies are traded may constitute securities or derivatives (called cryptocurrency contracts or cryptocontracts).

“In this case, the cryptocurrencies or the contracts under which they are exchanged are subject to the requirements for distribution by means of a prospectus and through registered securities dealers, and Law on derivatives in the case of derivatives,” Lor Fuen concludes.

Rather, she said, the question that should be asked is: Under what circumstances are cryptocurrency contracts or instruments that are not themselves securities considered securities under the CSA’s concept of “cryptocurrency contracts”?

“The concept of a cryptocurrency contract is based on the lack of immediate delivery: when a contract or instrument for the purchase, sale or delivery of cryptocurrency does not create an obligation to immediately deliver the cryptocurrency and is not resolved by immediate delivery of the cryptocurrency, the CSA can consider it a security,” she answers.

“The Financial Markets Tribunal of Ontario recently clarified in a specific case of a foreign platform conviction (Mek Global Limited (Re), 2022 ONCMT 15) that in such a case a cryptocurrency contract is an ‘investment contract’ within the meaning of Securities Law because in the absence of immediate delivery, the investor depends on the efforts of their counterparty to store and then deliver the cryptocurrency in a timely manner,” she adds.

Currently, eight platforms are exempted from continuing to offer cryptocurrency asset contracts under the temporary restricted brokerage regime and under certain conditions aimed at ensuring investor protection. These platforms are also required to register as a broker with the Investment Industry Regulatory Organization of Canada (IIROC) within a specified period.

In addition to the CSA, anti-money laundering authorities have clarified that cryptocurrency exchanges are subject to the laws and regulations that govern them.

“Thus, if regulators continue down the same path, we can expect not so much a new regulatory framework, but primarily an increased application of existing rules and regulatory frameworks through prospectus requirements (and the transparency that comes with it) and registration requirements (including financial strength, asset protection, insurance and other related obligations),” says Laure Phuen.

Other risks

Some cryptocurrency exchanges have recently had to shut down due to volatility. How can investors guarantee that such a situation will not happen to them?

Not working with foreign platforms that don’t follow the rules that apply in Canada, Lor Phuen answers.

“We’re fortunate to have the regulatory framework and big players in the market in Canada. Here I would draw a parallel with the platforms for trading binary options that were so popular a few years ago: the Autorité des marchés financiers (AMF) multiplied the notices to investors and lists of unauthorized platforms, but for a long time investors continued to trade with them, which in some in some cases leading to serious losses, and in other cases falling victim to outright fraud by illegal platforms. Today it is clear that such platforms must be authorized by the AMF and distribute their derivatives products through a duly registered derivatives broker, and it is to be hoped that the number of victims of fraud has decreased. »

From the point of view of cyber security, it is also possible to protect against the risk of hacking, the expert assures.

“Analyzing the terms and conditions applicable to the eight platforms mentioned above, we see a framework for safekeeping and insurance: the safekeeping of at least 80% of the assets of the clients of these platforms must be entrusted to a custodian qualified under securities law. and required insurance against loss of client assets, such as hacking, copying, loss or theft of keys, internal theft or other fraud by employees or managers,” explains Laure Phuen.

These various points show that it is very important to be well-informed before investing in cryptocurrencies and to thoroughly research the companies and platforms you choose to entrust your money to.