Can Canada Unlock its Blockchain Potential?

Torys Quarterly: Pressure Points

In the early days of the Internet, there was much skepticism as to its utility, even while those in the vanguard promoted its revolutionary potential.

Ultimately, a community of entrepreneurs and programmers, with government funding, and later with private capital, brought the Internet to the world. Blockchain, the technology powering Bitcoin and other “cryptocurrencies,” is generating similar reactions.

Originally driven by “crypto-anarchists,” the open source development movement and technologically savvy investors, blockchain has the power to disrupt entire industries (including financial services) or even create the basis for a new peer-to-peer internet. Further to that, blockchain has the potential to more broadly distribute the economic benefits of a successful technology by rewarding the users of the services, not just the early investors in a venture.

Canada’s Blockchain Hub

Blockchain also has a hub of talent in Canada – centered in the Toronto-Waterloo Region tech corridor. One notable and promising project, Ethereum, was in large part developed in Canada, and there are blockchain incubators and other hotly anticipated projects based in Toronto.

But despite this local talent, much of the value generated by innovation in the blockchain space is being captured outside Canada. It is a combination of regulatory barriers to cryptocurrency and token issuances and a general air of regulatory uncertainty that is driving developers and entrepreneurs to seek out more predictable jurisdictions like Switzerland and Singapore.

The greatest risk for Canada is the opportunity cost of not being a global hub for a potentially revolutionary technology.

These missed opportunities have concrete costs to Canada. Not only are provincial and federal governments foregoing potentially significant sources of tax revenue, but talent that may contribute to the next wave of technological innovation is leaving Canada. Canadian companies focused on blockchain are increasingly establishing offshore operations as the base for their blockchain activities. Examples of this include Kik, a Canadian company that excluded Canadians altogether from its recent token offering due to regulatory uncertainty, and the Ethereum project’s governing foundation, which is located in Switzerland.

Amid this uncertainty, the greatest risk for Canada is the opportunity cost of not being a global hub for a potentially revolutionary technology.

Regulatory Response to Technology

Regulators’ attitudes toward blockchain technology are understandable: the decentralized, open-source ethos of the blockchain community transcends borders and facilitates transactional pseudonymity. Governmental control has been cited as a basis for bans on cryptocurrency in China and other jurisdictions.

But if Canada is to begin capturing the potential value generated by blockchain technology, a compromise between regulators and the blockchain community needs be reached. What might that compromise look like? We look at two of the main regulatory challenges: securities law and taxation.

Securities Law

Canadian securities regulators to date have responded conservatively to the blockchain revolution, with reference to the existing case law and regulatory treatment of “investment contracts.” That approach is generally consistent with the SEC, although in practice, it appears that bona fide blockchain developers see greater opportunities for U.S. token issuances that have demonstrated consumptive utility (that is, they can be used to pay or reward contributors to the particular blockchain technology). Conversely, the token-based ventures that have been accepted by the Canadian securities regulators to date (through exemptive relief, including Impak and Token Funder) have been limited in scope or have been subject to specific restrictions that differ from the prevailing market practice in other jurisdictions.

Real challenges lie in arriving at a compromise that fulfills the needs of both the government and the blockchain community.

Securities regulators are required to balance investor protection with the support of fair and efficient capital markets. Where novel instruments or structures emerge in the market, typically the regulatory reaction is to “occupy the field” and deal with any perceived immediate investor protection concern. Regulatory innovation or adaptation may follow, but that can be a protracted and ultimately unfulfilling process from the entrepreneurs’ perspective. Consider, for example, the gap between the initial enthusiasm for crowdfunding and subsequent limited uptake after a specific regulatory framework was developed. Canada’s blockchain and broader technology communities will be best served if the securities regulatory response is nimble, timely and competitive with those of other global jurisdictions.

Emerging Best Practices

On the other side of the equation, blockchain’s increased profile and use has arguably started to drive the development of “best practices” by the blockchain community. Increased transparency and blockchain community assessment of specific projects can help “cull the herd” and mitigate the risk of investor loss due to fraud, or simply unviable projects. Investor and regulatory confidence alike should be strongest where:

  • The project team has released a technical white paper that details the technology and does not simply function as a marketing document and, as discussed below, where there has been independent review
  • The project has a website detailing the project, including the backgrounds and biographies of the core management and technology teams and its financial or other sponsors
  • Potential investors have a meaningful way to contact the project team to ask questions
  • The underlying protocol or application of the token is sufficiently advanced in development to demonstrate that the token has meaningful utility
  • The code is open source and audited by credible third parties, which may help expose fraudulent or non-viable offerings
  • The project and its technology are capable of being assessed online by community members, with engagement from the project team
  • The percentage of tokens retained by the foundation and core team is transparent and consistent with market standards

In addition, the cryptocurrency community – traditionally opposed to centralized authority – will need to accept some barriers to entry as a means of filtering fanciful or fraudulent projects so that government’s interest in consumer and investor protection can also be fulfilled.

Presently, the “vetting” of projects is largely performed by reputable community members. This practice often consists of rigorous online reviews of the project and official code audits. In both cases, the results are publicly released so that community members are able to gauge risk and make decisions accordingly.

One option is for the community to accept a formalization of this role – so that regulators and community members can take greater comfort from the credibility of code audits as well. This approach would not be unique. For instance, regulators already rely on reports of the International Standards Organization and the American Institute of Certified Public Accountants. These organizations are not governmental bodies, but they prescribe standards and test compliance.

With these considerations in mind, regulators can develop policy that enables the blockchain community to retain the open-source and collaborative ethos that has allowed it to thrive.

Taxation

Although regulatory issues are a significant barrier to the success of blockchain technology in Canada, taxation cannot be overlooked. Currently, blockchain companies often structure their affairs so that the entities issuing the tokens are located in low-tax, regulation-light jurisdictions such as Singapore, Switzerland and, more recently, Gibraltar.

Tax expenditures are a valuable policy tool, and a regime of tax credits and other financial incentives for blockchain startups can help Canada remain competitive against low-tax jurisdictions and ensure that value created by Canadians is captured in Canada.

Conclusion

Real challenges lie in arriving at a compromise that fulfills the needs of both the government and the blockchain community. But the costs of the status quo are too high. Not only is capital escaping to other jurisdictions, but talent—the real engine of innovation and growth—attracted to this technology is escaping as well.

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The Authors

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