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The failure of FTX pushed the sector even lower and raised questions about the transparency and management practices of these still relatively new products based on blockchain technology.MARCO BELLO/Reuters

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If recent events have not brought home the security demands of owning cryptocurrencies, it’s likely not much else can.

In little more than a week, one of the world’s largest and most popular cryptocurrency exchanges went from being a respected high flyer – boasting US$32-billion in assets – to bankruptcy. And tellingly, the failure of Bahamas-based FTX Ltd. spread far beyond its books, reverberating through global cryptocurrency markets.

With global values already declining, the failure of FTX pushed the sector even lower and raised questions about the transparency and management practices of these still relatively new products based on blockchain technology.

The contagion, which originated and spread in a jurisdiction with far fewer regulatory controls than in Canada, may hold lessons for Canadians who are either cryptocurrency investors or considering future purchases.

While only 13 per cent of Canadians own cryptocurrencies, according to an October survey by the Ontario Securities Commission (OSC), 31 per cent said they plan to buy these assets over the next year.

If they confine their transactions to Canada, they will be making their purchase in one of the few jurisdictions in the world with a regulatory structure that uses a broad range of tools to oversee the sale of cryptocurrencies.

The OSC along with the other provincial securities regulators, the Investment Industry Regulatory Organization of Canada, and the Financial Transactions and Reports Analysis Centre of Canada regulate crypto exchanges.

The Office of the Superintendent of Financial Institutions (OSFI) supervises federally regulated financial institutions and pension plans to determine whether they are in sound financial condition and meeting regulatory and supervisory requirements. As such, OSFI does have a role to play when these organizations are either investing in, issuing or acting as custodian for cryptoassets. This role often takes the form of guidance regarding risk management practices.

Canadian retail investors are also barred from owning more than $30,000 in so-called “alternative” or altcoins as a consumer-protection measure. The four that are not restricted include bitcoin, bitcoin cash, ethereum and litecoin.

Dean Skurka, president of Bitbuy Technologies Inc., a registered exchange and one of the largest in Canada, notes that Canada’s system stands out in this respect. Its regulatory framework should “encourage” investors who are thinking of buying these products from registered exchanges to know that these platforms are “safe, secure and compliant,” he says.

“When you look internationally, you see a lot of activity in this industry, but you don’t see a ton of regulation around these platforms.”

He notes some exchanges with light or no regulation that have collapsed in the past few years, including in Canada have been “incredibly popular.”

Yet, these firms “did not have the controls or oversight in place to actually run these businesses effectively or properly,” he says.

Whether to hold crypto directly or through an exchange

Notoriously, the day-to-day security of owning cryptocurrency assets can require a relatively high level of care and attention from investors. In the case of assets that are kept in what are sometimes known as self-hosted or non-custodial wallets, in which investors hold the assets directly and not through an exchange, security is entirely on the shoulders of the owner and is dependent on the proper use and storage of passwords.

That means creating long and intricate passwords, using multi-factor identification if required, storing passwords securely – a process that can be complex in itself – never sharing them, and ensuring devices, where the information may be accessible, are never lost. If these passwords, also called private keys, are lost or stolen, the investor’s assets may be permanently inaccessible.

However, for those who hold assets through an exchange, security issues have a different focus, says Lois Tullo, instructor of financial services at the Schulich School of Business at York University in Toronto.

These investors need to be especially vigilant about the custodial arrangements used by their exchange, which can become vulnerable to hackers when assets are moved over so-called digital “bridges” on the internet to other locations.

While custodial security at crypto exchanges is improving, Ms. Tullo says, “they are not there yet,” when it comes to offering the level of security represented by traditional financial services organizations like banks.

“Third parties are always looking for holes in the dyke,” Ms. Tullo says, noting that all it takes is a few successful breaches – of the hundreds of millions of cryptocurrency transactions that routinely take place – for hackers to achieve their goals.

“When you are thinking of cybersecurity, you need the wall to be 100 per cent secure,” she says. “If you are the hacker, and you send out a million attacks, you only need one to work.”

That can lead to huge losses for individual investors when the exchange they use is breached successfully.

“The whole reputational risk and loss of confidence in the crypto market [as a result of a breach], drives down the price – so, everybody suffers,” she adds.

For those who wish to enter the market without having to master the complexities of self-hosted wallets, there is a growing range of options.

In Canada, the most significant protections for investors are likely to be found in the use of a regulated exchange. While there are no guarantees against losses due to fraud or mismanagement, these risks are reduced. Regulated exchanges with technical support, including recourse when passwords are lost, may also provide additional reassurance for some investors, especially those new to the sector.

“When it comes to security, and you’re primarily talking about first-time entrants, it’s really important that they use a registered, centralized exchange,” Mr. Skurka says.

“What we’ve seen over the course of this year is the undue risk that Canadian investors put themselves under when they use unregistered, international platforms with little oversight or recourse, in the event that things go wrong.”

And in any case, certain types of risk, such as identity theft or online manipulation, extend to many types of traditional financial institutions, Mr. Skurka points out.

Investors ‘lured in at the wrong time’

Dan Hallett, vice-president, research, and principal at Highview Financial Group, also thinks Canada’s regulatory regime may be better than other jurisdictions at helping investors avoid a permanent loss of capital through fraud.

However, he’s not convinced that cryptocurrencies are ever a wise choice. In his view, it’s too difficult to assess the underlying values of these assets, unlike stocks which can be assessed on the basis of a company’s performance as a business over time, and in the context of a sector.

“I don’t see the fundamentals of crypto that would allow us to make a judgment about whether the price is fair, cheap or expensive,” he says.

In addition, there’s a long history of investors becoming infatuated with volatile investments, he says.

And even though such assets may eventually do well, retail investors “tend to get lured in at the wrong time,” Mr. Hallett notes, typically near the top of a cycle.

“Investor behaviour gets in the way of the vast majority of people being able to experience a good return [in volatile investments],” he says.

Editor’s note: An earlier version of this story had incorrect information that listed the Office of the Superintendent of Financial Institutions as one of the regulators of crypto exchanges in Canada.

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