Today, we are going to talk about the Order published on November 8th by the SEC. Zachary Coburn, founder of a decentralized exchange, EtherDelta, was charged with operating an unregistered securities exchange in violation of Section 5 of the Exchange Act during the period between July 12, 2016, and December 15, 2017. As part of the settlement with the SEC, Coburn agreed to pay a total of $388,000 in fines.
In this article, we will discuss the Order’s arguments in regard to whether EtherDelta is a security exchange that’s subject to the Exchange Act, which digital assets does the SEC consider as securities and how the SEC thinks the founder should be liable for the violation instead of the exchange. We have further elaborated our analysis as listed below.
1. EtherDelta, as a decentralized exchange, meets the criteria of a security exchange as defined by the Exchange Act.
“Section 5 of the Exchange Act makes it unlawful for any broker, dealer, or exchange, directly or indirectly, to effect any transaction in a security, or to report any such transaction, in interstate commerce, unless the exchange is registered as a national securities exchange under Section 6 of the Exchange Act, or is exempted from such registration. ”
“EtherDelta brought together orders by receiving and storing orders in tokens in the EtherDelta order book and displaying the top 500 orders (including token symbol, size, and price) as bids and offers on the EtherDelta website. EtherDelta provided the means for these orders to interact and execute through the combined use of the EtherDelta website, order book, and pre-programmed trading protocols defined in the EtherDelta smart contract.”
“EtherDelta operated as a marketplace for bringing together the orders of multiple buyers and sellers in tokens that included securities.”
The SEC concluded that EtherDelta is not fully decentralized and was operated as a security exchange. Regardless the “decentralized” feature of EtherDelta smart contract may be unconventional for securities markets and its non-custodial nature, the SEC appeared to focus more on the aspects of the platform’s function, such as whether you have a website, order book and/or a user interface with a trading protocol.
One interesting note in the Order, “EtherDelta provides a user-friendly interface and resembles online securities trading platforms.” user-friendly UI? Possibly the SEC did not trade on EtherDelta back in 2017 or perhaps this is the first trading platform they have actually visited.
It does not matter whether the platform is decentralized or centralized. It does not change the nature of the platform being an exchange as long as it meets the foregoing criteria. If you look like an exchange and function like an exchange, you are an exchange. So now what matters is whether there were securities traded on the platform to upgrade EtherDelta from an exchange to a ‘security exchange’.
2. Digital assets traded on EtherDelta includes securities.
The Order referenced the 2017 DAO report, which was the first time the SEC said a token was a security, and cited that 92% of the trades took place subsequent to the DAO report but did not identify a single token that is considered a security. There were 3.3 million trades and the SEC only needs to name one trade. Just one trade. It would be sufficient for liability but throughout the entire Order, you do not find that answer.
The SEC’s argument simply said “I can tell you what qualifies as a security by applying Howey test and referencing 2017 Dao report. However, I’m not gonna tell you which token is a security in this case. I’m only telling you that there are securities.” It was like when you came home from work and your girlfriend looked really upset. You asked her what’s wrong and she got so irritated and goes “You know what you did.” You have to figure it all out yourself. Asking more question does not help. Here the SEC plays the girlfriend.
3. The SEC went against the founder of EtherDelta instead of the exchange.
The Order pointed out that Coburn caused EtherDelta to violate the Exchange Act by writing and deploying the smart contract, operating a platform that interacts with the smart contact and exercising sole control over the operations. In this case, the SEC is not really at the forefront of the people in terms of compliance. The Order shows that just because it is operated by a decentralized network, doesn’t mean any liability is gone. Decentralization does not protect developers. The government might not be able to shutdown a decentralized network, but at least it could prosecute the person who created it.
As cited in the Order, EtherDelta was sold to foreign buyers in 2017 and Coburn does not currently operate EtherDelta. Then the question is, did the SEC go after Coburn only because he is the creator of the platform and a U.S. resident at the same time? Had EtherDelta been sold to a U.S. buyer, would the SEC have gone after Coburn still?
It’s worth mentioning that a separate governmental agency the FinCEN (Financial Crimes Enforcement Network) has issued rulings with a completely different perspective. The FinCEN believes that software developers who create decentralized protocols would not be subject to the BSA (Bank Secrecy Act) as they do not have control over the software. The company would be instead.
In regard to the debate over who should assume responsibility for decentralized protocols, the FinCEN appeared to be in favor of developers while the SEC, in this case, stands in the opposite. Seeing two separate governmental regulators having different interpretations of the same issue can bring a variety of legal questions and uncertainty to developers. It can be deeply frustrating for developers in need of a clear guidance. Consequently, it would not be a surprise if developers choose to go anonymous in response.
4. Our closing thoughts
There has been a prevailing notion in the crypto space that a decentralized exchange or protocol, in general, would actually not result in any kind of compliance. In this case, the SEC has made it clear that the creator of the protocol should assume liability. The SEC’s strategy here is to set up favorable precedence by penalizing a cooperative small fish before moving on to tougher targets. In translation, “If you work with us, we will make it easier for you.”
It seems like the SEC has been building up this case for a while. Early this year in March, the SEC issued a statement warning about “Potentially Unlawful Online Platforms for Trading Digital Assets.” Eight months later in November, EtherDelta was fined. This is likely the SEC’s first enforcement action to be imposed against a digital assets trading platform. It may be the first ring of the bell tolling for the end of unregistered digital currency exchanges.
As mentioned in the previous paragraph, the Order not identifying which digital assets were securities has brought even more confusions to the current crypto industry. The SEC continues to leave everyone in the dark on what qualifies as a regulated security. We as a digital currency exchange finds it very disappointing as there is no clear guidance for the industry to categorizing security tokens and this also correspond to why it is still unclear how the federal securities laws apply to digital assets. It would not be a surprise to see the SEC keeps avoiding to clarify such regulatory uncertainty. If such issue was brought to the court and the SEC loses, it could disrupt their enforcement strategy. The best way to avoid it is to leave the rules vague and ambiguous.
We are still in the very early stage of the technology and a very little history for the case study. There will be a long way to go and this may be just a start to all the cryptocurrency exchanges.