Should Cryptocurrency Exchanges Register with the SEC?

I. Environment Overview

On November 8, 2018 the Securities and Exchange Commission (SEC) issued a cease-and-desist proceeding against Zachary Coburn for operating an exchange (EtherDelta) in violation of the Securities and Exchange Act of 1934.[1] As a result, Coburn was ordered to pay just shy of $400,000 in penalties and interest a for five month period of operation.[2] EtherDelta continues to operate today, although Coburn ceases to involvement with the project.

Currently, more than 200 cryptocurrency exchanges are operating throughout the world.[3] Although each exchange has different operations, protocols and token offerings, many United States exchanges should analyze whether SEC registration is required. To be clear, an analysis should only be done if the exchange is subject to United States jurisdiction, which usually requires a physical presence or application of a long-arm statute. To date, no cryptocurrency exchange has registered with the SEC, which leaves exposure to potential risk if the SEC starts pursuing these actions. Before any trade is executed over a platform, a registration analysis should be done to determine whether registration should be completed.

This proceeding against Coburn may be one of the first signals by the SEC as to future exchange enforcement actions. Although the SEC attempts to reason why this action was pursued, it falls short of giving much needed clarity and comprehensiveness to triggering factors requiring registration. It is my intention to shed light from a legal perspective as to why this action will not change industry perspective on registration.

II. Exchange Legal Regime

A. History of the Securities and Exchange Act of 1934.

The Securities and Exchange Act of 1934 (the “Act”) is the controlling law when determining whether registration is required. The Act was passed in the midst of the Great Depression as part of Franklin D. Roosevelt’s New Deal in an effort to protect investor and avoid another market collapse. The solution Roosevelt came up with was protecting investors through mandatory disclosure of businesses. Entity disclosure was viewed as the solution because companies were issuing worthless company shares, to drive short term growth. Because these companies were undercapitalized, recovery from any unanticipated expense or liability would result in insolvency and render shareholders with a complete loss. This set off a chain reaction where the stock market crashed while investors tried to sell in an attempt to mitigate losses. Roosevelt believed if the shareholder had more information they would be in a better position to make investment decisions. Through broad sweeping disclosure requirements, the markets stabilized to a point where investors re-entered the market.

These disclosure requirements created during the depression era continue to bind broker-dealers, exchanges and securities today. Before the age of technology, middlemen were seen as an important agent in the market because of their ability to inject liquidity and stability into the market. The Act achieved this goal by creating and allowing self-regulatory organizations (SRO’s) to operate within the market.[4] The main purpose of an SRO is to exercise regulatory authority over other market actors on behalf of the SEC. SRO’s are required to make periodic disclosures to the SEC to assure compliance measures are being met. Some well-known SRO’s include the New York Stock Exchange (NYSE), the Chicago Board Options Exchange (CBOE) and the Financial Industry Regulatory Authority (FINRA).

B. Black Letter Law.

The main SRO designation concerning the EtherDelta case is Section 5. This designation makes it illegal for any broker, dealer or exchange to influence any transaction in a security, unless they are registered as a national securities exchange under section 6 or are exempt from such registration.[5] This definition requires an understanding of what an exchange and security are to fully comprehend when registration is required.

Under Section 3(a)(1), an “exchange” is defined as “any organization, association, or group of persons, whether incorporated or unincorporated, which constitutes, maintains, or provides a market place or facilities for bringing together purchasers and sellers of securities or for otherwise performing with respect to securities the functions commonly performed by a stock exchange as that term is generally understood.”[6] Further guidance is given under the Exchange Act Rule 3b-16(a) in determining whether a trading system meets the definition of an exchange. The Exchange Act Rule 3b-16(a) states an organization, association, or group of persons will be maintaining “a marketplace or facilities for bringing together purchasers and sellers of securities or for otherwise performing with respect to securities the functions commonly performed by a stock exchange,” if two elements are met: (1) brings together the orders for securities of multiple buyers and sellers; and (2) uses established, non-discretionary methods (whether by providing a trading facility or by setting rules) under which such orders interact with each other, and the buyers and sellers entering such orders agree to the terms of the trade.[7]

The second definition to understand is “security”. There are four elements to determine whether security registration should be completed: (1) there is an investment of money; (2) with the expectation of profit; (3) from a common enterprise; (4) with the profit being the result from a third party.[8] This has been the definition for over seventy years because of how flexible each element is in application. If this definition is met, the token must either be offered in a private placement or be registered with the SEC. The definition of an exchange and the definition of a security must be read in the same context to give a complete understanding of the law. Whenever an exchange registers under Section 5, the argument of whether securities are being traded or not is not foreclosed upon by the exchange.

III. Grey Areas in Cryptocurrency Exchange Law

By the SEC pursuing this enforcement action against Coburn under the Act, the SEC assumed securities were being traded over EtherDelta. This assumption was evident because an exchange exists for the purpose of trading securities. This is concerning because Jay Clayton, who is the current head of the SEC, recently stated no tokens have been registered as a security.[9] When further pressed regarding when tokens need to be registered, neither Clayton nor the SEC has given a clear answer. Essentially, the SEC is saying securities are being traded, but refuse to give clear guidance on when registration would be appropriate.

To date, the SEC has been slow to analyze characteristics of coins that trigger registration. There has been some light guidance on the subject, but nothing substantial enough to put issuers worries at ease. First, Clayton has said “cryptocurrencies, like bitcoin, are not securities”.[10] From this statement, we assume store of value tokens do not require registration or private placement. This conclusion, by Clayton, could be based on the fact bitcoins can be mined. Therefore, no capital contribution is required by the individual and Howey is not met. Unfortunately, no additional commentary was given on the matter.

Two tokens the SEC said required registration were the DAO[11] and Munchee[12]. In a post DAO failure analysis, the SEC said registration should have been completed as a result of meeting the definition of a security.[13] The purpose of the DAO was to raise money and further the Ethereum platform, which ran similar to a venture capital fund. Through the power of Section 21(a)[14], the SEC determined the DAO tokens should have been registered because of how similarly the organization resembled an investment contract.[15] There was an additional violation of offering tokens through an unregistered exchange not operating within an exception to Section 5 of the Act.[16] Therefore, had the DAO not failed, the SEC said an enforcement action would have been pursued.[17]

In the Munchee case, the SEC walked through all four elements of the Howey test and concluded registration would be appropriate for the “MUN” token.[18] Munchee was a token that was to be used to purchase food and give reviews of food purchased.[19] The Munchee team ran into trouble mainly concerning their advertising. The team was advertising that holders would be able to buy good in the “ecosystem” the team was creating. Munchee also claimed there was to be expected increase in value of the token as this “ecosystem” grew.[20] All this would lead a reasonable purchaser to believe that there were going to be profits as a result of a third party (Munchee) creating an ecosystem (common enterprise).[21] As for the investment of money element, Munchee was looking to raise $15 million to help fund future operations.[22] For the foregoing reasons, the SEC determined registration would be appropriate.

In the Coburn proceeding, the SEC put the horse before the carriage by suggesting an exchange was present without proof of a security offering. Although the SEC was quick to point out over 100 different tokens were traded over the platform, they declined to give any example of security tokens and non-security tokens. As a result, the industry remains unsure about the criteria being used to determine whether a token should or should not be registered. Likewise, exchanges are left pondering whether they should register based on the uncertain status of these tokens.

IV. Possible Alternatives for Registration

Before considering possible alternatives to registration under the Act, there must be an understanding of how financial markets operate. In general, entities required to adhere to regulatory requirements should not and will not disclose information not required. By volunteering privileged information, entities take on additional risk by giving up potentially protected information under the Federal Rules of Evidence. Regardless of how any individual feels about regulatory matters, no market actor will provide more information than required out of self-interest and self-preservation. Therefore, disclosure should be the last choice if no other option exists.

Currently, exchanges are registering as money-transmitters or state-chartered trust companies subject to Commodities Future Trading Commission (CFTC) monitoring.[23] These structures only work as long as the platform is not creating a market for tokens with the “security” designation. Although governments are often playing catch-up with technology, there will come a point when greater clarity is given on token status. When this happens, alternative method of compliance methods will be needed.

In the event the SEC starts designating tokens as securities, and a platform wishes to create a market for such tokens, registration as an alternative trading system (ATS) will be the path of least resistance for these platforms to become compliant under the Act. In 1998, the SEC adopted Regulation ATS in an effort to drive market innovation as well as protect investor. By registering as an ATS, the trading system would operate under an exemption to Section 5 of the Act. Traditionally, large investment banks have created ATS’s (Goldman — SIGMA X, Credit Suisse — CrossFinder, Deutsche Bank — SuperX, etc.) for the purpose of executing large block orders.[24]

If a platform determines ATS status to be beneficial, certain filings will need to be made. The general process involves registering as a broker-dealer and filing a Form ATS with the SEC.[25] By filing form ATS with the SEC, the ATS is giving general notice of its operations and operations. The greatest benefit from registering as an ATS is broker-dealer laws and regulations apply, as opposed to exchange laws and regulations.[26] ATS laws and regulations are set out and enforced by the SEC and the Financial Industry Regulatory Authority.[27] Compliance requirements include fees[28], consumer protection[29], examination[30], and books and records[31].

The level of disclosure depends on the trading volume the exchange allows on any given day. If the ATS handles less than 5% of the aggregate trading volume of each security (assuming the tokens being traded are “securities”) the ATS must only file a notice of operations and quarterly reports, maintain records and refrain from using the words “exchange”, “stock market”, or similar names, which may lead to confusion.[32] If the exchange exceeds the 5% threshold, order display and fair access rules come into play which require more disclosure.[33]

Regulation ATS’s original purpose was to drive market innovation, similar to what cryptocurrency platforms are doing. These platforms offer a new alternative investment class which challenges traditional outdated definitions. Cryptocurrency exchanges are perfectly poised to take advantage of ATS to avoid entity and personal enforcement actions. By registering as an ATS, exchanges such as EtherDelta can avoid having to register under Section 5 and limit disclosure responsibilities. ATS compliance costs are far less than exchange, which allows easier integration of cryptocurrency exchanges into the national market.

V. Effects of the Cease and Desist Proceeding

Other than the SEC showing they are considering exchange registration; this action will have little influence on registration consideration. The penalty assessed against Coburn was not large enough to warrant reconsideration for many exchanges. This penalty also is not considered a criminal offense, further taking out any bite the cease-and-desist proceeding may have had prior to issuance. The only potential silver lining the SEC may have seen is this proceeding does not preempt a private action from moving forward against Coburn or EtherDelta.

Although the enforcement actions changed little as far as considerations of registration, it could be a sign of what could be coming in 2019. It will be interesting to see whether cryptocurrency exchanges start to pursue ATS registration or continue to avoid registration altogether.

[1] In the Matter of Zachary Coburn, Exch. Act Rel. 84553 (Nov. 8, 2018).

[2] Id.

[3] CoinMarketCap, Exchanges — All, https://coinmarketcap.com/exchanges/volume/24-hour/ (last visited Jan. 24, 2019)

[4] 15 U.S.C.A. §78s(a)(1).

[5] 15 U.S.C. §78e.

[6] 15 U.S.C. § 78c(a)(1).

[7] 17 C.F.R. § 240.3b-16(a).

[8] SEC v. Howey Co., 328 U.S. 293 (1946).

[9] SEC Cracks down on initial coin offerings, CNBC, https://www.cnbc.com/video/2018/11/26/sec-cracks-down-on-initial-coin-offerings.html, (last visited Jan. 24, 2019).

[10] Id.

[11] Exchange Act Release №81207 (July 25, 2017).

[12] Sec. Act Release №10445 (Dec. 11, 2017).

[13] Id.

[14] Section 21(a) of the Act authorizes the Commission to investigate violations of the federal securities laws and, in its discretion, to “publish information concerning any such violations.

[15] SEC v. Howey Co., 328 U.S. 293 (1946).

[16] Exchange Act Release №81207 (July 25, 2017).

[17] There is contention on this point because the DAO was set up by Slock.it, which was a German corporation. There was no analysis as to why the SEC has jurisdiction over the German corporation.

[18] Sec. Act Release №10445 (Dec. 11, 2017).

[19] Id.

[20] Id.

[21] Id.

[22] Id.

[23] States differ on the application and whether the exchange is going crypto to crypto or USD to Crypto or vice versa. See generally Coinbase Licenses, https://www.coinbase.com/legal/licenses?locale=en-US (last visited Jan. 24, 2019).

[24] If an institution would like to divest itself of an investment that they hold a large ownership in (say 20% of a public corporation), they cannot go to the normal market and flood the market with sell orders. If they did this, the market for that stock would substantially drop because supply is increasing. Therefore, institutions will trade in dark pools to avoid identity disclosure and posting of the transaction volume and price.

[25] 17 C.F.R. 242.301(b)(1).

[26] 17 CFR 242.30.

[27] 17 CFR 242.30(b)(7).

[28] 17 CFR 242.301(b)(4).

[29] SEC Rule 15c3–3.

[30] ATS’s are subject to examination by FINRA to assure complete compliance measures are being met.

[31] The books and records requirements require the maintaining and preservation of books and records by the ATS.

[32] 17 CFR 242.301(b)(11).

[33] 17 CFR 242.301(b)(5).