By: Lori Smith, Michael Psathas and Jamie Wang
On March 7, 2018, the US Securities and Exchange Commission (SEC) issued additional guidance with respect to digital assets trading platforms, affirming that platforms that offer trading of cryptocurrencies that are securities and operate as an “exchange,” as defined by the federal securities, must be registered with the SEC or operate under an exemption from registration. The SEC’s statement focuses on trading platforms that allow investors to buy and sell the vast array of digital coins including Bitcoin, Ethereum and Litecoin. The SEC guidance follows on the heels of an SEC action announced on February 21, 2018 against a former cryptocurrency exchange, Bitfunder, and its founder, who were charged with operating an unregistered exchange and defrauding its users.
The SEC’s principal concern is that many online trading platforms are currently unregulated vehicles that engage in the activities of an exchange. Unless registered, the SEC has not reviewed the trading protocols used by the platforms, which include how buy and sale orders are executed. In fact, trading services offered by the platform may not be the same for all users, and some investors may have certain advantages to the detriment of other investors. The SEC has long held that these basic investor protections are essential for the integrity of any exchange.
A trading platform will be considered an “exchange” if it brings together the orders for securities of multiple buyers and sellers and uses established nondiscretionary methods under which such orders interact with each other, and buyers and sellers entering such orders agree upon the terms of the trade. The SEC highlighted two options to comply with the federal securities law for market participants that desire to operate exchanges for digital assets that are securities: (1) register as a national securities exchange or (2) seek to operate as an alternative trading system (ATS).
As detailed in the SEC’s statement, a registered national securities exchange must, among other things:
- create rules designated to prevent fraud and manipulative practices;
- create rules and procedures governing the discipline of its members and persons associated with its members;
- enforce compliance by its members and persons associated with its members with the federal securities law and the rules of the exchange; and
- must itself comply with the federal securities laws and must file its rules with the SEC.
Alternatively, a platform may seek to operate as an ATS. An ATS must, among other things:
- register with the SEC as a broker-dealer, which registration requires the platform to have reasonable policies and procedures to prevent the misuse of material non-public information, to meet certain books and records requirements and to implement financial responsibility rules, including, as applicable, requirements concerning the safeguarding and custody of customer funds and securities;
- become a member of a self-regulatory organization (SRO), such as the Financial Industry Regulatory Authority(FINRA); and
- comply with the federal securities laws and its SRO’s rules, and file a Form ATS with the SEC.
In the same statement, the SEC recognizes that some online trading platforms, such as platforms offering “digital wallet services” to hold or store digital assets or transacting in digital assets that are securities, may not be operating as an exchange. However, the SEC cautions that these platforms may be subject to other registration requirements, including broker-dealer, transfer agent or clearing agency registration.
Many analysts have reported that they believe the SEC’s focus is less on established cryptocurrencies like Bitcoin (which likely will be regulated by the Commodity Futures Trading Commission (CFTC)), and more on token sales and Initial Coin Offerings (ICOs) by smaller issuers. The guidance may be a precursor to the aggressive issuance of subpoenas to various unregistered platforms facilitating the trading of cryptocurrencies, similar to the recent wave of subpoenas issued to the issuers of digital tokens and ICOs.
With this guidance, the SEC continues to send a clear message of its unwavering focus on digital assets and platforms that offer the trading of digital assets. While most of the recent scrutiny has been on the issuers and developers of digital assets, including a recent federal district court decision in the Eastern District of New York that concluded that the Commodity Futures Trading Commission has standing to regulate cryptocurrencies as commodities, this newly released statement is a warning to trading platforms that they need to carefully examine their practices and ensure that either the cryptocurrencies or tokens listed on their platforms are not securities, or if they are, then they fully comply with the federal securities regulatory framework.