On March 7, 2018, the U.S. Securities and Exchange Commission issued a statement on potentially unlawful platforms trading digital assets (the Trading Platform Statement). Following up on an issue which was highlighted in its July 2017 report on the offering of digital tokens by “The DAO” (the DAO Report), a critical question is whether exchanges that allow token holders to trade tokens need to register as a national securities exchange or operate pursuant to an exemption from registration ( he enforcement actions cited are: SEC v. Jon E. Montroll and Bitfunder; In re BTC Trading, Corp. and Ethan Burnside.; SEC v. REcoin Group Foundation, LLC et al.; SEC v. PlexCorps et al.; In re Munchee, Inc.; and SEC v. AriseBank et al.).

In the Trading Platform Statement, the SEC addresses this question by highlighting key considerations for both investors and market participants operating online trading platforms, while also providing links to various SEC resources. The statement concludes with an admonition to consult with SEC staff or potentially face the severe consequences of non-compliance (as evidenced by the six enforcement actions cited at the end of the statement).[3]

Crypto-exchanges

With the rise in cryptocurrency trading, crypto-exchanges have become increasingly prominent. According to a recent Bloomberg news article, which lists by name the top 20 major crypto exchanges, the top 10 exchanges may be generating as much as “US$3m in fees a day, or heading for more than US$1bn per year”. In short, the business of providing exchange services in the cryptocurrency markets has become quite lucrative. Additionally, these exchanges are almost exclusively located outside the United States and frequently are established in Tokyo, Hong Kong or elsewhere in Asia. However, as the SEC noted in the DAO Report, virtual currency exchanges that provide secondary-market trading in tokens that are securities (within the meaning of U.S. securities laws), but that are not registered as securities exchanges, are violating the U.S. federal securities laws when they are providing services to token holders in the U.S., notwithstanding that they are located outside the United States.

Exchange Registration and Regulation ATS

Section 3(a)(1) of the U.S. Securities Exchange Act of 1934 defines an “exchange” as any group or entity that “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.” As the SEC noted in the DAO Report, the functional test as to whether a trading system meets the definition of an exchange is whether it (i) provides a marketplace “for bringing together purchasers and sellers of securities or for otherwise performing with respect to securities the functions commonly performed by a stock exchange;” (ii) brings together the orders for securities of multiple buyers and sellers; and (iii) uses “established, non-discretionary methods under which such orders interact with each other,” and that are accepted by those trading on the exchange.

An alternative trading system (ATS) is an SEC-regulated trading venue which serves as an alternative to trading on a public exchange. The existing regulatory framework under Regulation ATS was adopted by the SEC in 1998 to address advances in technology and the proliferation of electronic trading systems. Under Regulation ATS, an ATS is exempted from the definition of “exchange” under Section 3(a)(1) if it complies with certain requirements, including the requirement to register as a broker-dealer and file a Form ATS with the SEC to provide notice of its operations. Prior to the advent of the cryptocurrency markets, the ATS as a vehicle was primarily utilized in the equity markets, typically as a “dark pool”. Dark pools arose in the 1980s, when the SEC allowed brokers to bring together buyers and sellers of big blocks of shares, but their recent growth has been driven by electronic and algorithmic trading. The use of the ATS as a prospective solution to the question of where tokens can trade is intriguing, and would in any case bring additional regulatory oversight to the market.

In the Trading Platform Statement, the SEC notes that even if a platform does not resemble a traditional exchange, the fact that it offers exchange-like services (such as digital wallets) may trigger exchange registration requirements. Furthermore, to the extent that tokens being traded on a platform are in fact securities, then the platform may be participating in the unregistered offer and sale of securities if those securities are not registered or exempt from registration.

The following key points arise from the Trading Platform Statement:

• A platform that trades securities (including tokens that are securities) and operates as an “exchange,” as defined by U.S. federal securities laws, must register as a national securities exchange or operate under an exemption from registration, such as the exemption provided under Regulation ATS.
• An SEC-registered national securities exchange must, among other things, have rules designed to prevent fraudulent and manipulative acts and practices.
• Because an SEC-registered national securities exchange is a self-regulatory organization (SRO), it must have rules and procedures governing the discipline of its members and persons associated with its members, and enforce compliance by its members and persons associated with its members with U.S. federal securities laws and the rules of the exchange.
• An entity seeking to operate as an ATS is also subject to regulatory requirements, including registering with the SEC as a broker-dealer and becoming a member of an SRO.
• Registration as a broker-dealer subjects the ATS to a host of regulatory requirements, such as the requirement to have reasonable policies and procedures to prevent the misuse of material non-public information, books and records requirements, and financial responsibility rules, including, as applicable, requirements concerning the safeguarding and custody of customer funds and securities.
• An ATS must comply with U.S. federal securities laws and its SRO’s rules, and file a Form ATS with the SEC.
• In short, the Trading Platform Statement sets out a comprehensive list of compliance items for any current and prospective crypto-exchange to consider. Given the SEC’s stated view that many if not all tokens are securities, it follows that the SEC could conclude that exchanges that allow trading in tokens should be registered as either an exchange or an ATS. Lastly it is a clear warning to prospective investors that, in the absence of SEC oversight of a crypto-exchange, many of the traditional safeguards in respect of order execution, fees, customer information, asset custody and cybersecurity may not be present.