On July 25, 2017, the SEC issued a Section 21(a) Report on an investigation related to an initial coin offering (ICO) by the DAO, concluding that the ICO was a securities offering. In that Report the SEC stated that securities exchanges providing for trading must register unless an exemption applies. In its numerous statements on cryptocurrencies since then, the SEC has consistently reminded the public that exchanges that trade securities, including cryptocurrencies that are securities, must be licensed by the SEC.
The SEC has also stated that as of today, no such licensed securities cryptocurrency exchange exists. However, a few CFTC regulated exchanges have now listed bitcoin futures products and, in doing so, engaged in lengthy conversations with the CFTC, ultimately agreeing to implement risk mitigation and oversight measures, heightened margin requirements, and added information sharing agreements with the underlying bitcoin trading platforms.
The topic of the registration of exchanges for trading cryptocurrencies is not new to regulators. Years before the Section 21(a) DAO Report and crypto craze, on December 8, 2014, the SEC settled charges against BTC Virtual Stock Exchange and LTC-Global Virtual Stock Exchange, which traded securities using virtual currencies, bitcoin or litecoin. According to the SEC release on the matter, “the exchanges provided account holders the ability to use bitcoin or litecoin to buy, sell, and trade securities of businesses (primarily virtual currency-related entities) listed on the exchanges’ websites. The venues weren’t registered as broker-dealers despite soliciting the public to open accounts and trade securities. The venues weren’t registered as stock exchanges despite enlisting issuers to offer securities for the public to buy and sell.” The exchanges charged and collected transaction-based compensation for each executed trade on the platforms.
Since the Section 21(a) DAO Report, most of the statements from the SEC and other regulators have focused on ICOs and the issuance of cryptocurrencies as opposed to focusing on the exchanges that trade cryptos. On March 7, 2018, the SEC finally issued a public statement directed specifically to online platforms for the trading of digital assets – i.e., cryptocurrencies. This blog will summarize that statement. Also, at the end of this blog is a list with links to my numerous other blogs on the topic of distributed ledger technology (blockchain), cryptocurrencies and ICOs.
SEC Statement on Potentially Unlawful Online Platforms for Trading Digital Assets
Online trading platforms have become prevalent for the buying and selling of coins and tokens, including new cryptocurrencies offered in initial coin offerings (ICOs). Many platforms bring buyers and sellers together in one place and offer investors access to automated systems that display priced orders, execute trades, and provide transaction data. If a platform offers trading of digital assets that are securities and operates as an “exchange,” as defined by the federal securities laws, then the platform must register with the SEC as a national securities exchange or be exempt from registration. As mentioned above, no such SEC-registered platform exists as of today.
In its statement, the SEC cautions investors that “[T]o get the protections offered by the federal securities laws and SEC oversight when trading digital assets that are securities, investors should use a platform or entity registered with the SEC, such as a national securities exchange, alternative trading system (‘ATS’), or broker-dealer.”
The SEC is concerned that online platforms have the appearance of regular licensed securities exchanges, including using the word “exchange” when they are not. The SEC does not review the standards these “exchanges” use to pick or vet digital assets and cryptocurrencies, the trading protocols used to determine how orders interact and are executed, nor any internal controls or procedures of these platforms. Furthermore, the SEC warns that data provided by these trading platforms, such as bid and ask prices and execution information, may lack integrity.
The SEC provides a list of questions for investors to ask when considering trading on an online platform, including:
- Do you trade securities on this platform? If so, is the platform registered as a national securities exchange (see our link to the list below)?
- Does the platform operate as an ATS? If so, is the ATS registered as a broker-dealer and has it filed a Form ATS with the SEC (see our link to the list below)?
- Is there information in FINRA’s BrokerCheck ® about any individuals or firms operating the platform?
- How does the platform select digital assets for trading?
- Who can trade on the platform?
- What are the trading protocols?
- How are prices set on the platform?
- Are platform users treated equally?
- What are the platform’s fees?
- How does the platform safeguard users’ trading and personally identifying information?
- What are the platform’s protections against cybersecurity threats, such as hacking or intrusions?
- What other services does the platform provide? Is the platform registered with the SEC for these services?
- Does the platform hold users’ assets? If so, how are these assets safeguarded?
Registration or Exemption of an Exchange
Section 5 of the Exchange Act of 1934, as amended (“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 or is exempted from such registration. A national securities exchange registers with the SEC under Section 6 of the Exchange Act.
Section 3(a)(1) of the Exchange Act defines an “exchange” 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….” Exchange Act Rule 3b-16 further defines an exchange to mean “an organization, association, or group of persons that: (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.” The SEC has also stated that “an exchange or contract market would be required to register under Section 5 of the Exchange Act if it provides direct electronic access to persons located in the U.S.”
According to the SEC website, as of today there are 21 licensed exchanges registered with the SEC. Exchanges that trade securities futures are registered with the SEC through a notice filing under Section 6(g) of the Exchange Act. There are 5 such registered exchanges. There are two exchanges that the SEC has exempted from registration on the basis of limited volume transactions.
Although the SEC is certainly correct that an online trading platform that trades securities must be licensed by the SEC, that would not be the case if the asset being traded is not a security. In fact, if the asset is a currency (and not a security) or a “thing” such as loyalty points, no US federal agency would regulate its trading. The SEC only regulates the trading of securities and security-related products. The CFTC has regulatory oversight over futures, options, and derivatives contracts on virtual currencies and has oversight to pursue claims of fraud or manipulation involving a virtual currency traded in interstate commerce. Beyond instances of fraud or manipulation, the CFTC generally does not oversee “spot” or cash market exchanges and transactions involving virtual currencies that do not utilize margin, leverage or financing. Rather, these “exchanges” are regulated as payment processors or money transmitters under state law.
Likewise, no federal regulator has direct jurisdiction over “exchanges” that trade loyalty points such as converting airline points to use for hotels, cars, consumer goods and services, or cash. Online platforms such as www.points.com and www.webflyer.com operate using contractual partnerships with entities that issue loyalty points. In fact, points.com is owned by Points International Ltd., which trades on the TSX and Nasdaq and refers to itself as “the global leader in loyalty currency management.” Certainly, today there is a vast difference in the trading of loyalty points versus those looking to make profits in cryptocurrency trading, but there are also analogies, especially with the “currency” side. In a recent 6-K, Points has this to say about the loyalty industry:
Year-over-year, loyalty programs continue to generate a significant source of ancillary revenue and cash flows for companies that have developed and maintain these loyalty programs. According to the Colloquy group, a leading consulting and research firm focused on the loyalty industry, the number of loyalty program memberships in the US increased from 3.3 billion in 2014 to 3.8 billion in 2016, representing an increase of 15% (source: 2017 Colloquy Loyalty Census Report, June 2017). As the number of loyalty memberships continues to increase, the level of diversification in the loyalty landscape is evolving. While the airline, hotel, specialty retail, and financial services industries continue to be dominant in loyalty programs in the US, smaller verticals, including the restaurant and drug store industries are beginning to see larger growth in their membership base. Further, newer loyalty concepts, such as large e-commerce programs, daily deals, and online travel agencies, are becoming more prevalent. As a result of this changing landscape, loyalty programs must continue to provide innovative value propositions in order to drive activity in their programs.
Companies that believe that their crypto is truly a utility with currency value may feel they have more in common with a loyalty point than a security, and regulators have yet to be able to give any level of firm ground on which to stand.
In a hearing before the House Financial Services Committee on May 16, 2018, Stephanie Avakian, co-director of the SEC Division of Enforcement, told lawmakers that the SEC will continue to look at each case involving a cryptocurrency on a facts-and-circumstances basis. Ms. Avakian and co-director Steven Peiken both gave testimony and sat in the hot seat. The Financial Services Committee members were pushing for more definitive input on how ICOs should be defined and regulated, without result. The hearing became contentious, with Committee members becoming frustrated with the lack of direction and lack of certainty from the SEC as to how they define and view cryptocurrencies, other than “on a case-by-case basis” and using the same federal securities principles that already exist – a mantra that has been repeated.
However, the SEC enforcement division could rightfully feel they are being put in an unfair position with this line of questioning. Commissioner Hester M. Peirce warned against rulemaking by enforcement in a recent speech. Ms. Peirce has strong opinions on the subject. She states, “[D]ue process starts with telling individuals in advance what actions constitute violations of the law.” She continues with “[A] related issue to which I am paying attention is the degree to which our enforcement process is being used to push the bounds of our authority. Congress sets the parameters within which we may operate, and we ought not to stray outside those boundaries through, for example, overly broad interpretations of ‘security’ or extraterritorial impositions of the law. Our canons of ethics specifically caution us against exceeding ‘the proper limits of the law’ and argue for us remaining ‘consistent with the statutory purposes expressed by the Congress.’”
In fairness, Ms. Peirce was talking in the context of enforcement as a whole. Not once did she mention cryptocurrencies, ICOs or blockchain in that speech. However, in light of the prevalence of the topic and many industry leaders, politicians and market participants looking to the SEC for guidance on the question of “what is a cryptocurrency” and “how should it be regulated,” I can’t help but think the SEC is looking back at Congress with the same question.