HIGHLIGHTS:
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Coinbase, one of the largest cryptocurrency exchanges, recently approached the U.S. Securities and Exchange Commission (SEC) about possible licensing as a broker-dealer. If Coinbase decides to register with the SEC, it will become among the first of the existing cryptocurrency exchanges to be registered with the SEC.
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In consideration of recent events and pronouncements regarding possible registration, other digital asset exchanges should take note of the regulatory concerns and exemptions related to their operations.
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This client alert provides a brief overview of the registration options available to digital asset platforms and the benefits and restrictions of registration as a national securities exchange, a broker-dealer operating an alternative trading system (ATS) or a funding portal.
Coinbase, one of the largest cryptocurrency exchanges, recently approached the U.S. Securities and Exchange Commission (SEC) about possible licensing as a broker-dealer. If Coinbase decides to register with the SEC, it will become among the first of the existing cryptocurrency exchanges to be registered with the SEC. This news comes on the heels of a pronouncement by the SEC Division of Trading and Markets, warning that platforms that offer or trade digital assets which are deemed to be securities, including many initial coin offerings (ICOs), must register as a national securities exchange or otherwise be exempt from such registration.
In consideration of these recent events and pronouncements, other digital asset exchanges should take note of the regulatory concerns and exemptions related to their operations. While it appears that Coinbase's determination is related to its intention to broaden its offering beyond traditional cryptocurrency, the SEC's statement regarding the trading of digital assets leaves little doubt that, in its view, most ICOs will constitute a securities offering. This client alert provides a brief overview of the registration options available to digital asset platforms and the benefits and restrictions of registration as a national securities exchange, a broker-dealer operating an alternative trading system (ATS) or a funding portal.
National Securities Exchange Registration
The SEC's statement concludes that an online trading platform which brings together buyers and sellers of digital assets deemed to be securities would need to be registered with the SEC as a national securities exchange under Section 6 of the Exchange Act unless it is otherwise exempt from such registration.
The process of registering as a securities exchange is complex, time-consuming and subject to the SEC's determination that such entity is able to comply with all requirements imposed on exchanges, such as enforcing compliance by its members with its rules as well as the federal securities laws. Fundamentally, registered national securities exchanges are self-regulatory organizations (SROs) and as such (subject to SEC oversight and approval under Section 19(b) of the Exchange Act), an exchange is able to establish its own rules regarding trading, conduct of members and applicable fees. Additionally, an exchange is responsible for the supervision and compliance of its members with applicable regulations and therefore has an obligation to develop and maintain inspection and disciplinary programs, as well as monitor and conduct appropriate surveillance of the activities of its members. Under the Exchange Act, a national securities exchange must provide fair access to its members. Although it may limit membership through reasonable standards for access, such standards must not be discriminatory. Finally, all members of a national securities exchange must be registered broker-dealers or persons associated with a registered broker-dealer.
Takeaway: While the foregoing obligations are no doubt significant and onerous, certain business models may favor the application of a national securities exchange model. If a digital asset exchange wishes to register with the SEC as a national securities exchange, it may enjoy its status as an SRO which allows it to set its own rules and dictate how it wishes to operate. Certain exchanges may find that control over listing fees from issuers will allow an exchange to better sustain its business model. In addition, while an exchange has significant monitoring and supervisory responsibilities relating to its members, increasingly, SROs contract out a significant portion of their regulatory obligations through a regulatory services agreement. Importantly, the exchange would be limited to admitting members who are registered broker-dealers or their associated persons, thus impeding the ability for retail customers or issuers to trade without the use of an intermediary.
Alternative Trading System Registration
Another option for a cryptocurrency exchange is Regulation ATS (Reg ATS), which exempts an ATS from registering as a national securities exchange if it registers as a broker-dealer and provides the SEC with certain information regarding its operations on Form ATS. An ATS generally receives and executes orders in securities electronically through its trading system. While exempt from registration as a national securities exchange, a firm relying on Reg ATS (known as a sponsor) remains subject to several regulatory requirements, some of which are required by Reg ATS, and some of which are due to its status as a broker-dealer.
An ATS also has several ongoing reporting requirements. As with registered national securities exchanges, an ATS may be required to provide fair access to the trading system (provided that trading on the ATS reaches certain thresholds). Additionally, the ATS must establish adequate safeguards and procedures to protect subscribers' confidential trading information and make and maintain prescribed books and records. In order to prevent customer and market participant confusion, an ATS is prohibited from using "exchange," or derivations such as the term "stock market," in its name.
In addition to Reg ATS, additional issues may arise from the ATS's registration as a broker-dealer and compliance with all applicable SEC and Financial Industry Regulatory Authority (FINRA) rules under broker-dealer regulation, including, but not limited to:
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Customer Protection: Under SEC Rule 15c3-3, a broker-dealer must maintain the physical possession or control of all fully paid securities and excess margin securities carried by the broker-dealer for the account of its customers. A common feature underlying cryptocurrency or digital asset exchanges is the use of distributed ledger technology (DLT) whereby transactions are recorded on a database that is maintained over a public or private network. Broker-dealers need to consider how the use of DLT impacts the receipt, delivery and custody of securities and other assets of their customer's accounts. For example, will ICO tokens, securities or other assets be held in an individual's account (wallet) or will the sponsor of the ATS provide for the custody of these securities and assets with a third-party qualified custodian?
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Books and Records: Registered broker-dealers must make and maintain current books and records. Specifically, Rules 17a-3 and 17a-4 under the Exchange Act and FINRA Rule 4511 require that broker-dealers preserve certain records for specified periods of time. The use of DLT must be considered as it potentially impacts a broker-dealer's requirements under these rules. For example, certain records must be maintained for a period of time in a prescribed manner (i.e., solely electronic records must be stored in a "write once read many" (WORM) format). How will a digital-asset ATS ensure that the DLT is recording and maintaining such information in compliance with applicable rules?
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Fees: To the extent that a subscriber participating on a digital-asset ATS would be subject to any fees or commissions, additional concerns may arise. Regulatory requirements may apply if a subscriber is subject to fees for the management of wallets and keys, onboarding, or commissions or markups for trades placed through the ATS.
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Examinations: Dangers relating to regulatory examinations may also arise. Potential registrants and regulators are still in the nascent stages of understanding these new technologies and how existing regulations apply. FINRA's current examination module for an ATS may very well be largely inapplicable to a cryptocurrency or digital asset ATS.
Takeaway: If a cryptocurrency exchange registers as an ATS, it may have less stringent regulatory requirements than it would if it registers as a national securities exchange. However, the cryptocurrency ATS must still consider the regulatory impact of registration as a broker-dealer.
Funding Portal Registration
The JOBS Act exempts certain intermediaries who operate "funding portals" from the requirement to register with the SEC as a broker-dealer. A funding portal is defined as a crowdfunding intermediary that does not 1) offer investment advice or recommendations, 2) solicit purchases, sales or offers to buy the securities offered or displayed on its website or portal, 3) compensate employees, agents or other persons for such solicitation or based on the sale of securities displayed or referenced on its website or portal; 4) hold, manage, possess or otherwise handle investor funds or securities, or 5) engage in such other activities as the Commission, by rule, determines appropriate.
A registered funding portal must be a member of FINRA. While the funding portal does not need to register as a broker-dealer, it remains subject to FINRA's and the SEC's examination, enforcement and rulemaking authority. A funding portal is required to, among other things, provide disclosures and investor education materials to investors, take steps to protect the privacy of information collected from investors, and make efforts to ensure that no investor in a 12-month period has purchased crowdfunded securities that, in the aggregate, from all issuers, exceed certain investment limits.
Takeaway: The crowdfunding portal option is clearly the most limited option for a potential registrant. The activity would be limited to the relatively passive listing of ICOs. Moreover, the compensation model for an operator is limited as well as the receipt of transaction-based is prohibited. Nevertheless, this may be an option depending on the business model and potential issuer base of the digital currency platform.
Conclusion
If Coinbase completes this regulatory process and becomes an SEC-registered exchange, it may herald a wave of registration with the SEC. In this event, these exchanges should take note of the regulatory requirements and concerns related to such registration to decide which option fits best with their current and proposed business model.
