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By Jason Somensatto
Jason Somensatto is Of Counsel at Orrick, Herrington & Sutcliffe LLP in Washington, DC, and is a member of Orrick’s Blockchain Working Group. This article was written with assistance from Ken Herzinger and Chris Austin, both partners at Orrick.
This article uses the term cryptocurrency generally to include terms such as virtual currency, digital tokens, or crypto assets.
What does it mean for a cryptocurrency trading platform to be compliant with U.S. laws? The answer is not as clear as some may expect and hinges on such questions as how tokens on the platform are legally categorized and how trading is conducted.
What is clear from recent developments is that multiple U.S. regulators are scrutinizing whether trading platforms are complying with various regulatory schemes. Most notably, token trading platforms risk enforcement for not following laws applicable to money transmission and to securities and commodities trading. Although enforcement against cryptocurrency businesses in these areas has thus far been minimal, trading platforms should expect that to change in light of the increasing attention being paid by regulators to these issues.
To the extent that cryptocurrency trading platforms are engaged in the business of “money transmission” in the U.S., they must comply with the federal Bank Secrecy Act (BSA) as well as with certain state laws. The BSA requires money transmitters to collect and retain information about their customers and share that information with Financial Crimes Enforcement Network (FinCEN) in an effort to prevent money laundering and terrorist financing. State laws generally require money transmitters to obtain licenses and to follow similar requirements focused primarily on consumer protection.
The definition of money transmission varies between states, but at the federal level, money transmission broadly covers the transfer of “currency, funds, or other value that substitutes for currency” from one person to another person or location. Since 2013, there have been multiple court rulings, FinCEN guidance documents, and settled cases that can generally be interpreted as standing for the proposition that cryptocurrency intermediaries are money transmitters under federal law and must register with FinCEN and comply with the BSA.
In February, FinCEN reiterated this position in a letter to Senator Ron Wyden when stating that “an exchange that sells ICO [initial coin offering] coins or tokens, or exchanges them for other virtual currency, fiat currency, or other value that substitutes for currency, would typically also be a money transmitter.”
At this stage, it should be well-accepted that cryptocurrency trading platforms generally must meet the requirements of the BSA and analyze their obligations under state money licensing regimes.
Thus far, FinCEN has only brought enforcement actions against two cryptocurrency businesses ( Ripple Labs and BTC-e) for not complying with the BSA. However, cryptocurrency trading platforms should be aware that FinCEN and other regulators have generally been increasing the number and size of enforcement actions against financial institutions for having inadequate anti-money laundering procedures in place to comply with the BSA. For example, just last year, another money transmitter, Western Union, agreed to pay $184 million for willful shortcomings with its AML program.
Whereas cryptocurrency trading platforms may have thought in the past that compliance with the BSA alone was sufficient, developments over the past year should have changed that calculus, particularly when considering the activities of the Securities and Exchange Commission (SEC). Generally, platforms that allow securities trading must register with the SEC as a national securities exchange, alternative trading system, or a broker-dealer, all of which require the trading platform to follow restrictive rules addressing everything from preventing fraud to safeguarding customer accounts.
A financial instrument that meets the definition of a “security” can only be sold in the U.S. if registered with the SEC or sold pursuant to a specific exception to the securities laws. Several lawyers in the space have raised concerns over the past few years that some cryptocurrencies, particularly those sold through ICOs, may meet the definition of a security. Consistent with those concerns, in the past year, the SEC has begun issuing warnings and bringing enforcement actions against certain projects and taking the position that certain tokens are being sold as unregistered securities in violation of federal law. More recently, in January 2018, the Chairman of the SEC, Jay Clayton, went so far as to testify to Congress that every ICO he has seen is a security.
As a result, the cryptocurrency industry now finds itself at a stage when many are expecting a wave of enforcement, with reports suggesting that the SEC is conducting a sweep of the industry and issuing numerous subpoenas to that end.
The current environment presents significant risk to any trading platform listing cryptocurrencies that may fall under the definition of a security. The SEC recently brought an enforcement action against an exchange in part for selling unregistered digital securities in exchange for bitcoin. And on March 7, 2018, the SEC went a step further and issued a public statement explicitly acknowledging that a number of cryptocurrency trading platforms are listing assets that meet the definition of a security.
To the extent that cryptocurrency trading platforms were ignoring compliance with securities law before, the SEC has clearly signaled that such an approach will no longer be tolerated.
The simple solution may seem to be for trading platforms to register with the SEC. Putting aside the significant business changes that will be required, as well as the cost and time required to go through a rigorous registration process, such an approach fails to recognize that most of the various tokens currently available that an exchange may be looking to list on its platform may be unregistered securities. There is no legal exemption that allows properly registered exchanges to sell unregistered securities. Therefore, an exchange deciding to register with the SEC is making a bet that the industry will develop to adopt cryptocurrencies registered as securities in the future that can be traded on its platform.
As an aside, it is worth noting that SEC registered entities fall into a different category that money transmitters under the BSA, but all still must comply with the anti-money laundering provisions in the BSA.
Even a trading platform that is a registered money transmitter in compliance with the BSA and state licensing laws and that is not listing any securities on its platform still faces potential regulatory scrutiny from the Commodities Futures Trading Commission (CFTC). In a detailed opinion issued in March 2018, a federal judge ruled that “virtual currencies” are commodities subject to oversight by the CFTC. This opinion is consistent with earlier positions publicly taken by the CFTC.
The CFTC’s authority over the commodities markets varies based on the type of activity. U.S. law generally does not provide for direct regulation of the commodities spot market. That is to say, there are no regulations governing transactions involving the actual transfer of a commodity directly from one person to another. Instead, the CFTC has regulatory authority over derivative transactions, such as futures and options, tied to the value of a particular commodity. Intermediaries selling derivatives must typically register with the CFTC and follow rules similar to those applicable to registered securities broker-dealers.
As confirmed in the recent ruling, despite the inability to pass rules affecting the spot market, the CFTC does have jurisdiction to police fraud and manipulation in the spot market. As a result, cryptocurrency trading platforms must be mindful that the CFTC will be monitoring their markets for potential fraudulent activity, including by the platform itself. Indeed, the ruling comes from a case involving allegations by the CFTC that a cryptocurrency exchange misappropriated investor funds.
Moreover, there is still some question as to the dividing line between what constitutes a spot market cryptocurrency transaction and a derivative transaction. The distinction depends on the definition of what constitutes “actual delivery” of a cryptocurrency from one person to another. The CFTC is currently seeking comments on a proposed rule that would clarify this issue but has already brought an enforcement action against one exchange for, in part, failing to register with the CFTC despite allowing transactions in bitcoin that did not result in actual delivery.
Public comments by the CFTC and its commissioners suggest a more patient and accepting approach to the current state of the cryptocurrency market. But cryptocurrency trading platforms should not discount the enforcement risk, particularly as it relates to selling derivatives, allowing users to leverage transactions, or otherwise operating in the space that the CFTC generally sees as falling within its direct regulatory jurisdiction.
Cryptocurrency trading platforms face regulatory risk on multiple fronts, and the likelihood is high of increased enforcement activity by regulators responsible for overseeing money transmission as well as securities and commodities trading. In an effort to mitigate that risk, platforms should ensure they are:
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