This post originally appeared on ZeMing M. Gao’s website, and we have republished with permission from the author. Read the full piece here.
The crypto exchanges convert a crypto asset into unregistered security offerings, even if the asset is not yet such security.
This is mainly for the following reasons:
(1) the fully centralized nature of these crypto exchanges;
(2) the predominantly off-chain transaction environment created by the crypto exchanges.
Most crypto assets are already securities because of how they are created, spent and mined. See Even BTC Has Become a Security.
However, even if a cryptocurrency is not yet a security, subsequent offerings of the cryptocurrency on exchanges trigger a secondary offering that can constitute a security offering, where the provider is the exchange and the receiver is the traders on the exchange.
Most crypto assets have a following secondary offering on an exchange. I believe that all crypto exchanges that are centrally managed in a mostly off-chain environment are really making securities offerings when they facilitate crypto trading. This act of offering converts the asset being offered into a security, even if the asset is not yet a security.
For example, even if a crypto exchange is offering tokenized gold (which, when properly tokenized on-chain, can be a non-security), the specific manner of offering would make it a security offering, making it tokenized gold converted into a security when traded on such an exchange.
At this point, the world has been misled into believing that these crypto exchanges are simply providing a trading platform to facilitate transactions between a buyer and a seller.
Absolutely not. Essentially, what these centralized exchanges do is:
Take BTC trading as an example. The exchange creates account-based virtual tokens from BTC (a token of a token, so to speak), but presents them not as tokens, but rather as BTC itself (that’s part of the deception). These account-based virtual tokens are linked to the real BTC held in a pooled wallet owned by the exchange. When a buyer buys bitcoin from a seller on the exchange, the buyer is actually buying a virtual token of BTC, not the on-chain BTC itself. The virtual token is just a numerical representation of a virtual user account on the exchange. Such a virtual account has a counterparty, namely the exchange, and offers legal rights that are very different from direct ownership of the on-chain BTC.
Only when the holder of the virtual token leaves the exchange platform does the holder actually receive the real BTC.
This is similar to a banking system, but it is unregulated and therefore lacks protections including regulatory oversight, disclosure requirement, etc. The fact that very few crypto exchange customers are even aware of their virtual account status is just a natural consequence of such unregulated circumstances.
The exchanges are all betting that the vast majority of transactions will be on-platform trading (which is really just trading the exchange’s account-based representation tokens) rather than on-chain activity, which only happens when a customer make a deposit or withdraw from the platform.
Under normal circumstances, the above condition is overwhelmingly true. The reason why this has remained so is ironic because these crypto exchanges simultaneously benefit from the following two conjugating factors:
(1) that the underlying blockchains of the crypto assets are not scalable and have high costs for on-chain transactions. In other words, crypto exchanges thrive because of, not in spite of, the shortcomings of the blockchains that produced the crypto assets in the first place.
(2) most exchange users fail to understand that everything that happens on a crypto exchange happens in an extremely centralized and unmonitored environment, which is the antithesis of the “cryptoness” they have been tricked into believing. In other words, crypto exchanges thrive because of, not in spite of, the lack of understanding of the crypto mass of economics and lack of actual participation in the real economy.
Trading is offered in different asset pairs, but everything is linked to an account through the virtual accounts created on the exchange. Even when a trading pair involves a fiat such as the US dollar, the real trades mainly take place between synchronized virtual accounts with very little involvement of the real money. For that, the creation of a stablecoin like USDT provides the otherwise non-existent liquidity, sustaining the artificial environment on a much larger scale.
But why is this a problem?
The exchanges charge fees for transactions. So far it still sounds like an offer of a service, not a security.
But from there the deeper deception begins: the exchanges mainly charge fees for the coin being traded (e.g. BTC) or a special coin created from scratch by the exchange itself to facilitate the payment of fees (BNB, for Binance , for example).
As a result, the income of the exchange depends on the Prices of the coins and tokens, e.g. BTC and BNB.
By doing this, the entire business model of the exchange is to promote the price of the traded coins (e.g. BTC) and the special currency of the exchange (e.g. BNB). They don’t even have to be greedy to do this because it is a necessity created by the design of the company itself.
It is a self-referential circular economy that does not create economic value, but is alone financed by the external fiat money that is drawn to the exchanges. In other words, these offers are really a way to raise capital, which is then used to create more offers to raise more capital, and so on.
When such financing activities are placed in light of the securities laws, as measured by the Howey testing standards, it is difficult to see how these exchanges can claim that they have not made illegal securities offerings by doing the above, even if they have done it without committing fraud, such as trading manipulations, which of course they regularly do, but that’s another story. See the cancerous crypto.
Come to think of it, it explains why Satoshi initially objected to the crypto exchanges as they are, but devoted much of his initial efforts after bitcoin’s release to a different kind of exchange for bitcoin. He clearly understood these issues from the very beginning, not by accident, as the polymath also studied law and was the mastermind behind the network security of the Australian stock exchange. But sadly, the world went in a different direction to come to the current reality, which is scam-ridden.
The problem goes beyond securities laws. By the very nature of the business, these exchanges are giant blood-sucking parasites to the real economy.
This is not to say that all the projects behind the crypto assets traded on exchanges are also blood-sucking parasites. That’s another matter. There are many projects based on good ideas that try to solve real problems. But they have to prove their usefulness by providing actual utility instead of pointing at the price on crypto exchanges, which proves nothing under such anomalous Ponzi conditions created by the crypto exchanges.
For more information on the corrupt crypto exchanges, see the cancerous crypto.
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