How To Build A Compliant Crypto Exchange Post-Coinbase
I gained a reputation for being a skeptic about the legality of selling cryptocurrency tokens in the United States. I used to write extensively about this, especially in 2017 when I was studying for my master’s degree in law and therefore had more free time and leeway to say what I wanted.
Moreover, I held this position when it was unpopular and unobtrusive, unlike the recent crop of crypto critics, such as former government attorney John Reed Stark (who seems to take endless pleasure in kicking the industry while it’s down). See, for example, on July 9, 2014, when my friend Tim Swanson and I were quoted in a Cointelegraph article, “Mitigating the Legal Risks of Issuing Securities on a Cryptoledger,” when I said that “[Virtually] no one has done this correctly. To date, I have not seen any crypto security that is well structured.”
Preston Byrne is an attorney and partner of Brown Rudnick’s Digital Commerce Group.
People thought I was crazy then. Others probably thought I was just a jerk. The truth probably lies somewhere in between the two. Keep in mind, of course, that in 2014 the idea of an “initial coin offering” (ICO) didn’t really exist; entrepreneurs like Joel Dietz marketed his “Swarm” crowdfunding token as “crypto-equity,” a term that has fallen out of favor with more sophisticated projects like Ethereum that, just a month after I was quoted in the Cointelegraph article, have been ICO launched. But even that was not called an ICO. That, presumably according to the advice Joe Lubin received from his lawyers, was a “crypto fuel sale for the Ethereum network”. Or as the New York Attorney General claimed in his recent lawsuit against KuCoin, a security.
Ethereum then exploded in 2017 and with it came a thousand imitators and other similar variations. US regulators were slow to respond. Then-SEC Executive Bill Hinman added fuel to the ICO fire when he gave his famous “Hinman Speech” in which he called the (now discredited) “adequately decentralized” exception to the how so test. Bearing in mind that Hinman was based in San Francisco, the common assumption among those of us who weren’t part of the cool SF venture capitalist crowd was that they had successfully convinced that office that Ethereum – a popular investment out there – the next wash. Internet and the best government can do is to get out of the way and let Ethereum prove it.
I think it’s safe to say five years later that Ethereum hasn’t solved many of the scaling issues it took to become the next internet. With those broken promises on the one hand, it is perhaps not surprising that the government has decided to restore the status quo ante, with the NYAG’s lawsuit against KuCoin.
Confusion and weird settlements
What followed Hinman’s speech can only be described as confusing. Until the Hinman speech, the SEC had really only gotten involved in the crypto business in cases of blatant and notorious fraud. The first case I can remember was the case of SEC vs Trendon Shavers and Bitcoin Savings and Trust (a Ponzi scheme) and SEC v GAW Miners, Joshua Homero Garza et al. (another Ponzi scheme involving the sale of “mining contracts” and a $20 stablecoin called “paycoin”).
In terms of non-fraud enforcement, in late 2018, just months after the Hinman speech was released, the SEC began its first set of enforcement actions, announced through settlements, on a number of coin-related projects. The first such settlement, with a founder of early decentralized exchange, or “DEX”, EtherDelta, was announced on November 8, 2018; the SEC alleged that DEX operated an unregistered exchange, which necessarily implied that the SEC believed that some of the assets on EtherDelta – being Ether and ERC-20s – were securities. Ten days later, the SEC announced its first settlements with two otherwise utterly unmemorable ICO matters, Airfox and Paragon; both respondents agreed to register their tokens as securities (which appears not to have happened to my knowledge).
What followed in the next year was a series of strange settlements that did not serve as a deterrent to further ICO issuance, along with a number of strange transactions that tried to work their way towards compliance with the non-gradual guidelines issued by Bill Hinman . For example, EOS, which announced its product on a giant billboard in Times Square during Consensus 2017 and raised north of $4 billion worth of crypto (as valued at the time), somehow got permission to skate by being fined $24 million to pay – and not even a registration requirement!
Other projects were less fortunate. Kik Interactive, Telegram, and Ripple Labs launched absolutely massive ICOs; both Kik and Telegram lost heavily in federal court, and I’m not estimating Ripple’s chances. Similarly, the much smaller LBRY project, located in New Hampshire and predating EOS by several years, was not, to my knowledge, offered a settlement with the SEC that would allow their company to continue operating; the only logical reason I’ve been able to deduce for this is that the SEC’s Boston office wanted a scalp and the only place you’ll find a crypto startup in New England is in New Hampshire.
No surprises
This brings us to the Coinbase complaint. None of it will come as a surprise to a lawyer who practiced in the US after 2018.
The alleged allegations are numerous. The SEC is accusing Coinbase of violating the registration requirement of the Securities Act of 1933 with respect to its custody offering.
It also accuses Coinbase of violating the Exchange Act’s registration requirements, which require anyone transacting securities to register and be supervised by the Commission. In addition, Coinbase is charged with operating as an unregistered broker-dealer and operating as an unregistered clearing house, being “any person who acts as an intermediary in making payments or deliveries or both in connection with transactions in securities or … provides facilities for comparison of data subject to the terms and conditions of the settlement of securities transactions.”
I am not going to bore you by quoting chapter and verse on registration requirements for brokers and dealers. Nor will I go into a detailed Howey analysis of many of the coins mentioned in the complaint – including Solana, ADA, Matic, Filecoin, SAND, AXS, CHZ, FLOW, ICP, NEAR, VGX, DASH and NEXO. The main thing here is that as a remedy, the SEC is seeking a permanent injunction against Coinbase from operating an unlicensed exchange. If they can get one of the tokens to hold and win in the process, they may be able to completely shut down Coinbase’s core business.
What surprised me is that it took so long. In 2017, I hypothesized that one day there would be an event – an event I was referring to when law enforcement would launch something akin to “simultaneous raids on the major exchanges and the homes and offices of the major ICO promoters, with a variety of of agencies in different countries coordinating their activities.” It’s hard to say if we’re at the beginning of such an extensive process but if the SEC goes after Coinbase no one in Coinbase’s business is safe I called that event “The Zombie Marmot Apocalypse” said that it has been hugely bearish for crypto and i think it is safe to say it is now imminent.
What now?
The question then turns to what comes next. Crypto isn’t going anywhere, so I guess the answer is “new exchanges that don’t carry all this regulatory baggage.” In terms of what that might look like, here’s my current thinking:
- Paradoxically, there’s probably no better time — other than 2012 — to launch a crypto exchange than today. For the first time since perhaps the inception of Bitcoin itself, compliance costs less than non-compliance. Existing industry giants have many legal-technical debts to settle, which will distract them and cost them huge amounts of money.
- Crypto is not dying. In places where it is growing fastest, especially Latin America and Africa, there is neither the political will nor the harmonized enforcement capacity to stop it.
- Making companies like Coinbase treat crypto tokens like old-fashioned securities is like trying to regulate Starlink the way we regulate road traffic. Nor was it unrealistic to expect the US government to just let crypto happen. Increased lobbying efforts and openness to compromise by US crypto giants will result in a middle ground in the US that will regularize the crypto business within the next five years if not sooner.
- The companies that will succeed will have a growth strategy that doesn’t include the United States, and will then have to be ready to move to the United States as soon as the regulations are favorable – or, instead, they’ll have to develop a subsidiary that works like INX and gets proper regulatory approvals. I suspect that regulations will eventually relax, allowing companies like INX to operate more like companies like Coinbase and Gemini do today. To achieve scale, startups will need to gain a foothold in countries with substantial populations of English-speaking crypto users that do not ban ICOs and allow exchanges to trade spot crypto without regulating them as broker-dealers or clearing houses.
- The only G20 country I can think of that meets these criteria is the United Kingdom. The UK should be used as a jumping-off point to access Anglophone Africa and India while the US gets its act together and (probably) implements a change in presidential administrations to one that doesn’t want to completely eliminate dollar escape options .
So. Crypto is not dead, it just needs a little legal revamp. May the best and most docile startup win.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.