Patrick McCarty is a former regulator and CEO of McCarty Financial LLC
On November 8, 2018 the SEC fired what might be characterized as “the shot heard round the Cryptocurrency Exchange world” in publishing the EtherDelta Settlement. This Settlement Order, which fined Zachary Coburn – the founder of EtherDelta, a small cryptocurrency trading platform which offered trading in Ether and approximately 500 ERC20 tokens, for operating an unregistered securities exchange. The implications of the EtherDelta Settlement are enormous. It could signal that the SEC intends, finally, to aggressively assert jurisdiction over a vast swath of the cryptocurrency market. Followed to it’s logical conclusion, the EtherDelta Settlement could change the face of cryptocurrency regulation and trading in the United States.
The SEC’s Settlement was with Zachary Coburn, the founder of EtherDelta. Mr. Coburn is 31, lives in Chicago and used to work for an SEC registered broker dealer. In 2015 Mr. Coburn left the SEC registered broker dealer and went out to start his own trading platform business. He started 2 trading platforms – one being EtherDelta – in 2016. The SEC found that EtherDelta was a sophisticated trading platform which permitted multiple participants to buy and sell approximately 500 ERC20 tokens. The SEC asserted, without naming or analyzing, that some of the 500 ERC20 tokens listed for trading by EtherDelta were “investment contracts” under the Howey Test and therefore “securities” for purposes of the federal securities laws. Because EtherDelta acted as an exchange for purposes of buying and selling “securities” it was required to register as either a national securities exchange or register under Regulation ATS and become an SEC registered Broker/Dealer – which it had not done. The SEC fined Mr. Coburn – who sold EtherDelta in 2017 – $75,000, required disgorgement of $300,000 and payment of $13,000 in prejudgment interest. Id at 10.
The EtherDelta Settlement could radically change the Cryptocurrency Exchange market in the United States. Most cryptocurrency exchanges in the US are registered as “money services businesses” (MSB) with FinCEN and with multiple States as money transmitters. A small number of US cryptocurrency exchanges (under 5) have BitLicenses from New York Department of Financial Services. None of the cryptocurrency exchanges are currently registered with the SEC as national securities exchanges or under Regulation ATS and SEC registered as Broker/Dealers. The EtherDelta Settlement could require most of the cryptocurrency exchanges in the United States – as well as those who solicit US customers – to register with the SEC as national securities exchanges or, more likely, under Reg ATS and become SEC registered broker dealers. Needless to say, this would be a dramatic change for the cryptocurrency world.
While the EtherDelta Settlement signals a dramatic change in the SEC’s views/approach with respect to cryptocurrency trading platforms, some significant questions remain. For instance, the biggest question is what will the SEC say about trading platforms that only offer Bitcoin, Ether and their hard fork tokens for trading? SEC Chairman Clayton and Division of Corporation Finance Director Hinman have said publicly that neither Bitcoin, nor Ether are “securities.” In addition, some commentators suggest that any “hard forks” coming off Bitcoin and Ether should/would be treated in the same way by the SEC. If the SEC sticks to the prior statements of Clayton and Hinman, it would mean that trading platforms which offer trading in only Bitcoin, Ether and their “hard forks” probably wouldn’t have to register as national securities exchanges or be registered under Regulation ATS and become a registered Broker/Dealer. That makes some sense since the SEC (at least SEC Chairman Clayton and Corp Fin Director Hinman) has said those cryptocurrencies are not “securities”- and requiring “non securities” to be traded on a national securities exchange or by an SEC registered broker dealer would seem a little over the top — even for the SEC. But this would be a somewhat curious result, as Bitcoin, Ether and their hard fork tokens represent 65% or more of the cryptocurrency world market cap and probably more than 60% ADV in terms of cryptocurrency trading. So is the SEC only asserting jurisdiction over just 35% of the crypto market cap and 40% of the ADV trading? That seems very odd. Perhaps it is just an opening bid in the federal regulator cryptocurrency jurisdictional poker game?
Another nagging question is does the SEC really mean what it says in the EtherDelta Settlement about ERC20 tokens being “investment contracts” and therefore “securities”? The Settlement Order is actually very “thin” on this issue. The Settlement Order “asserts” that some of the approximately 500 ERC tokens listed on EtherDelta are “securities” – “investment contracts” under the Howey Test. I’m not surprised that the Order doesn’t go into significant detail in terms of analyzing the approximately 500 ERC20 tokens listed on EtherDelta, however no specific tokens are mentioned or analyzed to show that any ERC20 tokens met the Howey Test. That is confusing and frustrating. One would have thought that the EtherDelta Settlement would have been a good vehicle for the SEC identifying certain ERC20 tokens as being “investment contracts” and others which are “not securities.” It is hard to believe that the SEC believes all 500 ERC20 tokens listed by EtherDelta are “investment contracts” under the Howey Test. Conservative lawyers will, however, probably have to advise their clients going forward that that there is a “risk” that the SEC sees it this way and point to the EtherDelta Settlement. This means the “risk averse” cryptocurrency trading platforms which offer any ERC20 tokens will have to register with the SEC as either national securities exchanges or, more likely, as Reg ATS entities and become SEC registered Broker Dealers.
The “hot off the presses” Airfox and Paragon ICO Settlements from November 16, 2018 dispel any thoughts that SEC Chairman Clayton and the SEC were going to be “all talk and no action” in the ICO arena. The Airfox and Paragon ICO Settlements include fines, restitution offers and SEC registration and reporting requirements for issuers and tokens which the SEC believes are “investment contracts” under the Howey Test. While the Howey Test investment contract analysis in these ICO Settlements is much better than in the EtherDelta Settlement (which was non existant), it remains disappointingly thin and mostly conclusory. Three factors seem to be emerging as being important (1) some form of fundraising, (2) the product, network, service is not operating yet, and (3) the tokens are listed for trading on a platform/exchange. Reading between the lines, if all 3 factors are present, it’s probably going to be an “investment contract” under the Howey Test to the SEC. I’d note that neither ICO promised the token buyers voting rights, dividend payments, interest payments, etc. which are the traditional “rights” which go along with a “security.”
We are almost 18 months removed from the SEC’s issuance of the DAO Token Report. With the EtherDelta, Airfox and Paragon Settlements, the SEC is starting to deliver on their threats to crack down on ICOs as unregistered securities offerings and unregistered exchanges where they are traded. That’s probably a good thing as it will help clean up the cryptocurrency space. What is needed, however, is more guidance/clarity on what factors are most important in distinguishing between a cryptocurrency that is an “investment contract” (DAO Token, Munchee, Airfox, Paragon) versus one which is “not a security” (Bitcoin, Ether and their hard forks). A good place to start would be the top 25 cryptocurrencies by market cap and ADV. This would cover 90% plus of the market cap and ADV in cryptocurrencies. The SEC could issue a report stating their view on the status of each of the top 25 cryptocurrencies by market cap and ADV and permit public input/comment before making any final decisions. This kind of approach would provide some legal/regulatory clarity which the cryptocurrency industry has been desperately seeking.