How can cryptocurrency exchanges move towards compliance after heavy regulation?

How can crypto exchanges comply with regulations?

Author: Preston Byrne, Partner at Brown Rudnick & Lawyer in the Digital Commerce Department; Translation: BlockingBitpushNews Mary Liu

I was collectively criticized by the crypto community for questioning the legality of selling cryptocurrency in the United States, especially during my law school years in 2017 when I wrote many articles. At that time, there was a lot of free time and freedom to write.

Unlike the latest batch of crypto critics like former government lawyer John Reed Stark (who seems to relish bashing the industry during market downturns), I played the role of “critic” back when crypto was still largely unknown and very niche. For example, my comments were mentioned in a CoinTelegraph article on July 9, 2014, titled “Reducing Legal Risks of Issuing Securities on the Blockchain,” in which I said: “[Almost] no one is doing it right. To date, I have not seen a properly structured crypto security.”

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Joel Dietz and SwarmFund

At the time, people thought I was crazy, and others may have thought I was just a pure hater. The truth may lie somewhere in between. Of course, remember that in 2014, the idea of an initial coin offering (ICO) did not exist; entrepreneurs like Joel Dietz marketed his “Swarm” crowdfunding token as “crypto-equity,” a term that was met with indifference by more complex projects like Ethereum, which held its ICO just one month after the CoinTelegraph article quoted me. But even then, it was not called an ICO. According to advice given by his lawyers to Joe Lubin, it was “cryptofuel sold for use on the Ethereum network,” or, as described by the New York Attorney General’s Office in its lawsuit against KuCoin, a security.

Ethereum subsequently exploded in 2017, followed by a thousand imitators and other similar copycat projects, with slow reactions from US regulatory agencies.

Bill Hinman

Then-SEC Director Bill Hinman gave his famous “Hinman Speech,” adding fuel to the ICO frenzy, suggesting (now discredited) that “sufficient decentralization” was outside the scope of the Howey test. This led venture capitalists to assume en masse that they had successfully persuaded the SEC that Ethereum was the next internet and that the best thing the government could do was to step aside and let Ethereum prove it.

It is safe to say that Ethereum has not addressed many of the scalability issues needed to become the next internet in five years. Given these unfulfilled promises, it is not surprising that the New York Attorney General’s Office has brought a lawsuit against KuCoin.

Chaos and Strange Enforcement Cases

What happened after Bill Hinman’s speech can only be described as chaos. Prior to Hinman’s speech, the SEC was only cracking down on crypto businesses in blatant and infamous fraud cases.

The first case I remember was SEC v. Trendon Shavers and Bitcoin Savings and Trust (a Ponzi scheme) and SEC v. GAW Miners, Joshua Homero Garza, and others (another Ponzi scheme involving the sale of “mining contracts” and a $20 stablecoin called “Blockingycoin”).

Outside of fraud enforcement, at the end of 2018, just a few months after Hinman’s speech, the SEC began announcing its first batch of enforcement actions, settling with multiple token-related projects. On November 8, 2018, the SEC announced its first such settlement with the founder of an early decentralized exchange or “DEX,” EtherDelta, claiming that EtherDelta was operating an unregistered exchange, implying that the SEC believed that some assets on EtherDelta — namely Ethereum and ERC20s — were securities. Ten days later, the SEC announced its first settlements with two ICO projects, Airfox and Paragon; both defendants agreed to register their tokens as securities (as far as I know, this did not happen).

The following year saw a series of strange settlements that failed to stop further ICO issuances and a series of strange trades, with projects attempting to comply with Bill Hinman’s non-binding guidance in their own ways.

For example, EOS advertised its product on a giant billboard in Times Square during the 2017 Consensus conference and raised over $4 billion in cryptocurrency (at the time’s valuation) but somehow was allowed to settle with the SEC for $24 million without even having to register!

Other projects were not so lucky. Kik Interactive, Telegram, and Ripple Labs launched massive ICOs; Kik and Telegram lost badly in federal court, and I don’t think Ripple has a chance. Similarly, as far as I know, the much smaller LBRY project, based in New Hampshire and predating EOS by a few years, did not settle with the SEC or allow its business to continue operating; the only logical reason I can find for this is that the SEC’s Boston office ran out of money, and in New England, the only place you can find a crypto startup is in New Hampshire.

Not Surprising

This reminds us of Coinbase’s lawsuit, any lawyer practicing in the United States after 2018 would not be surprised by this. The complaint lists many regulations, with the SEC accusing Coinbase of violating the 1933 Securities Act’s registration requirements for its custody of equity issuances.

It also accuses Coinbase of violating the registration requirements of the “Trading Act,” which requires anyone engaging in securities trading to register and be supervised by the Commission. Additionally, Coinbase is accused of operating as an unregistered broker-dealer and as an unregistered clearing agency, serving as “any person engaged in payment or delivery or intermediation thereof with respect to securities or transactions, or for facilitating data or other services with respect to settling terms of securities transactions.”

This article will not go into detail about the sections on broker-dealer registration requirements, nor will it provide detailed Howey analyses of the many tokens mentioned in the complaint, including Solana, ADA, Matic, Filecoin, SAND, AXS, CHZ, FLOW, ICP, NEAR, VGX, DASH, and NEXO. The focus here is that as a remedy, the SEC is seeking a permanent injunction prohibiting Coinbase from operating an unlicensed exchange. If they can catch any token and win in the lawsuit, Coinbase’s core business may be completely shut down.

What surprises me is that it took so long. As early as 2017, I assumed that someday something would happen: law enforcement agencies would “carry out simultaneous raids on major exchanges and major ICO initiators’ residences and offices, and regulatory agencies in different countries would coordinate actions.” It’s hard to say if it’s happening now, but if the SEC is investigating Coinbase, no one in Coinbase’s business is safe.

What to Do Now?

Then the question turns to what will happen next, and cryptocurrency will not disappear. I believe the answer is “a new exchange that does not carry all these regulatory burdens.” Here are some of my current thoughts:

• Other than 2012, there may be no better time than today to launch a cryptographic exchange. Perhaps for the first time since the birth of Bitcoin, compliance costs are lower than non-compliance costs. Existing industry giants have a lot of legal and technical debt to deal with, which will distract them and cost them a lot of money.

• Cryptocurrency will not disappear. In its fastest-growing markets, especially in Latin America and Africa, there is neither political will nor unified enforcement capacity to shut it down.

• Let companies like Coinbase treat cryptographic tokens as traditional securities, as we regulate SpaceX’s Starlink like we regulate road traffic. Similarly, it is unrealistic to expect the US government to let cryptography develop freely, and US cryptography giants are lobbying harder and more open to compromise, which will push the United States to take a middle path, making cryptography more standardized in the next five years (perhaps earlier).

• Successful companies will have growth strategies that do not include the United States and then be prepared to move to the United States when regulations are favorable. Or, in other words, they need to develop a subsidiary operation like INX and obtain appropriate regulatory approval. I suspect that regulations will eventually be relaxed so that companies like INX can operate like today’s Coinbase and Gemini. To achieve scale, start-ups need to establish footholds in countries with a large number of English-speaking cryptographic users, which do not prohibit ICOs and allow exchanges to trade spot cryptocurrencies without being regulated as broker-dealers or clearing agencies.

• The only G20 country I can think of that meets these criteria is the United Kingdom. The United Kingdom should be used as a starting point to enter the African and Indian markets with English language, while US lobbyists work together to (possibly) change the US government’s view of cryptography.

So. Cryptocurrency has not disappeared, it just needs some legitimate adjustments. May the best and most compliant startups win.

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