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Cryptocurrency Exchanges Must Navigate An Outdated Regulation System
July 9, 2018

Cryptocurrency Exchanges Must Navigate An Outdated Regulation System

By: Ifrah Law

More consumers are adopting cryptocurrency than ever, but regulators are less enthusiastic. As a result, cryptocurrency exchanges spend unnecessary time and resources working to comply with outdated guidelines.

Kraken, which oversees $150 million in daily cryptocurrency transactions, is the latest exchange to experience this problem. In an effort to bring itself into compliance with current Securities and Exchange Commission (SEC) regulations, cryptocurrency exchange Kraken recently announced its intention to register as an Alternative Trading System (ATS) under SEC Regulation ATS.

As an ATS, Kraken would be permitted legally to match eligible counterparties trading registered cryptocurrencies. That said, an ATS has little authority over its subscribers, rather relying on — and conceding to — the disciplinary powers of the national exchange under which they operate. In addition, the SEC imposes additional regulations and restrictions on an ATS, some more onerous than others.

First, under the regulations, the ATS exchange is assumed to be appropriately governed by the national exchange or SRO of which it is a member. Likely, this exchange would be NASDAQ as it has already expressed interest in becoming a key cryptocurrency exchange, but in practice an ATS may register under any national exchange. With an ATS trading in traditional securities this model works well enough, but for an ATS trading in cryptocurrencies — digital securities whose own regulatory regime is yet to be defined — the SEC could determine that any existing association lacks the proper framework to self-regulate a cryptocurrency exchange. In this case either the existing exchange would need to alter its bylaws and constitution to please the SEC, or the cryptocurrency exchange would need to establish itself as a new national exchange.

Second, and perhaps more fatal, is a clause in the regulations that gives the SEC the power to deny or revoke ATS approval based on the total volume of trade of particular securities. For example, an ATS may lose its exempt status if it handles more than 50% of the total trading volume of any given security. See 17 C.F.R. § 240.3a1–1(b). This suggests that to remain in compliance Kraken would need to be particularly careful with the trade volume of smaller cryptocurrencies that trade on fewer exchanges. Even when short of this volume, an ATS requires stricter record keeping and increased disclosures once more than 5% of the total trading volume of any given security trades on an ATS – a distinct possibility given the scarcity of crypto exchanges currently authorized by the SEC.

Finally, even if the SEC approves Kraken’s ATS, Kraken is still limited by the 1934 Act in what it may list and how. Most importantly, as an ATS operating under a national exchange Kraken may only list registered securities or ensure any unregistered securities are exempted. There are safe harbors Kraken could avail itself of, such as by vetting all potential investors in that security to ensure they fall within the statutory safe harbors available for transactions involving only accredited investors. But, this must be a preemptive vetting — it is a violation to even advertise an unregistered security to the public.  That means that Kraken will be unable to list tokens that have been issued in unregistered or exempted ICOs without putting its ATS registration at serious risk.

All of these are issues that can be resolved, but they highlight the complications that companies seeking to come into SEC compliance face. Both the agency and industry participants are looking for solutions. But without clear law or regulatory guidance, none of the existing regulations are neat fits.

This post is authored by Levi Barry, 2018 Summer Clerk for Ifrah Law.