Powers On … Broker disintermediation and unregulated crypto exchanges are a matter of great concern


Turn on… is a monthly opinion column written by Marc Powers who, after serving with the SEC, spent much of his 40-year legal career handling complex securities cases in the United States. Today he is an adjunct professor at Florida International University College of Law, where he teaches the course “Blockchain, Crypto and Regulatory Considerations”.

Increasingly, governments fear losing control of aspects of their respective legitimate financial systems, including raising capital and trading, to the hundreds of unlicensed, unregulated centralized and decentralized crypto exchanges around the world.

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The remarks by government regulators in the United States, England, China, Southeast Asia and elsewhere, focusing more than ever on the unregulated exchanges that offer trading in derivatives and spot markets in numerous cryptocurrencies, are clearly increasingly alarmed. These efforts follow on from regulators slowing the rampant IPO of cryptocurrencies in the form of initial coin offerings, simple agreements for token contracts, and security token offerings in the 2016-2020 period.

Some of the cryptocurrencies that are traded on exchanges like Binance, Poloniex, Coinbase, KuCoin, and Kraken – to name a few – are actually currencies in the form of stablecoins. Others are likely to be securities within the meaning of US federal securities laws under the broad interpretation of “investment contracts” by US courts and the SEC. Other cryptocurrencies are commodities like Bitcoin (BTC) and Ether (ETH). Their futures are one of the few cryptocurrencies that are traded on licensed US exchanges such as the Chicago Mercantile Exchange and Bakkt.

Related: It is time for the US to do a “ripple test” for crypto

In a way, these fears are justified – to the extent that investor protection is jeopardized by exposing investors to unacceptable risks who may not understand or appreciate the disadvantages of their trading activities. An example of this is margin trading, which allows significant leverage based on just a small deposit of funds or tokens in an account. Until recently, Binance allowed 125x leverage on Bitcoin futures purchases. (Reportedly, leverage was reduced to 20x in July, presumably due to pressure from various international regulators.) In other words, if you had $ 10,000 in your account, you could have cryptocurrencies worth up to $ 1 To buy $ 25 million! This is insane leverage, filled with potential problems for both the stock market and the customer.

Given the extreme volatility of the prices of various cryptocurrencies, this could be a big problem for the customer if prices drop and he is forced to keep sufficient reserves in his account. If they do not have the funds, their positions will be liquidated by the exchange, which is likely to result in significant losses to the account. The account may have a large debit balance.

Broker-Dealers, Disintermediation, and the Securities Acts

The exchange must carry out the transactions ordered by the customer and can remain liable for the customer’s losses even in the event of liquidations if he does not have the funds. In times of market turmoil, this can have a cascading effect on various exchanges around the world. One only has to remember the 2008–2009 financial crisis, which was triggered, among other things, by the failure of Lehman Brothers. Here in the US, most retail customers cannot use more than 60 to 75% of the value of their account. That’s not even 1x. Federal Reserve Regulation T and the Financial Industry Regulatory Authority’s margin rules require licensed brokers to monitor the level of customer debt to ensure that it does not exceed a certain level.

Related: Broker licensing for US blockchain developers puts jobs and diversity at risk

There are also net capital rules for brokers, technically known as “broker-dealers” under securities laws, which require them to hold a certain capital equal to the asset value of their client account. These rules are designed to ensure that you maintain a minimum level of cash and cash equivalents and are set out in Rule 15c3-1, which was published under the Securities Exchange Act of 1934. If the SEC registered broker-dealer holding the client’s assets in an account goes out of business, there is up to $ 500,000 in the Securities Investor Protection Corporation or SIPC to protect the client’s account. Worse still, criminals are constantly trying to hack these platforms and steal investor funds.

In addition, some exchanges – likely not the ones listed above – may unwittingly allow market participants to engage in manipulative trading patterns or activity. Many of these manipulative practices are defined and prohibited by law in Sections 9 (a) (2) and 10 (b) of the Stock Exchange Act. This includes spoofing, front running and insider trading.

What intrigues me about all of this is the fact that blockchain “disintermediation,” the mantra of crypto enthusiasts and supporters, is here – at least for the broker community. The buying and selling of crypto is done directly by the customer with the exchange without a broker intervening to facilitate trading. The middleman was cut out of the process. There is no broker who verifies the suitability of the trading activity – no broker who is there to hold and protect the digital assets. These digital assets are held directly on the exchange that is being traded or delivered to an investor’s personal digital wallet. If the stock market fails, investors could lose everything. There is no SIPC that reimburses the investor. There is also currently no federal or state regulatory agency that reviews the books and records of the exchange, receives reports on the company’s financial health and activities, or maintains liquidity, and that it does not allow what most people think of wrongdoing such as market manipulation and malpractice Insider trading.

Yes, Coinbase and Gemini have BitLicenses issued by the New York State Department of Financial Services to operate a crypto exchange and other regulatory agency licenses for the various businesses of their subsidiaries and affiliates. And the crypto group of this state authority has supervisory and audit rights. but the size of that group of maybe a dozen or two dozen people pales in comparison to the size of a state regulator like the SEC, which has over 4,500 employees. Many other centralized and decentralized exchanges are also unregulated. As a result, many of the safeguards for our financial system and the investors that brokers were responsible for are now missing. The exchanges also do not have a single country with globally uniform requirements such as net capital rules, anti-manipulation prohibitions, margin rules and adequacy rules to protect investors. Organizations like Global Digital Finance are an organization of which I am a member that seeks to establish these protocols and rules worldwide and to work with regulators in over 30 countries. And yes, these exchanges may also have their own Know Your Customer and Anti-Money Laundering Compliance efforts, but that’s more to complying with banking secrecy and the Financial Crimes Enforcement Network to stop criminal money laundering and terrorism, not to protect Investors on their platforms.

Related: The DeFi regulation must not kill the values ​​behind decentralization

Crypto exchanges are under close scrutiny

No wonder, then, that Binance has been the target of the Financial Conduct Authority (FCA) in the UK and other countries in Europe and Asia – or that new SEC chairman Gary Gensler has raised concerns. As early as the end of June, the FCA decided that Binance would operate an unregistered exchange for British citizens. Following this announcement, a number of UK banks no longer allowed their customer accounts to send funds to Binance or buy crypto with credit cards.

Related: Binance in the crosshairs: do the regulators watch out for crypto?

According to reports in May, the exchange is also being investigated by the U.S. Department of Justice and the IRS, who may be investigating money laundering and tax offenses. It’s also an ominous sign that the currency’s former acting auditor Brian Brooks has stepped down from his position as CEO of Binance.US after just four months. Knowing Brooks, I speculate that his departure was because he was unwilling to risk his reputation for an organization which he found irrevocable and which violated numerous rules and regulations in various countries.

Related: DEXs could see a surge in demand as regulators target centralized exchanges

Another centralized exchange, BitMex, was opened by the U.S. Commodity Futures Trading Commission and FinCen sued in federal court for allegedly operating an unregistered derivatives exchange from 2014 to October 2020 that enabled American residents to trade crypto futures. BitMEX agreed to settle the fees and pay a civil fine of $ 100 million, according to a press release dated Aug. 10.

On August 9, the SEC announced that it had initiated and resolved administrative proceedings against the Poloniex centralized exchange, which agreed to pay over $ 10 million in levy, interest and civil penalties. The resolution order alleges that Poloniex’s trading platform met the definition of “stock exchange” under the federal securities laws and that its failure to register as a “national stock exchange” violated Section 5 of the Stock Exchange Act (not to be confused with Section 5 of the Securities Act of 1933, which includes unregistered offers of securities). Noteworthy in the order is that Poloniex followed industry practice of obtaining a legal memorandum from an outside law firm to analyze whether the tokens that were going to be listed on the exchange were “investment contracts” or securities, and some Token even delisted in 2018, it appeared to pass the Howey test. In addition, SEC Commissioner Hester Peirce effectively wrote a public disagreement noting the slow pace and lack of clarity with which the commission has acted in determining how companies can interact with crypto.

Also earlier that month, the SEC was tracking an allegedly decentralized exchange called DeFi Money Market that used smart contracts and issued two types of tokens. One of the tokens, issued by Blockchain Credit Partners, promised interest payments, the other promised voting rights and part of the profits from the exchange’s activities. Fraud allegations were based on the company and its clients allegedly misrepresenting what assets would be used to pay the promised returns. In settling the lawsuit on August 6, the SEC stated: “Here, marking the offering as decentralized and the securities as governance tokens did not prevent us from ensuring that the DeFi money market is closed immediately and investors are repaid. ”

While it would appear that DeFi Money Market didn’t work in the same way as many decentralized exchanges out there, it might be advisable that all platforms that are recruiting U.S. investors do a thorough analysis of potential registration issues with their attorney – including the Registration as an exchange, a broker-dealer, an investment advisor, a custodian, a money transmitter or an issuer under various laws. Otherwise, you might end up in the crosshairs of governments and their regulators – or worse, criminal authorities. In this regard, it’s worth checking out the SEC’s first case against a crypto exchange, EtherDelta, dated November 2018.

This article does not provide investment advice or recommendations. Every step of investing and trading involves risk, and readers should do their own research when making a decision.

Marc Powers is currently Associate Professor at Florida International University College of Law, where he teaches Blockchain, Crypto and Regulatory Considerations and Fintech Law. He recently retired from Am Law 100 law firm, where he built both the national practice team for securities disputes and regulatory enforcement and the hedge fund industry. Marc began his legal career in the SEC’s Enforcement Division. During his 40 years as a lawyer, he has been involved in representations including the Bernie Madoff Ponzi program, a recent presidential pardon, and the insider trading trial of Martha Stewart.

Views expressed are those of the author alone and do not necessarily reflect the views of Cointelegraph or Florida International University College of Law or its affiliates. This article is for general informational purposes and is not intended and should not be construed as legal advice.