As with the regulation of ICOs and Cryptocurrency Funds, the regulation of exchanges and online trading platforms for ICO tokens and cryptocurrencies is in its infancy.  In the U.S., regulators at both the state and Federal level are scrambling to get their hands around this financing technology and to determine whether they have the authority to regulate it.

Depending on the structure of the exchanges and trading platforms, there are at least four regulatory bodies that may have jurisdiction:

  • Business activities in virtual currencies, which include a wide variety of activities including buying and selling virtual currencies as a customer service and operating a virtual currency exchange as a customer service, are now regulated by the State of New York, and similar state regulatory schemes are expected to be adopted in the coming months.
  • Platforms that allow for trading virtual and fiat currencies will be subject to regulation and licensing at the Federal and state level as money transmission businesses.
  • Trading in options and other derivatives on virtual currencies is regulated by the Commodities Futures Trading Commission (CFTC).
  • Trading platforms and exchanges for tokens and other cryptocurrencies that are treated as securities are regulated by the Securities and Exchange Commission (SEC).

Virtual Currency Licenses in New York

In June 2015, the New York State Department of Financial Service’s issued regulations governing virtual currency licensing became effective.  The regulations require a license, known as a BitLicense, for all Virtual Currency Business Activity involving New York or a New York Resident.  Virtual Currency Business Activity is defined as:

 “(1) receiving Virtual Currency for Transmission or Transmitting Virtual Currency, except where the transaction is undertaken for non-financial purposes and does not involve the transfer of more than a nominal amount of Virtual Currency;

(2) storing, holding, or maintaining custody or control of Virtual Currency on behalf of others;

(3) buying and selling Virtual Currency as a customer business;

(4) performing Exchange Services as a customer business; or

(5) controlling, administering, or issuing a Virtual Currency.

The development and dissemination of software in and of itself does not constitute Virtual Currency Business Activity.”

In certain cases, other New York licenses may be required, such as a money transmitter license or a banking license.

Since the regulations were adopted, several prominent exchanges and trading platforms have received licenses, including bitFlier, Coinbase and Gemini.

Several other states are looking to adopt similar regulations, and at the Federal level, the Acting Comptroller of the Currency, Keith Noreika, has stated that his agency is looking at adopting a nationwide licensing program for cryptocurrency exchanges, similar to the licensing program recently enacted in Japan.

Considerations Related To The Bank Secrecy Act

The ICO market recently saw criticism directed at it from notable figures across the financial services industry, given the potential of its being used to finance terrorism, facilitate money laundering, and be useful to other forms of criminal activity. ICO participants inside the United States, or those targeted at American citizens, need to be sensitive to the U.S. Bank Secrecy Act (BSA) as well as its associated regulations.

The BSA mandates any entity meeting the qualifications or definition of a “financial institution” to develop and maintain proper programs that can assist the Federal government in the prevention and detection of criminal activity. The BSA guidelines defining a “financial institution” include banks, futures commission merchants registered with the CFTC, and broker-dealers registered with the SEC, as well as any business other involved in money transmission. In particular cases, crypto exchanges and trading platforms that accept fiat currencies as well as virtual currencies will probably be subject to some or all BSA regulations as they are deemed money transmitters.

Anti-Money Laundering And General BSA Obligations

An anti-money laundering (AML) program has to be commensurate with any risks posed by the business size and location as well as the volume and nature of the financial services offered. An AML program should incorporate internal controls, procedures and policies that are designed to establish continual compliance with any applicable BSA requirements, independent monitoring, the continuing training of proper personnel, and the designation of a compliance officer or multiple compliance officers. The mandate that customer identities be verified definitely gives rise to tension in this industry, as the purchase of tokens often incorporates pseudonymous or even anonymous transactions.

Money Transmitter Licensing

Crypto exchanges and trading platforms that accept fiat currencies will probably be deemed to be money transmitters, given that BSA regulations define a “money transmission service” as a service that accepts funds, currency, or other value substitutes from one individual and transmits those funds, currency, or other valuables to another person or location through any means. The Financial Crimes Enforcement Network (FinCEN) has provided administrative rulings and interpretive guidance on this matter, but the issues revolving around crypto exchanges and trading platforms and how they may or may not be subjected to state and/or federal regulations are past the scope of this article. Generally speaking, any ICO sponsor dealing in a decentralized virtual currency, like Bitcoin, is probably not going to be subjected to federal regulations and be treated as a money transmission business. However, a crypto exchange or trading platform that runs a centralized platform on which a user can redeem tokens or transmit and accept virtual currency on the behalf of others might be subjected to such regulations. A SAFT might represent one way to help out addressing particular regulatory matters, such as concerns over money transmitter licensing.

Most states in the U.S. require the registration of firms engaging in the money transmission business, and thus an exchange or trading platform that accepts fiat currency will need to ensure compliance at the state level.

Crypto Derivatives

As we discuss on our ICO Funds page, the CFTC considers cryptocurrencies to be commodities, and thus futures, options and other derivatives on cryptocurrencies are subject to CFTC regulation.

In addition, the CFTC has approved several varieties of off-exchange trading platforms:

  • Traditional commodities exchange and boards of trade are called Designated Contracts Markets (DCMs)in the Commodities Exchange act (CEA), the main Federal statute regulating the commodities futures industry. The North American Derivatives Exchange (NADEX), a DCM, has traded binary options based on the Tera Bitcoin Price Index.  And in late 2017, both the Chicago Mercantile Exchange and the Chicago Board of Trade, which are CFTC regulated commodities futures exchanges, began trading of bitcoin futures contracts.
  • Swap Execution Facilities (SEF’s) are regulated trading facilities for financial swap transactions. Regulation of SEF’s was expanded in 2010 under the Dodd-Frank Act, which gave regulatory oversight of securities-based SEFs to the SEC and commodity-based swaps to the CFTC.  In 2014, the CFTC granted TeraExchange an SEF license for trading in swaps on Bitcoin.
  • A derivatives clearing organization (DCO) is an entity that enables each party to an agreement, contract, or transaction to substitute, through novation or otherwise, the credit of the DCO for the credit of the parties; arranges or provides, on a multilateral basis, for the settlement or netting of obligations; or otherwise provides clearing services or arrangements that mutualize or transfer credit risk among participants. A DCO that seeks to provide clearing services with respect to futures contracts, options on futures contracts, or swaps must register with the CFTC before it can begin providing such services.  In 2017, LedgerX registered with the CFTX as a DCO and a SEFto clear digital currency options.

SEC – Broker-dealer ATS

As discussed on our ICO Page, the SEC is taking an aggressive view on classifying various types of tokens as securities.  This means that a broker or dealer in securities tokens must register with the SEC under the Securities Exchange Act of 1934 (the Exchange Act).  A “broker” is a person engaged in the business of effecting transactions in securities for the account of others; a “dealer” is a person engaged in the business of buying and selling securities for his own account, through a broker or otherwise. Traditional stock brokerage firms operate in both capacities, either brokering stock purchase and sales, or buying securities from and selling securities to customers from their inventory.  Stock exchanges are also regulated by the CES under the Exchange Act.

Setting up and registering a full-blown securities exchange for the trading of securities tokens would be extremely difficult and expensive.  However, a licensed broker-dealer could set up an online trading platform for trading in securities as an “alternative trading system” (ATS) under the Exchange Act. This is the model followed by and other platforms for trading exempt securities.  There is no separate ATS license: if the sponsor of the trading platform has a broker-dealer license, then it just needs to file some additional forms with the SEC regarding its ATS activities.

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Lawyers for ICO's, ICO funds and BDC's, and Cryptocurrency Exchanges