The endangered state of digital asset exchanges
Introduction
According to a Bloomberg report, the Commodity Futures Trading Commission (CFTC) is investigating Binance Holdings Ltd. for permitting U.S. residents to access certain services. This follows the CFTC’s action against BitMEX for violating multiple regulations and Coinbase Global Inc.’s recent disclosure of an extensive CFTC investigation.
To those that believe that digital assets operate outside of government oversight, the U.S.’s expanding offensive on digital asset players should be a clear signal that existing regulatory structures apply to the digital asset ecosystem.
To that end, this article will discuss developing legal themes that endanger current digital asset exchanges. Surprisingly, beyond the current CFTC probes, some of the major names in the space, Binance, Kraken and Coinbase, make appearances across several legal risk categories. Not surprisingly, a further subset of this group, Binance and Kraken (along with ShapeShift), was arguably involved in a delisting campaign against BSV, an established digital asset that is not a security, because the exchanges and related persons did not agree with the personal position and stance of a specific individual, while these exchanges continued to list XRP, a digital asset alleged by the SEC to be a security, and ETH, a digital asset I have previously outlined as fitting the characteristics of a security.
As stated by the SEC, “Federal securities laws are based on a simple and straightforward concept: everyone should be treated fairly and have access to certain facts about investments.”
Accordingly, the actions of Binance, Kraken and ShapeShift debatably violated this principle and U.S. securities laws as discussed below.
As I will outline below, insofar as digital asset exchanges wish to continue serving the U.S. market without being shut down, they would be wise to undertake much more careful vetting of:
- the tokens they list or delist;
- the programs they provide to users, for example staking ETH to the Ethereum 2.0 network; and
- internal compliance regimes to ensure compliance with AML regulations, for example.
Exchange liability for listing securities tokens
Over the past several years, the SEC has brought civil lawsuits against several token issuers alleging violations of U.S. securities laws. Courts have ruled in favour of the SEC in two recent cases involving tokens not associated with initial coin offerings (See S.E.C. v. Kik Interactive, Inc. and S.E.C. v. Telegram Group).
However, these lawsuits did not present the question of whether and to what extent exchanges may face liability for listing and facilitating digital asset transactions that fall within U.S. securities law.
Recently, however, the SEC has filed a lawsuit that changes that. In SEC v. Ripple Labs, the SEC filed a complaint alleging securities law violations against Ripple Labs, the issuer of the XRP digital token. The SEC alleges that Ripple’s continuous offering of this token from 2013 through the present constitutes a series of unregistered securities transactions. XRP has long been listed by various major digital asset exchanges, including Binance, Coinbase, Kraken, ShapeShift, Bitfinex and OKCoin. In the wake of the filing of this complaint, though some exchanges have announced their intention to suspend trading in XRP for U.S. customers, others continue listing XRP despite the SEC’s filed complaint.
These developments raise the question of whether those exchanges that have listed and facilitated trades in XRP—whether or not they have since delisted—have exposed themselves to liability under U.S. securities law. This lawsuit also raises the question of whether the exchanges that have chosen not to delist in the wake of the SEC’s complaint against Ripple face heightened exposure risks.
If the court should agree that the continuous distribution of XRP qualifies as a series of securities transactions, several provisions of U.S. securities law could give rise to exposure for exchanges that have facilitated purchases, sales and exchanges in XRP. These provisions include:
- Selling Unregistered Securities Liability – An exchange (whether registered or not) that lists and allows trades in unregistered securities could be liable under Section 5 of the Securities Act of 1933 (“Securities Act”), as amended, which prohibits selling an unregistered security by use of interstate commerce.
- Unregistered Securities Exchange Liability – Section 5 of the Securities Exchange Act of 1934 (“Exchange Act”), as amended, prohibits any exchange that does business in whole or substantial part in the United States from listing any security—registered or not—if that exchange is not registered as a national securities exchange with the SEC.
- Unregistered Broker/Dealer Liability – Section 15(a) of the Exchange Act makes it unlawful for any broker or dealer to facilitate securities transactions by way of interstate commerce unless the broker or dealer is registered with the SEC.
- Aiding and Abetting Liability – The Securities Act exposes parties to aiding and abetting liability where there is proof that the exchange acted knowingly or recklessly in substantially assisting the issuer of unregistered securities to violate Section 5 of the Securities Act.
The first three provisions are strict liability—requiring no proof that an exchange knowingly or recklessly violated the law in listing or facilitating transactions in the unregistered securities. In contrast, for the SEC to establish aiding and abetting liability, it would need to prove that the exchanges acted with scienter. Thus, the exchanges that have listed XRP could be found liable under the first three provisions regardless of whether they knew or understood that transactions in XRP might qualify as securities transactions. They may likewise be liable whether or not they opted to delist in the wake of the SEC’s complaint, since there is no requirement that they must have been put on public notice of the unlawful nature of the transactions before exposure may attach. However, those exchanges that have continued listing XRP in the wake of the SEC’s complaint face potentially heightened penalties, as their conduct would likely establish reckless disregard under the securities law, a showing that would expose these exchanges to drastically higher per-transaction fines.
Each of the exchanges that has listed XRP—whether or not they have since chosen to delist XRP—faces serious exposure under U.S. securities law. Furthermore, those exchanges that have refused to delist XRP in the face of the SEC’s 71-page complaint detailing how Ripple’s distributions fall afoul of U.S. securities law face even greater potential exposure.
The exposure risk, moreover, extends beyond the decision to list XRP to all similar tokens listed on their platforms. As I discussed in my previous article, if we accept the Hinman puzzle and assume ETH transitioned away from classification as a security, which I argue is debatable, there are compelling reasons to conclude that Ethereum 2.0 brings it back to its state as a security. If the Ripple complaint makes anything clear, it is that the SEC will not give exchanges a pass for facilitating violations of U.S. securities law. Thus, insofar as digital exchanges wish to continue serving the U.S. market without being shut down, they would be wise to register with the SEC or undertake much more careful vetting of the tokens they list to ensure that they are not listing tokens that implicate U.S. securities law.
Digital asset exchange Ethereum 2.0 staking programs under Howey
Ethereum’s creators recently announced the launch of a new Ethereum network, Ethereum 2.0. This network will run alongside the existing Ethereum network (also known as the “ethereum mainnet”). In order to launch, the creators required a certain threshold of users to stake 32 ETH each to the Ethereum 2.0 network and act as validators on the network. In exchange, the Ethereum Foundation promises a schedule of rewards to active validators.
In the wake of this announcement, more than one major digital asset exchange have offered to its customers the opportunity to stake ETH through their trading platforms. Presently, I am only aware of one exchange, Kraken, that is offering a staking program to U.S. users, with Coinbase offering an ETH staking waitlist to U.S. residents. Exchanges have offered their users the opportunity to stake less than the 32 ETH required to fund a validator and to pool those users’ assets with the staking assets of other users to be able to earn validator rewards as a collective.
These developments raise the question of whether these programs amounts to an offer or sale of a security under U.S. law.
There are several aspects of these programs that would likely cause the SEC or a court to conclude that the entire process constitutes an investment contract under the Howey test and thus qualifies as a security that must be registered.
As to the first element under Howey, a court would likely find that exchange users who stake ETH to the Ethereum 2.0 network through these programs have made an investment of money through the platforms.
As to the second element of Howey, a common enterprise, a court would likely find as to those users who stake less than 32 ETH, these platforms have engaged in pooling of funds that would give rise to horizontal commonality, because these exchanges can only participate as a validator by staking exactly 32 ETH to the Ethereum 2.0 network. The SEC might plausibly be able to establish a stricter version of vertical commonality to the extent that exchanges have staked a significant quantity of their own ETH holdings to the Ethereum 2.0 network, such that they would be incentivized to support the asset’s value.
As to the third element, a reasonable expectation of profits, there are several factors that would support a finding that the users who stake ETH through these exchanges have an expectation of profits. These exchanges generally offer their customers rewards between 5-20 percent per year. Accordingly, users who stake ETH to the Ethereum 2.0 network through these exchanges would reasonably expect profits through their validator rewards.
Finally, the SEC and courts are likely to find the fourth element likewise satisfied. This element asks whether the users who stake via these platforms bear a reasonable expectation of profits based upon the entrepreneurial or managerial efforts of others. In evaluating this element, a court would likely consider the role the exchanges play in these staking programs. To run a validator node on the Ethereum 2.0 network, one needs hardware and financial resources for node operation costs.
These exchanges have offered to provide these resources, post themselves as the validators on behalf of the users, and, under certain circumstances, bear the risk of on-chain penalty and forfeiture in the event that the user goes idle, engages in malicious conduct, or fails to validate while their ETH is staked to the Ethereum 2.0 network, where the exchange is at fault for such penalty. A court may thus reasonably find that the chance of obtaining the validator rewards available to Ethereum 2.0 validators depends heavily on the efforts of these exchanges to (i) provide the resources and hardware required to run the node and (ii) ensure that the validator does not go idle, fail to validate, or engage in malicious conduct that would result in forfeiture of the ETH staked to the new network.
While this question is entirely novel, to the extent that these programs allow U.S. users to participate, the facts above would reasonably support the SEC and federal courts concluding that these programs constitute investment contracts under Howey.
Again, given the U.S.’s expanding offensive on the digital asset ecosystem, it is clear the exchanges will not receive a pass for facilitating violations of U.S. securities laws.
Anti-Money Laundering Act of 2020 and digital assets
The National Defense Authorization Act, enacted January 1, 2021, includes the Anti-Money Laundering Act of 2020 (AMLA). The AMLA is the most significant change to US anti-money laundering law since the Bank Secrecy Act of 1970 (BSA). The BSA seeks to prevent and detect money laundering and the financing of terrorism. Building upon this, the AMLA seeks to, among other things, modernize the BSA, establish a uniform reporting regime, codify a risk-based approach to anti-money laundering (AML) compliance, and most relevant for this article, apply AML laws to digital asset businesses.
In addition, the AMLA increases criminal and civil penalties for violations of the BSA, vastly expands the subpoena power available to the Department of Justice (DOJ) and allows the DOJ to serve subpoenas on any foreign bank in investigations related to violations of the BSA, U.S. criminal law, or civil forfeiture statutes and establishes additional incentives for whistleblowers to report violations by increasing incentives vastly to 30% of the total amount collected by the government where sanctions exceed $1 million.
Putting this together, exchanges serving the U.S. market would be wise to undertake much more significant compliance regimes to ensure that they are not violating AML laws. As per The 2021 Crypto Crime Report by Chainalysis, exchanges are the main destination of unlawful funds and, in the three years studied by Chainalysis, the top two services accepting unlawful funds have not changed. Though not mentioned by name in the 2021 report, in The 2020 State of Crypto Crime report by Chainalysis, the lead exchange receiving unlawful BTC was Binance. This should be a red flag for regulators given Binance is the largest operating exchange and is arguably subject to the AML regulations highlighted in this section.
Conclusion
For the digital asset space to flourish, compliant exchanges are required to protect investors, facilitate access to capital and support fair, orderly and efficient markets.
About the Author
Johnny Jaswal is the Managing Director and General Counsel of the Jaswal Institute, responsible for providing regulatory, legal, government relations, strategic and related investment banking advisory services. He has a wealth of experience advising on regulatory matters, mergers, acquisitions, divestitures and capital raising activities.
Johnny represents global blockchain and digital asset companies and is responsible for leading international advisory services. In addition to advising governments and regulatory authorities on digital asset legislation, Johnny has formed/executed the global M&A, capital raising, regulatory and tax strategies for multiple businesses.
Prior to founding his advisory firm, Johnny was a member of senior management on the corporate development and strategy team of TMX Group, which owns a portfolio of financial and technology assets including the Toronto Stock Exchange, an investment banker at TD Securities, which is among Canada’s top-ranked investment banks, a business lawyer at Blake, Cassels & Graydon LLP and Goodmans LLP, two of Canada’s top law firms, and an engineer in several sectors.
Johnny has a Master of Business Administration from the Schulich School of Business, a Juris Doctor from Osgoode Hall Law School, a Bachelor of Engineering: Electrical Engineering from Ryerson University and has been admitted to the Ontario Bar.
This article is for informational purposes only and does not, and is not intended to, constitute legal advice. No person or entity may rely on this article for legal or other advice from Johnny Jaswal/the Jaswal Institute. The article speaks solely as of the date written. Future factual changes or developments, and future court cases or regulatory guidance, could affect the analysis or conclusions presented in the article. Johnny Jaswal/the Jaswal Institute are not under any obligation to update the article to reflect future events or factual changes, or for any other reason.
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