Starting a Crypto Exchange or ICO?

The regulatory landscape for blockchain, cryptocurrencies, and digital assets alike has changed drastically since its advent in 2017. Now to start a crypto exchange or ICO one must first register as either a National Exchange or an Alternative Trading System (ATS) while also registering as a Broker-Dealer. Gone are the days of unchecked Initial Coin Offerings (ICOs), when new players could raise millions of dollars by merely publishing a tombstone or whitepaper. Over the past year, the Securities and Exchange Commission (SEC) has flexed its regulatory muscles, bringing investigatory cases against mainstream players and unscrupulous firms alike. In fact, any entity that has raised capital through a digital securities token, has, or should soon expect to hear from the SEC at some point. Today, regulatory agencies like the Financial Industry Regulatory Authority (FINRA) and the SEC have not only updated themselves with most aspects of blockchain technology, but have become sophisticated enough to differentiate between a ‘utility token’ and a ‘security token’.

Regulations for Starting a Crypto Exchange or ICOs

Is it time for these companies to step out of the grey area and understand the reality of becoming a regulated concern? If so, how can blockchain companies, advisors and digital platforms meld their business to function in this new regulatory world? How can individuals start a new crypto exchange or ICO? To answer these questions, first, we need to understand how the regulatory framework concerning ICOs has developed over the past few years.

Cryptocurrencies – Are They Securities or Not?

There has been an ongoing debate about the classification of digital tokens; are they securities or not? This question has plagued the industry with regulatory uncertainty for the past 2 years, causing stagnation in the marketplace, and in many cases, significant fines and other legal issues for firms operating in the grey.

Financial Regulators are Finally Taking Notice

More recently, the debate over the classification of these tokens has gained real momentum. As mounting pressure for industry oversite builds, regulators have begun pursuing investigatory cases against almost all issuers, traders and/or sellers of securities tokens. With vast sums of money changing hands, it was only natural for regulators, namely the SEC, to take note of the digital asset phenomena and jump in to protect small investors from being scammed by bad actors.

According to ICO data aggregator website icodata.io, the total amount of money raised through ICOs reached $7.8 billion in 2018 which is an astronomical jump when compared to the $90.25 million raised just two years earlier. Needless to say, the amount of capital being raised through these unregulated channels, coupled with the rally that cryptocurrencies experienced in 2017 put tremendous stress on rule-makers around the world. While previously, regulators and government agencies like the SEC and Department of Justice (“DOJ”)  worried about cryptocurrencies like bitcoin, then becoming the currency of choice for black market operators and criminal elements; now they have to deal with the creation of a whole new digital market, fueled by hopes of the investment masses, and in many cases, ignorant, unsophisticated investors who are chasing rallies with good capital.

SEC’s Statement About Cryptocurrencies & ICOs

Last year the SEC Chairman, Jay Clayton, released a statement in which he said:

“Before launching a cryptocurrency or a product with its value tied to one or more cryptocurrencies, its promoters must either (1) be able to demonstrate that the currency or product is not a security or (2) comply with applicable registration and other requirements under our securities laws.”

Since then, the SEC has been working with FINRA to create guidance that will allow issuers of new token to determine whether their tokens would be classified as a security or not.

Using the ‘Howey Test’ to Classify Digital Assets

This guidance was published in April of this year (Framework for “Investment Contract” Analysis of Digital Assets) and can be found here SEC potentially unlawful online platforms for trading digital assets.

Potentially Unlawful Online Platforms for Trading Digital Assets

In essence, the framework uses the often-cited ‘Howey Test’ to analyze whether (i) a digital asset is an investment contract and (ii) whether the offer and sale of the said digital asset is a securities transactions. This framework has been quite helpful for established companies in determining how, and in what form to issue their securities. More recently, a handful of companies have touted their successful digital Reg. A+ issuances. For companies deciding to issue securities tokens, there is a variety of classic (and quasi-new) issuance choices, including but not limited to filings under Reg. D, Reg. S, and Reg. CF.

Who Gets to Sell These Digital Tokens?

But this leads us to a more critical, and perhaps industrious question: if companies can issue their tokens under these classic regulations, who will act as the underwriter and sell these tokens to the public?

When someone asks me what I do for a living, I generally respond, “I build investment banks”. I found it to be the shortest, quickest way to explain an incredibly complex process. Given our staff’s proficiency in building Broker-Dealers and subsequent involvement with regulators, you can imagine how many phone calls I’ve personally taken from ICO advisors, crypto firms, blockchain enthusiasts, other would-be digital asset providers; all with one question in mind – how can we become an investment bank?

Understanding the Established Financial System

The financial markets have a system; it’s a rather large system with many moving parts, most of which are not visible to the average CNBC viewer. It’s quite old, filled with ‘red tape’, and, top-down. It’s filled with regulators, SROs, exchanges, clearing firms and prime brokers, investment banks, and retail operations. In the middle of it all, hedge & private equity funds play center, acting as both liquidity providers and takers. Trading firms and prop-desks also provide liquidity. While large funds, funds of funds and banks act to hold assets. All this is just to name a few of the many moving parts to our system.

Incorporating Crypto’s Next-Gen Tech into an Old System

In reality, any of the assets moved through this marketplace can be done so digitally. The technology associated with blockchain has been groundbreaking, unique, and exciting. However, while developers have spent the lion’s share of their time and capital focusing on technology, they failed to figure out how to fit this next-generation asset class into the old system.

Importance of Liquidity in the Marketplace

Every sustainable market needs liquidity – that is a fact. Ergo, market liquidity for digital assets is no different, and regulators must find a way to fit the old with the new. Like in any market, trading (in this case, on a digital platform where digital coins can be bought and sold) needs to be subject to a particular set of conduct rules to keep the marketplace respected, clean and free from manipulation. Investor interest, which is the backbone of market liquidity, relies on this basic premise. Hence, without regulation and conduct rule creation, the digital industry cannot support the growth to its full potential.

New Crypto Exchanges vs. Old Market Regulations

The regulations for which cryptocurrency and digital asset can be exchanged, traded in and/or sold were laid out long ago. I would argue most digital asset platforms will succumb to regulations that have been in place for decades, well before the ‘Analysis of Digital Assets’ was published. Many brilliant, forward thinkers created the crypto/blockchain marketplace; but it has little understanding of financial market regulation. While market regulation experts can see the proverbial ‘writing on the wall’, the digital asset world has been waiting for concrete, written guidance from regulators. The regulators have issued some statements along the way. In March last year, the SEC released a public announcement stating:

“A number of these platforms provide a mechanism for trading assets that meet the definition of a “security” under the federal securities laws.  If a platform offers trading of digital assets that are securities and operates as an “exchange,” as defined by the federal securities laws, then the platform must register with the SEC as a national securities exchange or be exempt from registration.”

National Exchange or Alternative Trading System (ATS)

The industry took this to mean any platform or ICO issuer facilitating the trading of digital tokens/coins/cryptocurrencies will be required under law to register either as a national exchange or as Alternative Trading System (ATS).

Only a handful of securities exchanges exist in the U.S. (e.g. NYSE, CBOE, NYMEX, etc…) and for a good reason. The licensing requirements alone to qualify as a national securities exchange are incredibly demanding. As most established blockchain/crypto companies and startups alike lack the financial (and other resources) for such an endeavor, it becomes clear that an ATS is the only option to start a crypto exchange or digital asset platforms. Moreover, as an ATS required registration as a Broker-Dealer, FINRA has received an influx of applications this past year.

What is an Alternative Trading System (ATS)?

An ATS is a somewhat archaic part of the financial world used predominately in the late 1990s, and 2000s to trade assets between large investment banks. The ATS came into being when the SEC introduced Regulation ATS in 1998. Alternative Trading Systems can differ from one another based on what kinds of securities are authorized for trading on their platform or what kind of investors can participate. For example, an ATS can only have authorization to deal in publicly traded securities like stock, while another can have the authorization to facilitate accredited investors to trade in private securities. A true ATS platform provides in-house technology where one or more investment banks can facilitate “off-tape” trading between them. Why is this important? Well, the simple answer is market liquidity and stable pricing. Perhaps more known ATS trading included mortgage-backed securities (“MBSs”) which created the 2008 financial crisis. ATS’s can also be known as ‘Dark Pools’.

Using an ATS to Start a Crypto Exchange

In the case of digital assets, an ATS can be used for something completely different; namely, to facilitate the trading of buyers and sellers of digital securities that are matched. While each ATS is unique and comes with its own rules and proxies, generally speaking, an ATS won’t set rules for buyers and sellers like a conventional exchange would, but rather, it can set rules of conduct for the parties that are transacting on the platform.

How to Register as an ATS?

To register as an ATS, a firm must first become registered with FINRA and the SEC as a Broker-Dealer. Only duly licensed Broker-Dealers have the ability to apply with the SEC for ATS registration. Broker-Dealer registration in itself is a unique process and is not an easy undertaking even with substantial resources. Just ask the board of Coinbase, who’s had its application with FINRA to register as a Broker-Dealer buried for over a year (as have many other digital asset companies in pursuit of the Broker-Dealer registration).

What is a Broker Dealer?

For those newcomers to the process, let’s look at the basics: what is a Broker-Dealer? Simply put, a Broker-Dealer is an investment bank, a registered entity that trades securities for itself or on behalf of clients. Broker-Dealers are registered with FINRA, the self-regulatory body overseen by the SEC, and in charge of regulating all U.S. securities transactions – all of them. Assuming trading in common exchange-traded securities (e.g. stocks, options, and bonds) one way to better understand and categorize Broker-Dealers can be on the basis of whether they (i) need a clearing firm, (ii) are a clearing firm or (iii) act as a self-clearing firm. A self-clearing firm can clear trades and settle transactions done for its own account or on behalf of its clients (large investment banks), while other smaller mid-sized firms can utilize the platform of a clearing firm, also registered as a Broker-Dealer. Most digital asset ATS applicants will be neither and place them in a unique category called “Other” on the application. Either way, it is only after a company has successfully registered as (or acquired) a Broker-Dealer that they become eligible to apply to the SEC for an ATS license.

How to Register as a Broker Dealer?

There are many steps required to become a registered Broker-Dealer when you start a crypto exchange. Whether starting a new firm, or acquiring a Shell Broker-Dealer, there are some fundamental rules, and other complex nuances that every soon to be Broker-Dealer should understand. I invite you to read other articles on these topics we’ve published over the years, on topics including registering and/or buying a Broker-Dealer. While the process may deem daunting (it rightfully should) the good news is successfully registering as a Broker-Dealer, and ATS is possible with the right team in place.

Compliance Exchange Group specializes in buying and selling Broker-Dealers, providing guidance for Broker-Dealer registration, principal outsourcing, and full-service compliance solutions for Broker-Dealers.