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The Application of Broker-Dealer and Exchange Regulations to Secondary Markets – Thought Leaders

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The Application of Broker-Dealer and Exchange Regulations to Secondary Markets - Thought Leaders

Sweat the Small Stuff and Maybe the Bigger Issues Will Take Care of Themselves.

The Application of Broker-Dealer and Exchange Regulations to Secondary Markets Trading of Digital Assets.

The U.S. Securities and Exchange Commission’s (“SEC” or “Commission”) recent enforcement actions involving AirFox, Paragon, Crypto Asset Management, TokenLot, and EtherDelta’s founder illustrate that market participants must still adhere to well-established and well-functioning federal securities law framework when dealing with technological innovations, regardless of whether the securities are issued in certificated form or using new technologies, such as blockchain.

Broadly speaking, the issues raised in these actions fall into three categories: (1) initial offers and sales of digital asset securities (including those issued in initial coin offerings (“ICOs”)); (2) investment vehicles investing in digital asset securities and those who advise others about investing in these securities; and (3) secondary market trading of digital asset securities. 1 See Statement on Digital Asset Securities Issuance and Trading by the SEC’s Division of Corporation Finance, Division of Investment Management, and Division of Trading and Markets (Nov. 16, 2018). https://www.sec.gov/news/public-statement/digital-asset-securites-issuuance-and-trading  This article discusses some of the nuances of trading of digital asset securities in the secondary market.

As the Commission’ statement made clear “[a]ny entity that provides a marketplace for bringing together buyers and sellers of securities, regardless of the applied technology, must determine whether its activities meet the definition of an exchange under the federal securities laws. Exchange Act Rule 3b-16 provides a functional test to assess whether an entity meets the definition of an exchange under Section 3(a)(1) of the Exchange Act. An entity that meets the definition of an exchange must register with the Commission as a national securities exchange or be exempt from registration, such as by operating as an alternative trading system (“ATS”) in compliance with Regulation ATS.” 2 Id.

In determining whether an individual, entity or platform is acting as a broker-dealer or an exchange, the SEC will conduct its analysis based upon 1) the totality of the activities conducted by the participant as well as 2) the functional reality of what those activities achieve.  If an entity provides a marketplace for bringing together buyers and sellers of digital asset securities, the SEC may find that such an entity is operating as an exchange. If an entity or a person is effecting transactions in digital assets or buying and selling digital assets for its own account, the SEC may find that such an entity or individual is acting as a broker or dealer in securities. 3 See Scheibe, Taub, Selinger, Steele and Woodward, SEC DIVISIONS ISSUE DIGITAL ASSET SECURITIES STATEMENT November 28, 2018 https://www.mwe.com/insights/sec-divisions-issue-digital-asset-securities-statement/  Any such broker-dealer must register with the SEC, as well as become a member of a self-regulatory organization, such as FINRA.  Registration as a broker or dealer also results in adherence to a far-reaching compliance and investor protection regime.

Some of the most basic requirements that can pose roadblocks or speedbumps for the development of secondary market trading of digital assets include:

  • Books and Records: Registered broker-dealers must make and maintain current books and records. Rules 17a-3 and 17a-4 under the Exchange Act and FINRA Rule 4511, for example, require that broker-dealers preserve certain records for specified periods of time and use certain technology such as write once read many (WORM) format. How can a digital-asset ATS be sure that the use of Digital Ledger Technology for recording and maintaining such information is in compliance with the SEC and FINRA’s requirements? The short answer should be that the blockchain is immutable and thus satisfies this requirement but some regulatory assurances on this would be helpful.

 

  • Customer Protection: Under SEC Rule 15c3-3, a broker-dealer must maintain the physical possession or control of all fully paid securities and excess margin securities carried by the broker-dealer for the account of its customers. It is currently unclear whether the requirements of Rule 15c3-3 are met where transactions in digital securities are recorded on a database that is maintained over a public or private network. Does a Broker-dealer have the ability to demonstrate receipt, delivery and custody of securities and other assets of their customer’s accounts where such records are held on chain? For example, is it required that ICO tokens, securities or other assets be held in a customer’s account (wallet) or does the ATS sponsor need to provide for the custody of these securities and assets with a third-party qualified custodian?

 

  • Examinations: Broker-dealers and regulators are still figuring out these new technologies and how existing regulations apply to them. FINRA’s current examination module for an ATS may very well be ill suited to a digital asset ATS.  FINRA in Notice 18-20 (July 6, 2018) made clear that is seeking additional information from broker-dealers and “to encourage each firm to promptly notify FINRA if it, or its associated persons or affiliates, currently engages, or intends to engage, in any activities related to digital assets”.

 

  • Net Capital Rules: The Commission’s net capital rules will arguably have the most severe impact on the development of secondary trading markets in digital assets. The SEC has previously stated that Exchange Act Rule 15c3-1 “requires broker-dealers to maintain a minimum level of net capital (consisting of highly liquid assets) at all times.” 4 See SEC Securities Exchange Act Release No. 70073 (July 30, 2013) (Order Approving File No. S7-23-11). FINRA Rule 4100 Series (Financial Condition) expands the various requirements for broker-dealers to ensure compliance with the SEC’s net capital rules.  Given that digital assets coming off the Reg D imposed restriction period are unlikely to meet the requirements for highly liquid assets, these net capital requirements may pose the biggest hurdle in allowing for deep and liquid markets to come into being in the near term. In order to allow this nascent digital asset securities market to grow and bring liquidity to shareholders, the Commission and FINRA may wish to allow for a pilot program to facilitate the development and oversight of this market.

 

In conclusion, the promise of DLT and the application of Exchange Act Rules still have some ways to go before digital assets can be traded freely and transparently on exchanges and ATS’. That being said, it’s not too early for market participants in this space and regulators to come together to address a roadmap for the near future in the U.S. A discussion of some of these topics at the upcoming SEC Forum 5SEC Staff to Hold Fintech Forum to Discuss Distributed Ledger Technology and Digital Assets, SEC Press Release 2019-35 (March 15, 2019) is essential for furthering this dialogue and unlocking the promise of liquidity that digital asset issuers aspire to.

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Security Tokens or STO – When any Asset Becomes a Digital & Immutable Proof of Ownership – Thought Leaders

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Security Tokens or STO - When any Asset Becomes a Digital & Immutable Proof of Ownership - Thought Leaders

Regulation

The regulatory scrutiny has morphed into a permanent reality in the crypto space. This much had become clear in early 2018. Regulators from all corners of the globe are looking to fit the crypto phenomenon into some regulatory rules or framework. The main question however is to discern what crypto assets are? And whether crypto assets are securities? If they are, then the relevant law must be applied.

In the US, Securities and Exchange Commission (SEC) had announced that all crypto assets are investment contracts or – securities. This later corrected that all, except for Bitcoin and Ethereum (in its present stage) are to be deemed securities. 6https://coincenter.org/ files/2019-03/clayton-token-response.pdf

The reality is the American legal system largely still relies on the 86 year old Securities Act, with exceptions made available with enacting the JOBS Act in 2012. And within this amendment, there is a place for security tokens to be issued as well. Small issuances of up to USD 1m can be effected as crowdfunding projects. Larger deals can be done as private placements or public offerings limited to accredited (professional or high net worth) investors. Either way, the registration of the issuing security is mandatory. It is likely that the Securities Act may see a major revamp to exclude most cryptocurrencies from the scope of federal securities law. 7https://cryptovest.com/news/bipartisan-bill-proposes-to-exclude-crypto-from-us-securities-law/ In the meantime, the most recent discussion identifies guidelines on how to assess if the publicly offered or sold digital asset is an investment contract and therefore a security. 8https://www.sec.gov/files/dlt-framework.pdf

In Europe, on the other hand, the European Securities and Markets Authority (ESMA) has called to extend Europe’s revised Markets in Financial Instruments Directive (MIFID II) to include cryptocurrency products such as initial coin offerings with securities features among transferable securities or other types of financial instruments. 9https://www.esma.europa.eu/press-news/esma-news/crypto-assets-need-common-eu-wide-approach-ensure-investor-protection European Prospectus Regulations will apply in full from 21 July 2019 and replace the current directive. Under the Regulation each EU member state will be able to set its own limit between 1 and 8 million EUR when the mandatory prospectus requirement applies.

On the brink of Brexit, the UK’s Financial Conduct Authority (FCA) published an extensive consultation paper on the classification and regulation of crypto assets. 10https://www.fca.org.uk/publication/consultation/cp19-03.pdf The paper seeks to provide regulatory clarity for firms and consumers, when certain activities around “cryptoassets” or tokens themselves fall within the FCA’s regulatory perimeter. The FCA reminds that the breach of authorisation regime is a criminal offence and carries a maximum penalty of 2 years imprisonment or an unlimited fine, or both. Following the consultation period, FCA intends to publish the final Policy Statement in relation to cryptoassets by summer 2019.

Other pioneering jurisdictions, such as Switzerland, Malta, Estonia, Lithuania, Liechtenstein have reviewed the types of crypto assets and proposed a classification thereof.

All the above mentioned jurisdictions offer more-or-less similar classification of tokens. Largely separating tree or four types. It is a matter of not so distant future, when every national regulatory body will be compelled to put out their opinion or guidelines on the subject.

Tokenisation digital and immutable proof of ownership

The rise and fall of the ICO exuberance has resulted in setting a firm precedent in demand for tokenisation. It has also set an example for how the future of securities will likely look. There will always be a law governing securities issuance. But there also will be a decentralised reflection of the issued securities on the blockchain. With transparent protocol implementation, everyone should be able to access smart contract specifications and assess overall market interest.

The IEO or initial exchange offering appeared to remedy some of the most lacking aspects of a typical ICO, such as reliability, custodianship, vetting, transaction speed, cost, and sales channels. But it is yet to be seen, if it turns out to be the most appropriate utility token issuance method. After all, tokenisation is adding to a healthy competition amongst issuers and issuance platforms.

A legacy exchange listing cannot be applied to tokenised securities. Legacy exchanges lack understanding of the underlying technology and regulatory clearance. This is why there are many new technologically advanced initiatives, looking to set up a regulated space for security token listing and secondary market.

For a small-capital company a KYC/AML compliant STO campaign can be considered as an alternative way to access funding. Tokenising businesses by offering equity tokens, revenue sharing or raising capital with debt tokens may become an inevitable part of a company funding life cycle. A security token offering may be equaled to initial or subsequent equity or debt offering in the form of a digital token.

When asset becomes a digital and immutable proof of ownership to a global community, that is when we have created a democratic access for everyone to participate in the growth of the global economy. Today, not all countries have harmonised securities laws. But we are well on the way to lowering barriers of entry for both investors and issuers.

About the author

Liza Aizupiete, the Managing Director of Fintelum, which serves the crypto industry by carrying out a technically sound and KYC/AML compliant token sale process, crypto funds co-custody, transfer agency, secondary token OTC desk and corporate actions.

Previously Liza was a founder and the Managing Director of a cyptocurrency exchange Globitex, as well as the General Director of Lithuanian e-money institution NexPay UAB. A Latvian native, Liza graduated from the University of Geneva, Switzerland, majoring in Philosophy. Liza is experienced in the financial industry, including trading, fund and portfolio management. Since 2012, she has become passionate about Bitcoin and later crypto industry at large, as a proponent of a decentralised and sound monetary system.

About Fintelum

Fintelum is a comprehensive ICO/STO token launch platform for businesses looking to tokenise their assets in the form of utility, equity, debt and other asset or revenue sharing token. Fintelum suite of services comprises a regulated KYC investor onboarding, and continuous compliancy with the EU AML laws. The token sale process can be followed through a tailor made dashboard. The backoffice system allows data access and management as well as on-demand reporting. In addition, to help mitigate token sale process risks, Fintelum acts as a crypto currency co-custodian. The system incorporates an integrated multi signature cold/hot wallets. To serve the security token industry, Fintelum acts as a transfer agent, ensuring security token ownership amongst whitelisted investors. Fintelum is also able to provide secondary token OTC exchange desk functions, with ongoing corporate action services, such as voting, dividends and announcements.

Learn more at https://www.fintelum.com


 

This is part 5 of a 5 part series.

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Click Here for Part 3

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Security Tokens or STO: Evolution in Capital Markets – Thought Leaders

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Security Tokens or STO: Evolution in Capital Markets – Thought Leaders

From the traditional private equity or debt to less conventional crowdfunding. The most recent tokenisation method is the next step in the evolution of the capital markets.

Often ICO token issuers made public promises regarding future increase of value of their token. Such claims are deemed to be promoting securities, according to regulators. There were additionally cases where ICOs blatantly disregarded their roadmap commitments. Around the same time as some bad ICO apples were falling, and regulatory scrutiny was increasing, STO or security token offering ideas became vocal, as the natural continuation of the ICO industry.

Indeed, STOs make more legal sense, but much less retail buzz. The times of raising hundreds of millions for a white paper idea are definitely gone. But it is the contention of the author of the present article – that does not mean all ICOs are dead. There still can be cases of utility represented by a smart contract token.

However, if there is no utility or service on offer, then it is likely a future profit distribution, or outright corporate rights exercise. In other words – a security.

A security is a legally defined financial asset that can be traded or exchanged. A legal definition however varies by jurisdiction. The main categories are equity or debt, or derivatives thereof. Securities are offered by an issuer. The primary offering of a security today can be done either through crowdfunding, private placement, or full- fledged public prospectus offering. Depending on the amount and jurisdiction, either option would constitute an issuance of a security.

A tokenised security offers a combination of advantages of both the ICO practice as well as the existing securities laws. On the one hand, an STO complies with the law to the letter. And on the other hand, an STO offers a similar promise of an immediate (or delayed in case of legally required lockup periods) liquidity.

There are no “securities token exchanges” to date (April 2019). But there are quite a few initiatives looking to obtain regulatory authorisation to run a securities exchange for the modified securities asset class – security tokens. Potential way of exchanging security tokens would be OTC desks provided by ownership transfer agents such as Fintelum. See more below.

The main difference that sets security tokens apart from non-token securities is the actual blockchain aspect. Now in stead, or rather in addition to regulatory requirements, such as registration of certificates, shares, bonds and debentures – a smart contract is issued representing the registered rights and obligations of the issued security, whereas bearer securities could be most effectively tokenised.

Investors or participants of an STO are typically cryptocurrency users, but not necessarily. STO practice will continue the path carved by the ICO industry in setting the use cases for cryptocurrency at large. The STO offer is not so democratic than ICO used to be. Security token offering is much less frictionless than it used to be with utility tokens.

Today, the potential buyer of an STO will need to overcome burdensome KYC/AML profiling process to be compliant with the sales of a security. And often try providing the impossible – the accredited, sophisticated or professional investor status. And depending on the jurisdiction and the project offering, the pain levels may vary. This is why, an STO issuer should have an attractive proposition on the table to be able to attract investors.

Security token or tokenised securities?

As a note of importance, not to confuse the two concepts, well posted out by Noelle Acheson in her piece 11https://www.coindesk.com/security-tokens-vs-tokenized-securities-its-more-than-semantics. Security tokens are the subject of our present article. Whereas tokenised securities are a token representation of an already existing security. For example, an Apple stock may be tokenised and traded on a separate exchange than the original stock is traded (eg.: APPL ticker, traded on the New York Stock Exchange). Although it is questionable, but there seem to be attempts at listing tokens that allegedly represent an Apple stock 12https://www.fintelum.com/blog/digital-securities-tokens-based-on-share-of-10-nasdaq-listed-companies/.

This is part 4 of a 5 part series.

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Security Tokens or STO vs Crowdfunding, ICOs & IEOs – Thought Leaders

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Security Tokens or STO vs Crowdfunding, ICOs & IEOs - Thought Leaders

Crowdfunding and ICO a step in evolution of capital markets

ICO acronym abbreviates to “initial coin offering”. But the practice stems from small capital funding method known as the crowdfunding.

In 2009 a US company called Kickstarter launched and successfully continues today to promote and facilitate funding of creative ideas and products. The idea is to pre-sell some product that a creative team pledge to develop or mass produce and deliver to its backers. The practice had no clear legal foundation back when it started. It was only three years later, in 2012, the US law was amended to regulate the new practice of easier access to small capital financing, by adopting Jumpstart Our Business Startups (JOBS) Act 13https://www.sec.gov/spotlight/jobs-act.shtml.

Similarly, ICO phenomenon sprung up from the burgeoning crypto community. The first ICO is widely accepted to be the Mastercoin blockchain project in 2013. It set itself apart as the first crypto crowdfunding case. The idea was to presell a blockchain coin/token as a service that the team pledged to develop in future. To purchase interest in the project, one was able to pay in bitcoin cryptocurrency. All of a sudden, a new practice was born.

A new use case for cryptocurrencies was forged and started to unfold rapidly. By 2017, not only many new cryptocurrencies emerged, but there were hundreds of ICO projects,

pre-selling their services, often, but not exclusively blockchain-based business applications. Indeed, raising funding in less restrictive way was the prime goal of the practice. Selling a token as interest in the project that had some utility or representation. Hence the new expression – utility token.

By definition, investing in a nebulous utility token (typically Ethereum EIP-20, also known as ERC-20 compliant) had very loose legal obligations, only those pledged by the issuing entity. The investment was not an equity purchase, nor it was a loan, rather – a voluntary contribution. The attraction was an almost immediate liquidity of the newly minted token. After the initial offering, a bubbling secondary market developed and offered easy entry and exit to all participants. Selling a token was selling a promise of a non-existent yet service, not dissimilar to the age of discoveries of long sea voyage ventures.

Similarly, the beginning of 17th century introduced the first permanent joint stock form, where the investment into shares did not need to be returned, but could be traded on a stock exchange. 14https://en.wikipedia.org/wiki/East_India_Company

The crypto investment practice unfolded into a wave of ICO projects, culminating in 2017. Thus many startups and mostly white paper ideas got funded. Most were real projects. Some were bad apples. But the most attractive aspect of the ICO were the returns on investments. According to one source, the ROI yielded in excess of 10x, even if you had invested in both the winners and losers alike over the 2017 year.  The whole industry was on a steep upwards pressure, with strong interest from the institutional sector. Such returns are unprecedented in the normal trading environment. Fortunes were made and lost.

The year 2017-2018 went down in history as the ICO hype unfolded. It culminated with several major events that occurred at the same time. One was Bitcoin blockchain forking and the subsequent nose dive of most cryptocurrency value. There were other notable events that coincided and contributed to the overall price fall.

From peak to trough the crypto asset market value was at times suddenly and later gradually reduced from over USD800B to little over USD100B. The so called crypto winter had set in. The bittersweet mass interest receded and an immediate flight away from all things crypto ensued. See chart below. 15https://coinmarketcap.com/charts/

Security Tokens or STO vs Crowdfunding, ICOs & IEOs - Thought Leaders

IEO initial exchange offering

Similarly as with Slack and Spotify exchange listing, there are some ICOs that have listed directly on token exchanges. This way projects can leverage token trading venue client base to showcase their projects directly, without active promotion of the offering through other, often ineffective, marketing channels. This has prompted many token trading venues to start issuing utility token IEOs on behalf of token issuing start-ups.

For the contributors, exchange listing adds trustworthiness, security and vetting, knowing that a reputable exchange, such as Binance will have done certain due diligence before listing an unknown project. Indeed, for utility tokens IEO may prove to be a safe, if not cheap way to gain community trust. It is yet to be seen, however, if the initial listings continue to persist over a longer stretch of time, and what regulatory requirements may be imposed as to listing requirements. This also is a piece of history in the making.

This is part 3 of a 5 part series.

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Click Here for Part 2

Click Here for Part 4

Click Here for Part 5

 

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