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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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Considered to be a blockchain regulation visionary, Gautam S. Gujral is the Co-Founder and General Counsel at Vertalo SEZC.

Regulation

Bank of China Moves to Regulate STO

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Bank of China to Create STO Regulations

This month, executives from the bank of China unveiled some major announcements regarding the future of blockchain technology in the country. Apparently, the Bank of China will now create its own centralized cryptocurrency. Additionally, the bank intends to roll out a robust security token protocol in the coming weeks.

In the past, Chinese officials have been very critical of cryptocurrencies. The country famously banned exchanges back in 2017. Also, Chinese officials have been hard on miners in the country despite the fact that the Chinese government operates some of the largest mining facilities in the world.

Pivot Towards Blockchain – Bank of China

Now it appears as if Chinese officials got the memo that blockchain technology is here to stay. At the recent Finance Technology Summit in Beijing, the Chief Scientist of the Bank of China, Weimin Guo described the country’s new strategy moving forward.

Chief Scientist of the Bank of China - Weimin Guo

Chief Scientist of the Bank of China – Weimin Guo

National Digital Currency

China now intends to release its own cryptocurrency called China’s Digital Currency Electronic Payment (DCEP). This cryptocurrency will serve as the only national digital currency of the country. Interestingly, the token will be a stablecoin pegged to the Chinese RenMinBi (RMB).

Developers hope that the integration of blockchain and cryptographic technology will streamline the outdated financial practices currently in use. Blockchain tech brings some serious advantages to the table. For one, the tech eliminates the frictions seen in traditional payment systems.

Shade on Bitcoin

After acknowledging the huge benefits gained from blockchain technology, Guo stated that Bitcoin had failed its purpose to provide a safe haven from the traditional market manipulations. He stated that Bitcoin’s launch was poorly timed and its primary goal to disrupt the global economy was “impossible.”

Strict Regulations – Bank of China

While China loosens its blockchain leash, it’s obvious the country wants to keep the technology in check. For example, all STOs are to operate within a strict “regulatory sandbox mechanism” at first. Basically, the country wants to promote innovation with new technology but desires a measured integration to maintain complete control over the sector.

It’s no surprise that China feels the pressure from blockchain adoption. At one time, China controlled a large majority of the crypto market. Since that time, the country continually targeted crypto investors and traders.

Additionally, regulators expressed concern about major tech firms such as Facebook issuing a cryptocurrency. Not surprisingly, regulators only want currency creation to originate from a national bank or government agency.

China’s Big Hope

Chinese regulators now believe that the DCEP has the potential to evolve into a leading global currency. Bank officials seek to integrate the currency into the main economy as soon as possible. This integration will span the scope of the Chinese economic sector from retail all the way to major investment firms.

China Inches Back into the Game

It’s interesting to see how Chinese regulators continue to embrace blockchain technology. China has always been on edge over the emergence of cryptocurrencies, but as it stands today, the country has to embrace the technology or fall to the wayside against the growing competition.

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Regulation

VNX Exchange Hopes to Get in Front of Upcoming AMLD5 Legislation with Sumsub Collaboration

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VNX Exchange Hopes to Get in Front of Upcoming AMLD5 Legislation with Sumsub Collaboration

Tech Provider

Recently launched platform, VNX Exchange, and compliance expert, Sumsub, have announced a new collaboration. This will see Sumsub provide the necessary technology, which will allow VNX Exchange to ensure compliance with European laws surrounding AML/KYC.

This move is a proactive one, being taken by VNX Exchange. They have indicated that they chose to collaborate with Sumsub, as they possess the ability to remain compliant with the upcoming AMLD5 European legislation.

AML/KYC Importance

Anti-Money-Laundering and Know-Your-Client are important compliance mechanisms used world-over. While their implementation may vary depending on regions, the purpose of each remain the same.

These compliance measures are what allow for regulatory bodies to keep nefarious activity in check. This is done by, first, knowing who they are dealing with. This part is taken care of through KYC checks, which gather information such as legal names, place of residence, passport info, and etcetera. Next, AML puts roadblocks in place, designed to prevent the origins of money from being clouded.

Unfortunately, blockchain based endeavours (including digital securities), remain synonymous with nefarious activity, to date. Much of this stems from past markets that saw the ICOs boom and bust. The entire point of digital securities, however, is to offer the benefits of tokenization, through a regulatory compliant and legal manner. For this to be achieved, and to dispel pre-existing notions (warranted or not) surrounding blockchain based endeavours, AML and KYC remain of utmost importance.

Rival Providers

As indicated above, compliance measures surrounding AML and KYC are of the utmost importance within the digital securities sector. Many companies have recognized this, and are in the midst of developing their own solutions for the issue at hand. The following companies are but a few of those leading the way.

Commentary

Upon announcing their collaboration, representatives from each, Sumsub and VNX Exchange, took the time to comment. The following is what each had to say on the matter.

Alexander Tkachenko, CEO of VNX Exchange, stated,

“VNX Exchange is very serious about all aspects related to compliance and investor protection. For these purposes, we are leveraging the benefits and advantages of innovative compliance systems provided by Sumsub to create a seamless client experience and open access to the new class of liquid digital assets backed by venture capital investments.”

Jacob Sever, Cofounder of Sumsub, stated,

“AMLD5 is soon to gain full power and influence among all financial entities in Europe with reinforced AML demands. With many clients based in Luxemburg, such as JobToday, Wecan Group, etc., we see the demand for compliance and anti-fraud measures, and know how to ensure them. VNX is a serious and mature project, with founders and management from traditional well-respected foundations, so we are happy to provide them with a high-level solution, optimising compliance under the Luxembourg regulations.”

Sumsub

Founded in 2015, Sumsub is a tech provider operating out of London, U.K. Above all, services offered by Sumsub revolve around compliance. This includes KYC/AML, investor onboarding, and more.

CEO, Andrey Severyukhin, currently oversees company operations.

VNX Exchange

Founded in 2018, VNX Exchange operates out of Luxembourg. The team at VNX Exchange has recently announced the launch of their digital securities issuance platform, along with their inaugural STO.

CEO, Alexander Tkachenko, currently oversees company operations.

In Other News

Both, VNX Exchange and Sumsub, have found themselves in our headlines in the past. Now their past work has brought them together, as they work with one another moving forward. The following articles touch on past events pertaining to each company.

VNX Exchange Launches, Calling Luxembourg Home

Sum&Substance Introduced to Polymath ‘Service Provider Marketplace’

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Regulation

Gladius Fails to Pay SEC Fines

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Gladius Dissolves

The blockchain-based cybersecurity firm, Gladius announced that the company dissolved this week. Unfortunately for Gladius token holders, the company chose to ignore the $12.7 million settlement payment the SEC imposed earlier in the year. Now, Gladius token holders are left holding the bag.

In what seems to be a growing trend, another SEC charged ICO dissolved before repaying investors.  In this instance, Gladius received $12.7 in fines after self-reporting to the SEC in February. Understandably, the SEC showed some leniency towards the firm for their decision to self-report.

A Lenient Approach

As part of the SEC settlement, regulators didn’t impose any additional penalties on the firm. However, they did make the company executives agree to compensate investors fully. Also, the company was to register the tokens as securities. Gladius agreed to the terms but asked for multiple extensions on the repayment date. Rather than repaying investors, the company chose to dissolve.

Gladius Founder Max Niebylski

Gladius Founder Max Niebylski

News of the Dissolution

Investors first received the bad news via a November 22 telegram post. In the post, the company’s co-founder and chief technology officer, Alex Godwin described the decision. He explained that  the firm “ceased operations effective immediately.” He also stated that the firm “no longer has funds to continue operations.”

Rektiers

As you could imagine, investors are furious over the turn of events. Investors feel as if the SEC’s approach lacked enforcement. Investors have even formed a Telegram chat group called the Gladius Rektiers to organize another strategy to reclaim lost funds.

Gladius

Gladius entered the market in April 2017. The firm planned to utilize a combination of blockchain-based technologies to protect users. Specifically, the firm employed decentralized CDN and DDoS protection on the Ethereum Blockchain. Additionally, Gladius platform users could rent out unused bandwidth and computational power.

Gladius Website

Gladius Website

Interestingly, Gladius executives did decide to leave their open-source code available on GitHub. The team even welcomed developers to further their protocol on their now deceased website’s homepage.

Dipping on the Bill

While the Gladius dissolution is bad news, it joins a host of other SEC charged ICOs who skipped out on their deadlines. For example, AirFox missed an October deadline this year. Airfox entered the market as a mobile banking solution before the SEC charged the firm with selling unregistered securities.

Additionally, Paragon Coin missed its investor repayment deadline. As part of Paragon Coin’s SEC settlement, the company agreed to offer to repay investors and pay $250,000 in fines.  For their cooperation, the SEC withheld fraud charges. Also, the company agreed to register their tokens as securities and adhere to all relevant regulations moving forward.

The Paragon Coin saga received premier coverage as it involved a well-known beauty pageant winner and the rapper – The Game. Currently, the Paragon Coin website tells investors that want a refund to submit before November. Notably, their SEC repayment settlement date already pasted back in July.

The Gladius Saga Continues

The decision to dissolve prior to adhering to the SEC’s demands could prove to be a costly one for Gladius. For now, investors are culminating their outrage to organize their next maneuver. Many expect to see additional charges in some shape or form against the company’s owners as regulators decide how to handle the news and investor outcry.

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