The Trials and Tribulations of an American Crypto Trading Venue

Shattering Misconceptions: The Trials and Tribulations of a US Crypto Trading Venue By Merav Shor, Counsel, Regulatory Affairs, eToro USA

If you ask every day, non-crypto-savvy American consumer who follows financial news whether cryptocurrency business activity is regulated, the answer will likely be “No.” The modern misconception for the average user is that these assets are unregistered securities.

The SEC’s focus on high-profile crypto companies, such as Telegram and Ripple, has garnered the most attention from users and media outlets. The SEC’s ongoing rejection of bitcoin ETF proposals is also often discussed. And perhaps to a lesser extent, the FinCEN’s enforcement actions against operators of cryptocurrency exchanges (sometimes individuals) that have failed to register as a money services business and comply with the resulting anti-money laundering obligations.

However, an often overlooked area of ​​law is the state-by-state regulatory framework surrounding the activity of US crypto trading venues – a key player in introducing digital assets to everyday US consumers.

Regulatory process that Crypto Trading Venues must overcome

A closer look at the applicable US regulatory regime reveals the arduous process that crypto trading venues must overcome before they are allowed to open their gates to US consumers. Considering the “bearish” crypto sentiment held by regulators interpreting the regulatory framework, this could provide great insight into the obstacles to US crypto innovation.

The framework discussed below does not apply to firms engaged in the trading of digital assets that are classified as securities under US federal securities law. This article does not purport to encompass the entire body of legislation and regulatory requirements that cryptocurrency trading platforms are subject to, but it does provide a general overview of US regulations in the crypto space.

I. Unregulated? Not entirely. Introduction to the US Infinite Licensing Maze

Obtaining and maintaining a federal money services business (MSB) license is not a simple first step. At the federal level, an MSB is subject to the requirements of the anti-money laundering, anti-terrorist financing, and criminal activity provisions of the Bank Secrecy Act and the USA PATRIOT Act. It must also meet OFAC’s sanctions requirements. Establishing and operationalizing the required compliance policies, procedures and controls is by no means a trivial endeavor.

A particularly challenging compliance task for crypto MSBs is the requirement under the Fund Travel Rule. This is due to the fact that blockchain protocols are not designed to facilitate the transfer of the information intended by the rule. In fact, the Fund Travel Rule is the most cited violation in investigations of MSB crypto exchanges, according to FinCEN’s Director Blanco. Since FinCEN takes the position that the transfer of virtual currency falls under the definition of “money transfer,” crypto MSBs are required to include certain information with a “transfer order” of at least $3,000 denominated in virtual currency. Such information includes the amount, the name and address of the sender, the execution date of the transfer order, the identity of the recipient’s financial institution and other pieces of data.

An indirect consequence of federal regulation is the high compliance threshold imposed on crypto businesses by their banking partners. Forming US banking relationships as a crypto firm is extremely difficult. Crypto businesses can expect tighter oversight from their US banking partners. This is even more true now than a few years ago, given the recent OCC sanction against a NY-based private bank that serves corporate clients with cryptocurrency.

A retail-facing crypto company is subject to a whole host of additional federal consumer protection laws. To name a few, the GLBA requires the safeguarding of consumers’ personal financial information, and certain provisions of the Dodd-Frank Act and FTC Act prohibit unfair or deceptive acts or practices in connection with a consumer transaction or the offering of a financial product or service.

Following the federal MSB registration is the challenging process of deciphering the state-by-state money transmitter licensing regime. A vast majority of states have a money transmitter licensing regime that may or may not apply to a particular firm’s business model. A state-by-state legal analysis is warranted before moving forward. Sometimes firms will reach out to government financial regulators and ask, “do I need a license based on my business model?” But many times state regulators won’t give a clear answer. Early stage crypto firms will then have to decide for themselves whether to apply for a license in a particular state or not rely on legal advice. Continuous monitoring of changes in legislation, as well as changes in the business model that may affect the analysis, is also necessary.

Licensing requirements are often quite onerous, and include, for example, posting surety bonds in each state. A stricter financial standard is often applied by underwriters to crypto clients, as well as higher mortgage requirements imposed by certain states. Despite the well-intentioned measure to establish the National Multistate Licensing System (“NMLS”), a one-stop shop for submitting electronic state license applications, the process is far from streamlined. Many states have unique requirements, for example their own specific fingerprint cards for control persons, and a few still require a paper application submitted outside of NMLS with an old-fashioned handwritten check sent in the mail.

Adding a layer of complexity to the complicated government licensing regime are government initiatives that create a specific license for cryptocurrency business activity. This is not unique to trading platforms and can apply to various types of crypto-related businesses.

Most famous for its strict requirements and long processing times is the highly sought after NY State Bitlicense. This license does not replace the money transmitter license in NY State, and in many cases a crypto applicant will be required to apply for both the Bitlicense and the Money Transmitter license or another type of license (such as a Trust license) in the state. In particular, NYDFS maintains the highest threshold in the country for approval of crypto-related business activity. It may be advisable to apply to other states first to gain knowledge, improve the application materials and be better positioned. Other states have introduced bills considering their own version of a Bitlicense, with NJ being the latest to release such a bill aimed primarily at better informing consumers about the risks associated with trading cryptocurrencies .

II. State consumer protection laws and other regulations to consider

In addition to state money transmission laws and related obligations, state consumer protection laws also apply to the activities of crypto trading firms. This includes states’ versions of the prohibition of unfair and deceptive acts and practices, as well as state data privacy laws that are currently experiencing a surge across the country. State privacy laws require the provision of different rights to consumers in their respective states. California’s CCPA introduces new rights such as the right of a consumer to request the deletion of their personal information, and the right to know what categories of his or her personal information are being collected, along with the business purposes for which the information is shared . Crypto retail companies must also consider state exemption laws, tax reporting obligations and more.

Going back to the beginning of this article, one must not forget to consider the implication of US federal and state securities laws. Before offering opportunities to transact in a digital asset, the crypto company must ask whether a particular asset can be classified as a security and consider the risks involved. A separate article could be written about this matter and what such an analysis should look like. In short, it’s fair to say that despite some guidance released by the SEC, clarity has yet to be provided. Specifically, it would be beneficial to know what the SEC means by “sufficient decentralization” which would potentially remove a token from the definition of a security.

An additional point to consider is the CFTC jurisdiction over market manipulation and fraud in crypto spot trading transactions. Crypto trading firms must implement controls that address such risks. Additionally, they must be mindful of the Commodity Exchange Act’s “actual delivery” requirement of the cryptocurrency commodity. If there is no actual delivery of the cryptocurrency within 28 days, the transaction may be classified as a retail commodity transaction to be traded on a licensed domestic futures exchange or an offshore board of trade.

III. The effects of regulatory barriers to entry

The need to navigate a labyrinth of ever-changing laws, regulations and licensing obligations creates high barriers to market entry for new players.

Market share is concentrated in the hands of early mover crypto incumbents such as Gemini, Coinbase and Kraken, while younger innovators are delayed. This reality stifles competition and innovation and deprives consumers of a wider variety of crypto-financial products that they would otherwise have had.

A near-unanimous sentiment expressed in the Facebook congressional hearings surrounding Libra is that the distrusted tech giant is not best suited to lead crypto innovation to mass adoption. As a side note, the original Libra considered by Facebook has very few and far between characteristics in common with what is commonly known as a “cryptocurrency” such as Bitcoin. However, it appears that the Libra project has the potential to directly or indirectly promote the mainstream adoption of more decentralized cryptocurrencies as well. If Congress is so clearly opposed to the idea that big tech will lead to crypto innovation, it should consider taking steps to reduce market entry costs.

Trust will drive greater adoption and continued innovation in the crypto space. Awareness and appreciation of the rigorous process that US crypto firms face will help facilitate the building of these connections. Perhaps then we will see fewer government initiatives for additional crypto-licensing regimes, and an easing of the strict standard applied by some regulators. The latter is of particular importance to driving crypto innovation and adoption in the US

Disclaimer: This article should not be considered legal advice. Opinions are my own and do not necessarily reflect those of my employer or the publication.

About the Author: The author of this article is Merav Shor – Counsel, Regulatory Affairs eToro USA

Image by Colin Behrens from Pixabay