On Thursday (8 November 2018), the U.S. Securities and Exchange Commission (SEC) announced that it had settled charges against Zachary Coburn, the founder of decentralized exchange EtherDelta. What is significant about this enforcement action is that it is the first one ever based on “findings that such a platform operated as an unregistered national securities exchange.”

A Little Primer on the Relevant U.S. Securities Laws

In general, if a crypto exchange wants to deal with non-currency cryptoassets, i.e. securities in the eyes of the SEC, and it is offering (or promoting) its services to U.S. persons, it needs to be registered and regulated by the SEC under the Securites Exchange Act of 1934. Here is how the SEC explained this in a public statement titled “Statement on Potentially Unlawful Online Platforms for Trading Digital Assets” on 7 March 2018:

“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… To get the protections offered by the federal securities laws and SEC oversight when trading digital assets that are securities, investors should use a platform or entity registered with the SEC, such as a national securities exchange, alternative trading system (“ATS”), or broker-dealer.”

Since it is not very difficult to get registered by the SEC as a national securities exchange (an example is the New York Stock Exchange), the only other way to offer a trading platform that allows buy/selling of securities is register that platform as an Alternative Trading System (ATS). What is an ATS? This is the SEC’s definition:

“An ATS is a trading system that meets the definition of ‘exchange’ under federal securities laws but is not required to register as a national securities exchange if the ATS operates under the exemption provided under Exchange Act Rule 3a1-1(a). To operate under this exemption, an ATS must comply with the requirements set forth in Rules 300-303 of Regulation ATS.”

One of the main requirements for complying with Regulation ATS is registering as a broker-dealer. Under Section 3(a)(4)(A) and Section 3(a)(5)(A) and the Security Exchange Act 1934 respectively, a broker is “any person engaged in the business of effecting transactions in securities for the account of others” and a dealer is “any person engaged in the business of buying and selling securities for his own account, through a broker or otherwise.”

Also, according to the SEC’s “Guide to Broker-Dealer Registration”, in most cases, broker-dealer registration also requires the applicant to join a “self-regulatory organization” (SRO), such as Financial Industry Regulatory Authority (FINRA).

And that is why on 6 June 2018, Coinbase, announced (as covered by CryptoGlobe) that it had taken a major step on the path to becoming the first SEC-registered/regulated crypto exchange through its acquisition of Venovate Marketplace Inc, Keystone Capital Corp, and Digital Wealth LLC. Venovate Marketplace had the type of SEC registration that is not too common and one which is especially important to have for any crypto exchange that wants to deal with securities: an ATS license.

The SEC’s Case Against EtherDelta

EtherDelta is a decentralized crypto exchange that provides a secondary market for Ethereum (ERC-20) tokens, such as Augur (REP) and 0x (ZRX). According to CryptoCompare Research's October 2018 Exchange Review, “the total average 24h-volume produced by the top 5 decentralized exchanges on CryptoCompare totals just under 2.4 million USD,” which “constitutes just 0.4% of total exchange volume.”

The SEC's order found that Coburn was running “an unregistered national securities exchange” (since EtherDelta had no ATS license).

The SEC’s press release states that EtherDelta “provided a marketplace for bringing together buyers and sellers for digital asset securities through the combined use of an order book, a website that displayed orders, and a ‘smart contract’ run on the Ethereum blockchain,” and that its “smart contract was coded to validate the order messages, confirm the terms and conditions of orders, execute paired orders, and direct the distributed ledger to be updated to reflect a trade.”

It further claims that over an 18-month period, “EtherDelta’s users executed more than 3.6 million orders for ERC20 tokens, including tokens that are securities under the federal securities laws.” What made things worse was that almost “all of the orders placed through EtherDelta’s platform were traded after the Commission issued its 2017 DAO Report, which concluded that certain digital assets, such as DAO tokens, were securities and that platforms that offered trading of these digital asset securities would be subject to the SEC’s requirement that exchanges register or operate pursuant to an exemption.”

Stephanie Avakian, Co-Director of the SEC’s Enforcement Division, said:

“EtherDelta had both the user interface and underlying functionality of an online national securities exchange and was required to register with the SEC or qualify for an exemption.”

Steven Peikin, Co-Director of the SEC’s Enforcement Division, stated:

“We are witnessing a time of significant innovation in the securities markets with the use and application of distributed ledger technology. But to protect investors, this innovation necessitates the SEC's thoughtful oversight of digital markets and enforcement of existing laws.”

The SEC points out that it had “previously brought enforcement actions relating to unregistered broker-dealers and unregistered ICOs, including some of the tokens traded on EtherDelta.”

The EtherDelta founder, without any admission or denial of guilt, apparently, “consented to the order and agreed to pay $300,000 in disgorgement plus $13,000 in prejudgment interest and a $75,000 penalty.” The SEC says that had he not cooperated, the penalty imposed on Coburn could have been greater.

What the Crypto-Twitter Community Thinks About the SEC’s Action Against EtherDelta’s Founder?

Meltem Demirors, the Chief Strategy Officer at CoinShares:

what strikes me most about the @SEC_News action against @EtherDelta is:

– small disgorgement of $300k

– only $75k penalty for operating unregistered exchange w >3M trades

– co-operation listed as reason for not penalizing further overall, seems very … positive? pic.twitter.com/ypmdOGSO6N — Meltem Demirors (@Melt_Dem) November 8, 2018

Anthony Pompliano, Founder and Partner at Morgan Creek Digital:

The SEC just charged the founder of EtherDelta with operating an unregistered securities exchange. There will be many more enforcements like this to come. “Move fast and break things” only works if you’re not breaking US securities law. — Pomp 🌪 (@APompliano) November 8, 2018

Drew Hinkes, the General Counsel, Chief Legal Officer, and Co-Founder of Athena Blockchain (Also: Adjunct Professor at NYU School of Law):

THIS IS BIG: Coburn, the operator of @Etherdelta, admits to having caused the violation by writing, deploying and “controlling the operations of” the smart contract. Expect ripples (not XRPs) from this one. More potential ammo for the “hold the code writers responsible” crowd. pic.twitter.com/kfvA7WFuDJ — Drew Hinkes (@propelforward) November 8, 2018

but what's more important? That he wrote the code? deployed it? controlled it post-deployment? Not clear. But it is clear that the functionality being conducted by nodes didn't absolve him of responsibility. Massive implications for “decentralized systems” as regulatory arbitrage — Drew Hinkes (@propelforward) November 8, 2018

Marco Santori, President and Chief Legal Officer at Blockchain (Also: Fintech Advisor to the IMF):

2/ First, the order was not against EtherDelta. It was against the owner/operator of EtherDelta. According to the Order, the owner sold it to non-US purchasers. EtherDelta seems to be up and running, humming along just fine. — Marco Santori (@msantoriESQ) November 8, 2018

3/ The penalty ordered is over $300,000. That's pretty significant for an individual. It's…enormous actually. SEC supports it by arguing that EtherDelta did over 3.6 million (!) trades, and according to the order, EtherDelta was just him. — Marco Santori (@msantoriESQ) November 8, 2018

9/ Big picture? It supports common wisdom among attorneys today: DEX is not a good way to escape securities laws. They are very, very broad. Much broader than the money services laws in the US. — Marco Santori (@msantoriESQ) November 8, 2018

Jake Chervinsky, prominent American lawyer working at the Washington-based law firm Kobre & Kim:

7/ A few other key points for consideration. Most enforcement actions are kept confidential until they're resolved to protect both the defendant (from bad press) & the government (from losses & inconsistencies). That's why this case was settled before it was announced. — Jake Chervinsky (@jchervinsky) November 9, 2018

9/ The SEC continues its usual enforcement pattern: start with easy wins to set up favorable precedent before moving on to tougher (wealthier) targets. After all, it's easier to prosecute one guy who's out of the game than a centralized exchange with a healthy balance sheet. — Jake Chervinsky (@jchervinsky) November 9, 2018

13/ Turning back to the order, note that it references the 2017 DAO Report, which was the first time the SEC said a token was a security. The order basically says, “after we issued that Report, it was clear these tokens were securities, so don't tell us you didn't know better.” — Jake Chervinsky (@jchervinsky) November 9, 2018

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