Breaking Misconceptions: The Trials and Tribulations of a US Crypto Trading Venue

If you ask the everyday, non- savvy US consumer who follows financial news whether cryptocurrency business activity is regulated, the response would likely be “No”. The modern misconception to 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 continuous 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) who have failed to register as a money services business and comply with the resulting anti-money laundering obligations.

An often-overlooked area of regulation, however, is the state-by-state regulatory framework surrounding the activity of US crypto-trading venues – a key player in the introduction of digital assets to everyday American 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 may open their gates to US consumers. Considering the “bearish” crypto sentiment held by regulators who interpret the regulatory framework can provide great insight on the stumbling blocks to US crypto innovation.

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

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

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

A particularly challenging compliance task for crypto MSBs is the requirement under the Funds Travel Rule. This is due to the fact that blockchain protocols were not designed to facilitate the transmission of the information contemplated by the rule. In fact, the Funds Travel Rule is the violation most commonly cited in examinations of MSB crypto exchanges according to FinCEN’s Director Blanco.

Since FinCEN takes the position that transmission of virtual currency falls under the definition of “money transmission”, crypto MSBs are required to include certain information with a “transmittal order” of at least $3,000 USD denominated in virtual currency. Such information includes the amount, the name and address of the sender, the execution date of the transmittal 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 more stringent oversight from their US banking partners. This is true even more so now than a couple of years ago, given the recent OCC sanction against a NY-based private bank serving cryptocurrency corporate clients.

A retail facing crypto company is subject to a whole suite of additional federal consumer protection laws. To name a few, the GLBA mandates 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 daunting process of deciphering the state-by-state money transmission licensing regime. A vast majority of states have a money transmission licensing regime that may or may not apply to a specific firm’s business model. A state-by-state legal analysis is warranted before moving forward. Sometimes firms will reach out to state financial regulators asking “do I need a license based on my business model?” But many times state regulators will not provide a clear answer. Early stage crypto firms will then have to decide for themselves whether or not they need to apply for a license in a particular state or rely on legal counsel’s advice. Continuous monitoring of changes in legislation, as well as changes in the business model that may affect the analysis is also necessary.

Licensure requirements are oftentimes quite burdensome, and include, for instance, the posting of surety bonds in each state. A tougher financial standard is often applied by underwriters to crypto clients as well as higher bond requirements imposed by certain states. Despite the well-intended measure of establishing the National Multistate Licensing System (“NMLS”), a one-stop shop for electronic state license application submissions, 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 via mail.

Adding a layer of complexity to the convoluted state licensing regime are state initiatives creating a specific license for cryptocurrency business activity. This is not unique to trading platforms and may apply to various types of crypto related businesses.

The most well-known for its stringent 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 other type of license (such as a Trust license) in the state. NYDFS notably maintains the highest threshold in the country for approval of crypto related business activity. It may be advisable to apply with other states first to gain knowledge, improve the application materials, and be better positioned. Other states have introduced bills contemplating their own version of a Bitlicense with NJ being the latest to release such a bill that is mainly aimed at better informing consumers on the risks involved in 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 activity of crypto trading firms. These include states’ versions of the prohibition on 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 mandate 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 which categories of his or her personal information are being collected, along with the business purposes for which the information was shared. Crypto retail companies must also consider state escheatment 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. Prior to offering opportunities to transact in a digital asset, the crypto company must ask whether a particular asset may be classified as a security and consider the risks involved.

A separate article could be written on this matter and how such an analysis should look like. Briefly, it is fair to say that despite some guidance released from the SEC, clarity has yet to be provided. Specifically, it would be beneficial to know what the SEC means by “sufficient decentralization” that would potentially extricate 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. In addition, they must be mindful of the Commodities 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 which must be traded on a licensed domestic futures exchange or a foreign board of trade.

III. The Consequences of Regulatory Barriers to Entry

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

Market share is being concentrated in the hands of early mover crypto-incumbents like Gemini, Coinbase, and Kraken, whereas younger innovators are slowed down. This reality stifles competition and innovation, and deprives consumers of a wider selection of crypto financial products that they would have otherwise had.

A nearly unanimous sentiment expressed in the Facebook Congressional hearings around Libra is that the mistrusted tech giant is not the best suited to lead crypto innovation to mass adoption. As a side note, the original Libra contemplated by Facebook has very few and far between characteristics in common with what is widely known as a “cryptocurrency” such as Bitcoin. However, it seems that the Libra project has the potential to directly or indirectly promote mainstream adoption of the more decentralized cryptocurrencies as well. If Congress is so clearly opposed to the idea that big tech will lead crypto innovation, then it should consider taking action towards reducing 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 bonds. Perhaps then we’ll see fewer state initiatives for additional crypto licensing regimes, and an easing of the stringent standard applied by some regulators. The latter is of special importance for driving crypto innovation and adoption in the US

Disclaimer: This article should not be construed as legal advice. Views are my own and don’t necessarily reflect those of my employer.

Merav Shor, Counsel, Regulatory Affairs, eToro USAQ1 2020 hedge fund letters, conferences and more

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