Exchange Registration Requirements
Section 5 of the Securities Exchange Act of 1934 (Exchange Act) makes it unlawful for any exchange, directly or indirectly, to effect a transaction in a security unless the exchange is registered as a national securities exchange or is exempted from registration (e.g. a registered broker-dealer operating a trading system in reliance on Regulation ATS). An “exchange” is a marketplace or facilities for bringing together buyers and sellers of securities or for otherwise performing with respect to securities the functions commonly performed by a stock exchange. An exchange includes any organization, association or group of persons that: (1) brings together the orders for securities of multiple buyers and sellers; and (2) uses established, non-discretionary methods (whether by providing a trading facility or by setting rules) under which such orders interact with each other, and the buyers and sellers entering such orders agree to the terms of the trade. 1
An exchange must register with the SEC as either a national securities exchange pursuant to Section 6(a) of the Exchange Act or rely on an available exemption, such as registering as an Alternative Trading System (ATS) pursuant to Regulation ATS. 2 To be registered as a national securities exchange, an operator must (1) satisfy all the regulatory requirements for registration as a national securities exchange, including designing rules to prevent fraudulent and manipulative acts on such exchange; (2) function as a self-regulatory organization that provides rules and procedures for monitoring and disciplining its members for violation of the securities laws or rules established by the exchange; and (3) maintain compliance with SEC requirements. Alternatively, an operator may rely on an exemption from registration as a national securities exchange pursuant to Regulation ATS. An ATS is exempt from national securities exchange registration, but must (1) register as a broker dealer, (2) join a self-regulatory organization (most commonly the Financial Industry Regulatory Authority) and (3) comply with the securities laws and member rules established by the self-regulatory organization.
Typically, the operator of a registered centralized exchange facilitates trading by maintaining an order book of offers to sell securities and bids to buy securities. Buyers and sellers can access the order book, and if there is a corresponding bid/offer, enter a trade. In addition to maintaining an order book, the operator performs other services, including developing securities listing standards and user rules.
In contrast, a decentralized exchange, which has been made possible by distributed ledger technology, is not maintained by an operator but rather allows trading peer-to-peer among users that utilize smart contracts for matching and routing trade orders. Smart contracts are self-executing software code that can be deployed and run on a blockchain. In the context of a decentralized exchange, smart contracts replace the order book maintained by the exchange operator, allowing buyers and sellers to connect directly (through the smart contract) instead of connecting via a central intermediary. The software creates a functional exchange without the need for an entity to oversee operations. Decentralized exchanges do not generally hold customer funds, positions or information.
The lack of an intermediary or operator raises the question of who needs to register the decentralized exchange with the SEC or rely on an available exemption.
The EtherDelta Platform
In the case of EtherDelta, the SEC held that (i) EtherDelta’s functionality satisfied the definition of an “exchange” under the Exchange Act, and (ii) the Founder was the operator of the exchange and therefore responsible for registration.
EtherDelta operated as a marketplace for bringing together orders of multiple buyers and sellers and therefore satisfied the definition of an “exchange” under the Exchange Act. The EtherDelta website makes token “pairs” available for trading, provides access to the EtherDelta order book, and displays the current top 500 firm bids and offers by symbol, price and size. The SEC determined that the combined use of the EtherDelta website, order book and pre-programmed trading protocols defined in the EtherDelta smart contract established non-discretionary methods that allowed users to agree on the terms of their trades in tokens on EtherDelta and, as such, operated as an exchange that required registration or to rely on an exemption from registration under the Exchange Act.
The Founder was the operator who developed EtherDelta’s smart contract on the Ethereum blockchain to execute paired orders, validate the order messages, confirm the terms and conditions of orders, and direct the Ethereum blockchain to be updated to reflect a trade. After deploying the open source code, the Founder created listing standards, conducted issuer due diligence, collected exchange fees and provided operations updates to users through social media. Despite the fact that EtherDelta did not require intermediaries for its operation, the SEC determined that the Founder should have registered EtherDelta as an exchange, in part, due to the fact that EtherDelta still had the Founder as a centralized authority overseeing its operations. The SEC noted the Founder to be personally liable since he “founded EtherDelta, wrote and deployed the EtherDelta smart contract to the Ethereum Blockchain, and exercised complete and sole control over EtherDelta’s operations, including over the operations constituting the violations described above.” 3
This is the SEC’s first enforcement action finding a violation of the requirement to register as a national securities exchange by applying the definition of an “exchange” to a decentralized digital asset platform. The SEC has previously sanctioned a computer programmer for operating online venues that traded securities using virtual currencies for failing to register the venues as broker-dealers or stock exchanges. These exchanges provided account holders the ability to use Bitcoin or Litecoin to buy, sell and trade securities of businesses (primarily virtual currency-related entities) listed on the exchanges’ websites.4
SEC’s Statements on Digital Assets
The EtherDelta order follows the first enforcement action against an unregistered broker-dealer related to the sale of digital assets, In the Matter of TokenLot LLC. 5 In both EtherDelta and TokenLot, the SEC referenced unregistered activities involving blockchain tokens that “included securities,” without specifying which digital assets constituted securities. To this point, William Hinman, Director of the SEC’s Division of Corporation Finance, recently announced that the SEC plans to release “plain English” guidance in late 2018 or early 2019 regarding when a blockchain token sale is or is not the sale of securities. 6
While EtherDelta is the first enforcement action of its kind, the SEC has released numerous public statements and reports on the subject.
- In July of 2017, the SEC issued a report of investigation addressing whether a decentralized autonomous organization had violated securities laws pursuant to Section 21(a) of the Securities Exchange Act of 1934 (the DAO Report). In the DAO Report the SEC advised that a platform that offers trading of digital securities and operates as an exchange as defined by the federal securities laws must register with the SEC as a national securities exchange or rely on an exemption from registration.
- In his February 2018 speech before the Senate Committee on Banking, Housing, and Urban Affairs, SEC Chairman Jay Clayton noted his concern that digital asset trading platforms purporting to be exchanges may be confusing investors by referring to themselves as exchanges without offering investors the protections that registered national securities exchanges provide.
- In March 2018, the SEC Divisions of Enforcement and Trading and Markets issued a joint public statement echoing Chairman Clayton’s concerns and warning market participants that any platforms trading securities must register as a national securities exchange or rely on an exemption from registration.
The EtherDelta order is consistent with the SEC’s public statements regarding the need for digital asset exchanges (centralized or decentralized) to consider the application of the U.S. securities laws to its particular business. It also addressed the question, at least in certain contexts, as to whom will be held responsible for failing to follow the law with regard to a decentralized exchange.
In response to the need for regulatory guidance that persists in the market, the SEC recently launched the Strategic Hub for Innovation and Financial Technology, dubbed FinHub, as a dedicated resource for the SEC’s financial technology-related developments and initiatives. The SEC encourages market participants who have questions about the treatment of their blockchain project, platform or token to contact the SEC through FinHub.
1 Section 3(a)(1) of the Exchange Act and Rule 3b-16 thereunder.
2 15 U.S.C. § 78f; 17 C.F.R. §240.3a1-1
3 Similarly, CFTC Commissioner Brian Quintenz recently remarked that developers who program smart contracts that could be used to violate the Commodity Exchange Act may be liable for such violations, stating “the appropriate question is whether these code developers could reasonably foresee, at the time they created the code, that it would likely be used by U.S. persons in a manner violative of CFTC regulations.” https://www.cftc.gov/PressRoom/SpeechesTestimony/opaquintenz16.
4 In the Matter of BTC Trading Corp. and Ethan Burnside, https://www.sec.gov/news/press-release/2014-273.
5 See prior Sidley Update, One-Two-Three Punch: SEC and FINRA Announce Actions Against Unregistered Broker, Digital Asset Manager and FINRA Registered Person.
6 The comments were made November 5, 2018, at Georgetown University’s FinTech Week conference in Washington D.C.
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