How do crypto exchanges select the coins they offer their customers? It’s not as simple as picking a popular coin and figuring out how to support it.
Today, crypto exchanges have to consider regulations and compliance with every decision they make, including which coins to select.
With the release of the 2017 DAO Report, the Securities and Exchange Commission (SEC) put cryptocurrency issuers and exchanges on notice that federal securities laws related to issuing, purchasing, and selling securities could apply to them.
As a result, how an exchange selects the coins they offer became critically important. In other words, having a due diligence policy in place that allows an exchange to apply compliance protocols to the selection of coins is essential today.
In fact, it’s not a stretch to say it’s a cornerstone of building a solid exchange.
Before we get into the details about selecting coins, understand that this is a deep and complex topic. We’ll discuss some of the things exchanges should be thinking about, but reading this blog post isn’t enough. The reality is that cryptocurrency due diligence depends on a variety of factors that only an experienced compliance professional can help you figure out. This includes your risk assessment, customer archetypes, geographic locations, and more.
Your Cryptocurrency Due Diligence Policy will be unique to your exchange, so get the help you need from a compliance expert before you make any decisions.
Selecting coins is not a decision that should be taken lightly.
The Most Important Question To Ask
When selecting coins for your crypto exchange, the most important question you should ask is this:
Is the crypto a “security” as defined by the SEC or an “administer” as defined by the Financial Crimes Enforcement Network (FinCEN)?
The 1933 Act, §2(a)(1) defines a security as follows:
“Any note, stock, treasury stock, security future, security-based swap, bond, debenture, evidence of indebtedness, certificate of interest or participation in any profit-sharing agreement, collateral-trust certificate, preorganization certificate or subscription, transferable share, investment contract, voting-trust certificate, certificate of deposit for a security, fractional undivided interest in oil, gas, or other mineral rights, any put, call, straddle, option, or privilege on any security, certificate of deposit, or group or index of securities (including any interest therein or based on the value thereof), or any put, call, straddle, option, or privilege entered into on a national securities exchange relating to foreign currency, or, in general, any interest or instrument commonly known as a ‘security’, or any certificate of interest or participation in, temporary or interim certificate for, receipt for, guarantee of, or warrant or right to subscribe to or purchase, any of the foregoing.”
But what does that mean?
In simpler terms, a security is an interest in a corporation or other legal entity that gives certain rights to the person or entity who holds the security, such as voting, ownership, contractual, or corporate governance rights. Stocks, bonds, and commercial debt are all examples of securities.
If crypto is defined as a security, then the crypto needs to be properly registered with the SEC (unless it falls under an exemption), and your exchange might have to register with the SEC.
Risks To Your Exchange If You Select The Wrong Coins
In a panel at CoinDesk’s Consensus 2019 conference, Valerie Szczepanik, the SEC’s senior advisor for digital assets and innovation, warned that crypto exchanges which facilitate token sales for a fee and have U.S. buyers could be considered securities dealers, and that means they need to adhere to all registration and licensing requirements for securities broker-dealers.
With that in mind, exchanges should make choices about which coins pose an elevated level of risk to the institution, its customers, or the greater cryptocurrency marketplace.
As an example, Szczepanik referenced a 2018 SEC case against TokenLot accusing TokenLot LLC and its owners of acting as unregistered broker-dealers. TokenLot and its owners ended up paying over $500,000 in fines, penalties, and interest.
This isn’t an isolated incident. In 2018, the SEC charged EtherDelta founder Zachary Coburn with operating an unregistered exchange citing tokens traded during an 18-month period that included “tokens that are securities under the federal securities laws.” Coburn paid penalties, fines, and interest equaling nearly $400,000.
Also in 2018, the SEC charged BitFunder and its founder, Jon E. Montroll, with operating an unregistered online securities exchange.
With so many initial coin offerings, due diligence is crucial in order to avoid coins that could cause compliance problems or questions from the SEC. Earlier this year, the SEC sued Kik Interactive for selling unregistered tokens it deemed to be securities. This has been one of the most high-profile crypto crackdowns by the SEC to date. In 2018, both CarrierEQ Inc. (Airfox) and Paragon Coin Inc. settled with the SEC agreeing to pay $250,000 in penalties each and to register their tokens as securities.
The SEC has made it clear in public statements that it would be looking closely at crypto coin offerings and exchanges in an effort to identify tokens that are actually securities.
Bottom-line, crypto exchanges need to ramp up their efforts to select the right coins in order to stay out of trouble.
Using The Howey Test
The Howey Test was developed as a result of a U.S. Supreme Court ruling in a 1946 case, Securities and Exchange Commission v. W.J. Howey Co. The Howey Test is still used today to help determine if a transaction will be considered a security or not.
There are four criteria in the Howey Test, and if a transaction meets all four criteria, then it will be considered a security transaction:
- There is an investment of money
- The investment is in a common enterprise
- There is an expectation of profits
- Any profit comes from the efforts of others (including third party promotional efforts)
Therefore, if a crypto is purchased with money, the buyer expects to make a profit, and the profit will come thanks to someone else’s efforts (such as their work or their promotion of the crypto), then the crypto is a security. The buyer isn’t buying a tangible asset. They’re buying a type of investment contract – a security.
Applying the Howey Test should be an integral part of your Cryptocurrency Due Diligence process.
In addition to using the Howey Test, crypto exchanges should be looking for other things in their due diligence.
These considerations include whether the currency has a secure blockchain and whether the currency is centralized or decentralized (a decentralized cryptocurrency that has no cash equivalency and no central owner is less likely to fail the Howey Test).
Additionally, rely on third-party cybersecurity reviews to protect the integrity of your exchange and your customers.
Key Takeaways About Selecting Coins For Your Crypto Exchange
Remember, this article only touches the surface of cryptocurrency due diligence. Selecting coins for your exchange requires research and compliance expertise. Reading this blog post is not enough to ensure your exchange selects the right coins. Your crypto due diligence will depend on a variety of factors that only a compliance professional can help you figure out. This is not a one-size-fits-all situation.
Schedule a free consultation with the compliance experts at BitAML, and get the help you need to develop your unique crypto due diligence policies and processes.