How can crypto exchanges move towards compliance after the regulatory hammer?

I have been collectively criticized by the crypto community for doubting the legality of selling cryptocurrencies in the United States, especially when I was studying for my master's degree in law in 2017. I wrote a lot of articles and had a lot of free time and freedom to write at that time.

Unlike the latest crop of crypto critics like former government lawyer John Reed Stark, who seems to enjoy trashing the industry when the market is down, I played the role of “critic” when crypto was still relatively new and niche, such as the one I mentioned in CoinTelegraph’s July 9, 2014 article “Mitigating the Legal Risks of Issuing Securities on Crypto Ledgers” when I said, “[Almost] no one is doing it right. I have yet to see a properly structured crypto-security.”

Joel Dietz and SwarmFund

At the time people thought I was crazy, others probably thought I was a pure troll, and the truth was probably somewhere in between. Of course, remember that in 2014 the idea of ​​an “initial coin offering” (ICO) didn’t exist; entrepreneurs like Joel Dietz were marketing his “Swarm” crowdfunded tokens as “crypto-equity,” a term that was snubbed by more sophisticated projects like Ethereum , which conducted an ICO just a month after I was quoted in the CoinTelegraph article. But even then it wasn’t called an ICO. It was “crypto fuel sold for the Ethereum network,” according to whatever advice his lawyers gave Joe Lubin, or, as the New York Attorney General’s office described it in its lawsuit against KuCoin , a security.

Ethereum then exploded in 2017, along with a thousand copycats and other similar knockoff projects, and U.S. regulators were slow to respond.

Bill Hinman

Then- SEC Director Bill Hinman fueled the ICO craze with his famous “Hinman Speech,” which proposed the (now discredited) “sufficient decentralization” exclusion from the Howey test. This led venture capitalists to assume that they had successfully convinced the SEC office that Ethereum was the next Internet, and the best thing for the government to do was to get out of the way and let Ethereum prove it.

I think it’s safe to say that five years later, Ethereum has not solved many of the scaling issues it needs to do to become the next Internet. Given these broken promises, it’s no surprise that the New York Attorney General’s office filed a lawsuit against KuCoin.

A confusing and bizarre case of law enforcement

What happened after Bill Hinman’s speech can only be described as chaos. Prior to Hinman’s speech, the SEC had really only cracked down on crypto businesses in cases of clear and notorious fraud.

The first cases I remember were SEC v. Trendon Shavers and Bitcoin Savings and Trust (a Ponzi scheme) and SEC v. GAW Miners, Joshua Homero Garza et al. (another Ponzi scheme involving the sale of “mining contracts” and a $20 stablecoin called “paycoin”).

On the non-fraud enforcement side, in late 2018, just a few months after Hinman’s speech, the SEC began announcing its first enforcement actions in the form of settlements, involving a number of token-related projects. On November 8, 2018, the SEC announced its first such settlement with EtherDelta, the creator of an early decentralized exchange, or “ DEX ,” alleging that EtherDelta was operating an unregistered exchange, suggesting that the SEC believed that certain assets on EtherDelta — namely, Ethereum and ERC20 — were securities. Ten days later, the SEC announced its first settlements with two ICO projects, Airfox and Paragon ; both defendants agreed to register their tokens as securities (which, to my knowledge, does not appear to have occurred).

The following year saw a series of bizarre settlements that failed to prevent further ICO issuance and a series of bizarre transactions where projects tried to work their way into complying with the non-instructive guidance issued by Bill Hinman.

For example, EOS advertised its product on a giant billboard in Times Square during the 2017 Consensus conference and raised over $4 billion in cryptocurrency (at its valuation at the time), but was somehow allowed to settle with the SEC by paying a $24 million fine — without even having to register!

Other projects weren’t so lucky. Kik Interactive, Telegram , and Ripple Labs launched massive ICOs; Kik and Telegram both lost badly in federal court, and I don’t think Ripple stands a chance. Likewise, the much smaller LBRY project, based in New Hampshire and a few years older than EOS, did not, as far as I know, reach a settlement with the SEC or allow their business to continue operating; the only logical reason I could find for this was that the SEC’s Boston office was short of money, and the only place you could find a crypto startup in New England was in New Hampshire.

Not surprising

This brings us to the Coinbase lawsuit, which should come as no surprise to any lawyer practicing in the US since 2018. The lawsuit is long on the record, with the SEC alleging that Coinbase violated the registration requirements of the Securities Act of 1933 with respect to its custodial equity offerings.

It also alleges that Coinbase violated the registration requirements of the Exchange Act, which requires anyone who conducts securities transactions to register and submit to the Commission’s supervision. In addition, Coinbase is accused of operating as an unregistered broker-dealer and as an unregistered clearing agency, which is “a person who acts as an intermediary in payments or deliveries, or both, in connection with securities or transactions, or facilitates the comparison of data concerning the settlement terms of securities transactions.”

This article will not dwell on the section on broker-dealer registration requirements, nor will it provide a detailed Howey analysis of the many tokens named in the complaint — including Solana , ADA, Matic, Filecoin , SAND, AXS, CHZ, FLOW, ICP, NEAR, VGX, DASH , and NEXO. The point here is that as a remedy, the SEC is seeking a permanent injunction barring Coinbase from operating an unlicensed exchange. If they can seize any of the tokens and win the lawsuit, Coinbase’s core business may be shut down entirely.

I’m surprised it’s taken this long. Back in 2017, I hypothesized that one day something would happen: law enforcement would “conduct simultaneous raids on major exchanges and the homes and offices of major ICO promoters, with regulators from different countries coordinating actions.” It’s hard to say if this is happening now, but if the SEC is going after Coinbase, no one in the Coinbase business is safe.

What now?

The question then turns to what happens next, crypto isn’t going away, and I think the answer is “new exchanges without all this regulatory baggage.” Here are some of my current thoughts:

• There may not be a better time to start a crypto exchange than today, other than 2012. Perhaps for the first time since the birth of Bitcoin , the cost of compliance is lower than the cost of non-compliance. Existing industry giants have a lot of legal technical debt they need to solve, which is distracting and costing them a lot of money.

• Cryptocurrency is not going away. In its fastest-growing markets, particularly in Latin America and Africa, there is neither the political will nor the unified law enforcement capacity to shut it down.

• Letting companies like Coinbase treat crypto tokens as old-fashioned securities is like regulating Starlink in space like we regulate road traffic. Similarly, it is impossible to expect the US government to let crypto develop freely, and the increased lobbying and openness of US crypto giants to compromise will push the United States to take a middle path that will make crypto business more regulated in the next five years (maybe sooner).

• Successful companies will have growth strategies that do not include the US, and then need to be ready to move to the US when regulations become favorable. Or, in other words, they need to develop a subsidiary that operates like INX and obtain the proper regulatory approvals. I suspect that regulations will eventually loosen so that companies like INX can operate like Coinbase and Gemini do today. To achieve scale, startups need to establish a foothold in countries with large English-speaking crypto users, that do not ban ICOs and that allow exchanges to conduct spot cryptocurrency trading without regulating them as broker-dealers or clearing agencies.

• The only G20 country I can think of that meets these criteria is the UK. The UK should be used as a jumping-off point for entering English-speaking African and Indian markets, while US lobbyists make a concerted effort to (potentially) change the US government’s mind about crypto.

So. Crypto isn’t dead, it just needs some legal tweaks, and may the best and most compliant startups win.