Cryptocurrency trading hubs may look to stock exchanges as their business models of the future.
Wall Street's chief regulator recently provided a glimpse into its vision for the future of cryptocurrency exchanges, warning investors March 7 that many digital currency exchanges were operating illegally.
The statement, issued by the SEC's Divisions of Enforcement and Trading and Markets, spelled out guidance that cryptocurrency exchanges need to be registered as national securities exchanges or alternative trading systems, otherwise known as ATS. By doing so, the digital currency trading hubs could be regulated no differently than the New York Stock Exchange, Nasdaq Inc. or certain divisions of Barclays Plc.
"The SEC views this as a wake-up call in that the exchanges will get regulated," Greenwich Associates analyst Richard Johnson said in an interview. "I think, in general, [the exchanges] want to get regulated."
Cryptocurrency markets have been called "the wild, wild west," as concerns have mounted around digital currencies' volatility, hacking threats and scam offerings. As a result, U.S. regulators have worked for months to crack down on everything from fraudulent ICOs to fake websites and social media accounts for digital currencies. But the cryptocurrency regulatory landscape has largely remained unsteady.
The March 7 warning is not the first time that the SEC has hinted that cryptocurrency exchanges may need to be registered with the agency.
In July 2017, the SEC issued a report around the hack of the Decentralized Autonomous Organization in which it stated that if a company meets the definition of an exchange — meaning it brings security orders between buyers and sellers together and uses nondiscretionary methods through which the orders interact and trade — then it "must register" as an exchange, unless it is registered as an ATS or under similar exemptions.
If the SEC were to mandate that cryptocurrency trading platforms register, they could be opened up to additional regulatory scrutiny. But by doing so, crypto exchanges could gain seats at the table to help craft regulations overseeing their markets.
Cryptocurrency trading venues may look to the ATS model as a means of complying with federal securities laws without having to register as a national securities exchange. As of Feb. 28, there were more than 80 ATSs on file with the SEC, including venues operated by Barclays, UBS Securities LLC and J.P. Morgan Securities LLC.
To become an ATS, cryptocurrency exchanges would first need to register as broker/dealers, which would place them also under the purview of the Financial Industry Regulatory Authority. Under FINRA's watch, a cryptocurrency exchange operating as a licensed ATS would have to do everything from making sure investments are suitable to regulating traders cashing in on insider information, Nixon Peabody Partner Dan McAvoy said in an interview.
Overstock.com Inc.-subsidiary tZERO, the cryptocurrency company behind the tZERO token, operates PROSecurities LLC, which the company says is the first ATS regulated by the SEC and FINRA to support secondary crypto security trading.
The appeal of an ATS would be that it is a simpler process compared to becoming a full-on exchange. The most recently approved national securities exchange, IEX Group, Inc., had to endure a nearly two-year battle rife with comment letters, public scrutiny and regulatory inquiries to gain the SEC's approval.
"Most firms will choose to go the ATS route because it's simpler," Greenwich's Johnson said. "But there's also a much higher level of cachet involved if you're an exchange."
The exchange model could be particularly enticing for larger and more established cryptocurrency exchanges such as tZERO or Coinbase Inc.
While they could go through the SEC's lengthy approval process to reach that status, it is possible that cryptocurrency trading companies may also be drawn to acquiring Chicago Stock Exchange Inc., the smallest U.S. equity exchange operator, Johnson said.
By acquiring the Chicago Stock Exchange, a cryptocurrency exchange would already have access to an exchange license and could carve out a niche trading mechanism in the increasingly competitive equity market space. Bloomberg News reported March 7 that tZERO had approached the Chicago-based bourse about a potential acquisition.
Regulators across the U.S. financial framework remain somewhat divided on how cryptocurrency markets ought to be monitored.
U.S. Commodity Futures Trading Commission Commissioner Brian Quintenz has called for independent self-regulating bodies in the space. Organizations representing the industry's needs could "significantly contribute" to efforts to formalize regulation in the cryptocurrency space, Quintenz said at a March 7 conference presentation.
A collective of 16 Japanese government-registered cryptocurrency exchanges reportedly are already drawing plans to create such an organization in their home country, according to a Reuters report, which cited unnamed sources. Details regarding the organization's registration and powers were not immediately available, the report said.
Industry experts see the SEC's latest statement as a push for cryptocurrency exchanges to begin to think about their next step as regulation around digital currencies continues to evolve.
"At the end of the day, proactive communication [with regulators] may result in less speed bumps down the road for many market participants," Goodwin Law counsel Nick Losurdo said in an interview.
A spokesperson from the SEC did not respond to a request for comment.
