When is a cryptocurrency exchange required to become a registered exchange?

The precipitous rise of cryptocurrencies has numerous implications for securities trading, the most fundamental of which is when, and if, any given cryptocurrency exchange is required to become a registered exchange as defined by the SEC.

A cryptocurrency is a digital currency that can be traded and exchanged (Ian King, Investopedia). One defining feature of cryptocurrency is that it is decentralized, meaning it is not issued by a central bank or regulatory agency. Id.This foundational aspect of cryptocurrencies is desirable to investors because unlike traditional fiat currencies that are subject to governmental control and manipulation, cryptocurrencies and their values operate independently from a central authority. (Brian Martucci, Money Crashers). 

Due to the decentralized nature of online cryptocurrency trading, the SEC has consistently warned of the potential for scams and fraud in the crypto exchange marketplace. (Bernard Marr, Forbes). In a recent press release, the SEC cautioned that while many platforms portray themselves as regulated “exchanges,” few of them are actually national securities exchanges regulated by the SEC. (SEC Statement). The SEC further explained that while these digital marketplaces portray themselves as safely regulated, many of them lack the protections and legality of SEC-registered securities exchanges. Id.

A cryptocurrency trading platform is required to become a registered exchange when the platform (1) trades securities and (2) operates as an exchange, unless an exemption applies. (SEC Statement). 

First, the Securities and Exchange Act defines a security, among other things, as a “note, stock, treasury stock, security future, security-based swap, bond, debenture, certificate of interest or participation in any profit-sharing agreement…[or] investment contract”15 U.S.C.A. § 78c (West). In Howey, the Supreme Court articulated the legal standard for what qualifies as a security within the meaning of the Securities and Exchange Act. Securities and Exchange Comm’n v. W.J. Howey Co., 328 U.S. 293, 298–99 (1946). Known today as the “Howey Test,” an instrument qualifies as a security when there is (1) an investment of money (2) in a common enterprise (3) with an expectation of profits (4) that are reliant on a third party. (Peter Van Valkenburgh, Coincenter). 

Second, the SEC defines an exchange as a platform that “constitutes, maintains, or provides a market place or facility for [SB1] bringing together purchasers and sellers of securities.”15 U.S.C.A. § 78c (West). In 1998, the SEC clarified the interpretation of exchange as a recognition of advancing technology in securities trading. (SEC Regulation of Exchanges). The expanded definition of an exchange encompassed any organization or group of people that (1) brings together the orders of buyers and sellers, (2) uses established methods where the orders interact with each other, and (3) allows the buyers and sellers to agree to the terms of the trade. (SEC Regulation of Exchanges).

If a cryptocurrency satisfies the definition of a security and the platform qualifies as an exchange, the platform is required to register with the SEC unless it is exempt from registration as an Alternative Trading System (“ATS”).(SEC Statement). These systems are trading platforms that meet the definition of an exchange but are not required to register as a national exchange. (SEC ATS List). To comply with ATS regulations, the trading platform must register as a broker-dealer and file an initial operation report with the SEC. (SEC ATS List). This filing must be reviewed and approved by the SEC before commencing trading operations. Id.

Questions about what types of cryptocurrencies and their platforms qualify as securities and exchanges will undoubtedly persist as the popularity of cryptocurrencies grows. The markets and cryptocurrencies themselves are still relatively young. The SEC will likely continue to focus on strengthening its review and regulatory processes of the currencies if the burgeoning digital marketplace is to become legitimate.