What can the EtherDelta settlement tell us about how decentralized exchanges are regulated?

Exchanges that trade securities are subject to stricter rules than those that do not

The SEC has charged and settled with Zachary Coburn for operating an unregistered securities exchange, EtherDelta, in violation of Section 5 of the Exchange Act. This may come to a surprise to folks in the crypto community who assumed that services like EtherDelta would somehow be free of any obligation to register as exchanges by virtue of the fact that they are “decentralized.” In the interest of clarity, here are some important facts to know about how various laws may or may not apply to decentralized exchanges.

Firstly, exchanges trading only cryptocurrencies that are not securities are regulated differently (and by different regulators) than those trading tokens that qualify as securities:

  1. Cryptocurrency exchanges are generally regulated as money transmitters by state licensing authorities and must register as “money service businesses” with federal financial crimes authorities (FinCEN).
  2. Exchanges trading tokens that qualify as securities are regulated as securities exchanges by the SEC.

Second, the definitions that trigger these regulations are very different from each other. The definition of “exchange” under the securities laws is broadly drafted and focuses on persons performing these activities: “maintain[ing], or provid[ing] a market place or facilities for bringing together purchasers and sellers of securities.”

The definition of a money transmitter varies state by state but is typically narrower and generally similar to the federal definition of money services business. That definition focuses on persons performing these activities: “the acceptance of currency, funds, or other value that substitutes for currency from one person and the transmission of currency, funds, or other value that substitutes for currency to another location or person by any means.”

Decentralized exchanges, if they do anything substantially different from typical exchanges, generally obviate the need to trust an intermediary with custody of coins or tokens. Accordingly a decentralized exchange will generally not “accept and transmit,” so they will generally not fit the definition of money services business. But a decentralized exchange may be maintaining or providing a marketplace for bringing together purchasers and sellers of securities, assuming that any of the tokens they trade fit the relevant definitions of securities.

Whether any decentralized exchange is “maintaining” or “providing” these services would be in general harder to prove if the “exchange” was truly nothing more than software on the Ethereum blockchain (what we could call fully decentralized), but it would be easier to prove if the decentralized exchange’s administrator was actively maintaining data outside of the blockchain that was essential to facilitate trades, such as an order book. In the SEC’s Cease and Desist order, they note that EtherDelta orders “reside[] on a centralized server maintained by EtherDelta and not on the Ethereum Blockchain.” It’s unclear whether this fact is essential to classification as a securities exchange but it is worth noting that the distinction was carefully made by the SEC in this administrative proceeding.

The different definitional focus between “money services business” and “securities exchange,” is why being “decentralized” may mean that you are not regulated under certain laws (e.g. money transmission licensing requirements and the Bank Secrecy Act) but may not, nonetheless, mean that you are not regulated under the Exchange Act if you trade tokens that are securities.

EtherDelta clearly did (and still does) trade tokens that are understood by the SEC to be securities. They make markets in hundreds of tokens including tokens like Centra that have already been the subject of SEC enforcement actions for unregistered securities issuance.

Other decentralized (and centralized) cryptocurrency exchanges limit the tokens they trade to those that do not seem to be securities. This is a tricky area because while the SEC has articulated a principles-based approach indicating that many tokens and cryptocurrencies are not securities, they’ve only come out and specifically stated that two, (Bitcoin and Ether) definitively are not. So it is up to the administrators of an exchange to make those determinations carefully and reasonably, so as to not end up on the wrong side of an SEC enforcement action.

And again, the token-by-token securities inquiry is entirely separate from the question of whether the exchange is or is not an MSB or money transmitter. The MSB question depends on custody—something a well-specified DEX will not have.